Chapter 3

Basic Option
Strategies: Covered
Calls and Protective
Puts

1 © 2004 South-Western Publishing

 Outline
 Using options as a hedge
 Using options to generate income
 Profit and loss diagrams with seasoned
stock positions
 Improving on the market

2
 Using Options as A Hedge
 Introduction
 Protective puts
 Using calls to hedge a short position
 Writing covered calls to protect against
market downturns

3
 Introduction
 Hedgers transfer unwanted risk to
speculators who are willing to bear it
– E.g., insuring a home

 Insurance that expires without a claim does

not constitute a waste of money

4
 Protective Puts
 Definition
 Microsoft example
 Logic behind the protective put
 Synthetic options

5
 Definition
 A protective put is a descriptive term given
to a long stock position combined with a
long put position
– Investors may anticipate a decline in the value
of an investment but cannot conveniently sell

6
 Microsoft Example
 Assume you purchased Microsoft for $28.51
Profit or loss ($)

0
Stock price at
28.51
option expiration

28.51

7
 Microsoft Example (cont’d)
 Assume you purchased a Microsoft APR 25 put for
$1.10

23.90

23.90 25
0
Stock price at
option expiration
1.10

8
 Microsoft Example (cont’d)
 Construct a profit and loss worksheet to form the
protective put:
Stock Price at Option Expiration

0 5 15 25 30 40

Long stock -28.51 -23.51 -13.51 -3.51 1.49 11.49

@ $28.51
Long $25 put 23.90 18.90 8.90 -1.10 -1.10 -1.10

@ $1.10
Net -4.61 -4.61 -4.61 -4.61 0.39 10.39
9
 Microsoft Example (cont’d)
 The worksheet shows that
– The maximum loss is $4.61
– The maximum loss occurs at all stock prices of
$25 or below
– The put breaks even somewhere between $25
and $30 (it is exactly $29.61)
– The maximum gain is unlimited

10
 Microsoft Example (cont’d)
 Protective put

25
0
Stock price at
29.61
option expiration

4.61

11
 Logic Behind the Protective Put
 A protective put is like an insurance policy
– You can choose how much protection you want

 The put premium is what you pay to make

large losses impossible
– The striking price puts a lower limit on your
maximum possible loss
 Like the deductible in car insurance
– The more protection you want, the higher the
premium you are going to pay
12
 Logic Behind the Protective Put
(cont’d)
Insurance Policy Put Option

Premium Time Premium

Value of Asset Price of Stock
Face Value Strike Price
Deductible Stock Price Less
Strike Price
Duration Time Until Expiration
Likelihood of Loss Volatility of Stock

13
 Synthetic Options
 The term synthetic option describes a
collection of financial instruments that are
equivalent to an option position
– A protective put is an example of a synthetic call

14
 Using Calls to Hedge A Short
Position
 Introduction
 Short sale
 Microsoft example

15
 Introduction
 Call options can be used to provide a hedge
against losses resulting from rising security
prices

 Call options are particularly useful in short

sales

16
 Short Sale
 Investors can make a short sale
– The opening transaction is a sale
– The closing transaction is a purchase
 Short sellers borrow shares from their
brokers
 Closing out a short position is called
covering the short position

17
 Short Sale (cont’d)
 A short sale is like buying a put

 Many investors prefer the put

– The loss is limited to the option premium
– Buying a put requires less capital than margin
requirements

18
 Microsoft Example
 Assume you short sold Microsoft for $28.51
Profit or loss ($)

28.51
Stock price at
option expiration
0
28.51

Maximum loss = unlimited

19
 Microsoft Example (cont’d)
 Combining a short stock with a long call
results in a long put
– Assume the purchase of an APR 35 call at $0.50
in addition to the short sale
– The potential for unlimited losses is eliminated

20
 Microsoft Example (cont’d)
 Construct a profit and loss worksheet to form the
long put:
Stock Price at Option Expiration

0 15 25 28.51 35 40

Short stock 28.51 13.51 3.51 0 -6.49 -11.49

@ $28.51
Long 35 call -0.50 -0.50 -0.50 -0.50 -0.50 4.50

@ $0.50
Net 28.01 13.01 3.01 -0.50 -6.99 -6.99
21
 Microsoft Example (cont’d)
 Long put (short stock plus long call)

28.01

35
0
Stock price at
28.01
option expiration
6.99
The potential for
unlimited loss is gone
22
 Writing Covered Calls to Protect
Against Market Downturns
 A call where the investor owns the stock
and writes a call against it is called a
covered call
– The call premium cushions the loss
– Useful for investors anticipating a drop in the
market but unwilling to sell the shares now

23
 Writing Covered Calls to Protect
Against Market Downturns
 A JAN 30 covered call on Microsoft @ $1.20; buy
stock @ 28.51

2.69

0
30 Stock price at
27.31 option expiration
27.31

24
 Using Options to Generate
Income
 Writing calls to generate income
 Writing naked calls
 Naked vs. covered puts
 Put overwriting
 Microsoft example

25
 Writing Calls to Generate
Income
 Can be very conservative or very risky,
depending on the remainder of the portfolio
 An attractive way to generate income with
foundations, pension funds, and other
portfolios
 A very popular activity with individual
investors

26
 Writing Calls to Generate
Income (cont’d)
 Writing calls may not be appropriate when
– Option premiums are very low
– The option is very long-term

27
 Writing Calls to Generate
Income (cont’d)

Writing a Microsoft Call Example

It is now September 15, 2003. A year ago, you

bought 300 shares of Microsoft at $22. Your broker
suggests writing three JAN 30 calls @ $1.20, or
$120.00 on 100 shares.

28
 Writing Calls to Generate
Income (cont’d)

Writing a Microsoft Call Example (cont’d)

If prices advance above the striking price of $30,

your stock will be called away and you must sell it
to the owner of the call option for $30 per share,
despite the current stock price.

If Microsoft trades for $30, you will have made a

good profit, since the stock price has risen
substantially. Additionally, you retain the option
premium.
29
 Writing Naked Calls
 Very risky due to the potential for unlimited
losses

30
 Writing Naked Calls(cont’d)

Writing a Naked Microsoft Call Example

The following information is available:

 It is now September 15
 A SEP 35 MSFT call exists with a premium of $0.05
 The SEP 35 MSFT call expires on September 19
 Microsoft currently trades at $28.51
31
 Writing Naked Calls(cont’d)

Writing a Naked Microsoft Call Example

(cont’d)

A brokerage firm feels it is extremely unlikely that

MSFT stock will rise to $35 per share in ten days.
The firm decides to write 100 SEP 35 calls. The firm
receives $0.05 x 10,000 = $500 now. If the stock
price stays below $35, nothing else happens. If the
stock were to rise dramatically, the firm could
sustain a large loss.
32
 Naked vs. Covered Puts
 A naked put means a short put by itself

 A covered put means the combination of a

short put and a short stock position

33
 Naked vs. Covered Puts (cont’d)
 A special short put is a fiduciary put
– Refers to the situation in which someone writes
a put option and simultaneously deposits the
striking price into a special escrow account
– Ensures that the funds are present to buy the
stock if the put owner exercises it

34
 Naked vs. Covered Puts (cont’d)
 A short stock position would cushion
losses from a short put:

Short stock + short put  short call

35
 Put Overwriting
 Put overwriting involves owning shares of
stock and simultaneously writing put
options against these shares
– Both positions are bullish
– Appropriate for a portfolio manager who needs
to generate additional income but does not want
to write calls for fear of opportunity losses in a
bull market

36
 Microsoft Example
 An investor simultaneously:
– Buys shares of MSFT at $28.51
– Writes an OCT 30 MSFT put for $2

37
 Microsoft Example (cont’d)
 Construct a profit and loss worksheet for put
overwriting:
Stock Price at Option Expiration

0 15 25 28.255 30 35

Buy stock -28.51 -13.51 -3.51 -0.255 1.49 6.49

@ $28.51
Write 30 put -28.00 -13.00 -3.00 0.255 2.00 2.00

@ $2
Net -56.51 -26.51 -6.51 0.00 3.49 8.49

38
 Microsoft Example (cont’d)
 Writing an OCT 30 put on MSFT @ $2; buy stock @
$28.51

3.49 Stock price at

option expiration
0
30

56.51 Breakeven point = 28.255

39
 Profit and Loss Diagrams With
Seasoned Stock Positions
 Adding a put to an existing stock position
 Writing a call against an existing stock
position

40
 Adding A Put to an Existing
Stock Position
 Assume an investor
– Bought MSFT @ $22
– Buys an APR 25 MSFT put @ $1.10

 The stock price is currently $28.51

41
 Adding A Put to an Existing
Stock Position (cont’d)

Stock Price at Option Expiration

0 10 25 30 35 40

Long stock -22 -12 +3 +8 +13 +18

@ $22

Long 25 put +23.90 +13.90 -1.10 -1.10 -1.10 -1.10

@ $1.10

Net 1.90 1.90 1.90 6.90 11.90 16.90

42
 Adding A Put to an Existing
Stock Position (cont’d)
 Protective put with a seasoned position

1.90
0
25 Stock price at
option expiration

43
 Writing A Call Against an
Existing Stock Position
 Assume an investor
– Bought MSFT @ $22
– Writes a JAN 30 call @ $1.20

 The stock price is currently $28.51

44
 Writing A Call Against an
Existing Stock Position (cont’d)
 Covered call with a seasoned equity
position
9.20

0
30 Stock price at
20.80
option expiration
20.80

45
 Improving on the Market
 Writing calls to improve on the market
– Investors owning stock may be able to increase
the amount they receive from the sale of their
stock by writing deep-in-the-money calls against
their stock position

46
 Writing Calls to Improve on the
Market (cont’d)

Writing Deep-in-the-Money Microsoft Calls Example

Assume an institution holds 10,000 shares of MSFT. The

current market price is $28.51. OCT 20 call options are
available @ $8.62.

The institution could sell the stock outright for a total of

$285,100. Alternatively, the portfolio manager could write 100
OCT 20 calls on MSFT, resulting in total premium of $86,200.
If the calls are exercised on expiration Friday, the institution
would have to sell MSFT stock for a total of $200,000. Thus,
the total received by writing the calls is $286,200, $1,100
47 more than selling the stock outright.
 Writing Calls to Improve on the
Market (cont’d)
 There is risk associated with writing deep-
in-the-money calls
– It is possible that Microsoft could fall below the
striking price
– It may not be possible to actually trade the
options listed in the financial pages

48
 Writing Puts to Improve on the
Market
 Writing puts to improve on the market
– An institution could write deep-in-the-money
puts when it wishes to buy stock to reduce the
purchase price

49