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Chapter 18 Option Overwriting

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					    Chapter 18
Option Overwriting

    Business 4179
                       Key Points
• Writing of covered calls is an extremely important strategy that
  should be understood by everyone involved in the market.
• Writing puts is less common but is very appropriate for many
  investors.
• Many portfolio managers prefer index options to individual
  equity options. Margin considerations make this activity
  potentially involved, but also potentially very rich.
• Options can also be written to buy stock at a price lower than
  the currently prevailing price, or to sell stock at a higher than
  current price. In both cases the difference stems from time
  value of money implications.
                 Question 18 - 1

• Declining prices make put overwriting dangerous.
  Precipitous declines can be disastrous to put writers, as
  some people discovered during the crash of 1987.
                 Question 18 - 2

• The tradeoff is simple: the lower the striking price of a
  call, the higher its premium, but the greater the likelihood
  of it being exercised. An option writer would earn more
  premium by writing the APR 70, but would also have a
  higher risk of exercise.
                Question 18 - 3

• An in-the-money put stands a greater chance of exercise
  than an out-of-the-money put. The stock price must
  advance further with an in-the-money put before it ceases
  to have intrinsic value.
                Question 18 - 4

• Covered calls can be used in any portfolio that contains
  common stock. Writing covered calls is attractive during
  periods of declining market prices or when market prices
  are flat.
                Question 18 - 5

• The portfolio manager need not worry about individual
  equity positions being called away if index options are
  written. Also, the manager does not need to keep track of
  many different positions; it is much easier to follow a
  single index such as the S&P 100.
                 Question 18 - 6

• This would be very reasonable and is often done. Both
  writing calls and buying puts are bearish strategies, and
  there is no reason they cannot be done simultaneously.
                Question 18 - 7

• With covered calls, the maximum loss is known and
  limited. With naked calls, however, potential losses are
  theoretically unlimited. An unlimited loss would put the
  charitable organization out of business.
                Question 18 - 9

• As stated in the text, the term “short put” is somewhat
  ambiguous. For margin purposes, a put is covered if the
  put writer has a deposit cash or cash equivalent whose
  market value equals 100% of the strike price.
                Question 18 - 10

• This makes sense to me.
• If the short put is exercised, the put writer must buy shares,
  conceivably at a loss. But the short put position would
  hedge this loss entirely. The shares purchased could
  immediately be delivered against the short position.
               Question 18 - 11

• With a fiduciary put, the exercise price is escrowed. In the
  event of exercise, the put writer already has the funds to
  buy the stock. Non-fiduciary puts do not offer this
  protection.
               Question 18 - 12

• You cannot say that writing index puts is always preferable
  to writing individual equity calls. Sometimes company-
  specific events make it appropriate to writer individual
  equity calls, sometimes a portfolio is too small to permit
  the writing of even a single covered index call, and
  sometimes regulatory policy precludes the use of index
  options.
               Question 18 - 14

• If the plan is to buy stock the option writer wants a high
  likelihood that the options will be exercised. The more the
  option is in-the-money, the greater the likelihood of
  exercise. So presumably the in-the-money put is preferred.
              Question 18 - 15

• At expiration someone holds the valuable put. Whoever
  holds it when the music stops is going to exercise it.
  Otherwise they would be throwing money away.
     Problem 18 - 1


9

     61

          70

61


                      42
                Problem 18 - 2

Gain on stock: 40 × ( 77 3/8 - 70) = $2,950

Options expire worthless:
  gain = 2 × 2 1/2 × 100 = $500

Total gain = $3,450
         Problem 18 - 3


 6 1/8



                   80
          73 7/8
73 7/8


                          42
      Problem 18 - 4


      5



                   65
          62 1/2


125
                        42
                  Problem 18 - 5
A.   You paid $27,000; income received was $3,000, and
     the capital gain was also $3,000. Therefore,
               30,000  27,000  3,000
       HPR                             22.2%
                       27,000


              3,000        30,000
B.                                    27 ,000  0
            (1  R ) 60
                          (1  R ) 78




     This gives a daily R of 0.00263. To annualize, multiply
     by 365:
       .00263 × 365 = 96.0%
                  Problem 18 - 6
A.
                                    $10 million
     Maximum number of calls                      316 contracts
                                   $100  315 .66
     316 contracts  $1 1  100  $35,550
                         8

B.    .15 × 315.66 × 100 × N                    =      4734.9 N
     Plus
     N × 1 1/8 × 100                            =        112.5 N
     Minus
     (320.00 - 315.66) × 100 × N                =      (434.0) N
     TOTAL                                             4413.4 N
             Problem 18 - 6 ...

C.   59% of cash level: 2265 × .50 = 1132
                Problem 18 - 7

You received 50 × 1 1/8 × 100 = 5625

At expiration you must pay:
     (320.00 - 334.96) × 50 × 100 = $74,800
           Problem 18 - 8

  25 3/4
  20 3/4


                      120   125
            109 5/8


219 1/4
                                  42
                Problem 18 - 9
• Presumably the stock will be used for collateral in a
  margin account. Stock counts half the value of cash for
  margin purposes. You can then solve for N, the maximum
  number of contracts that can be written.

N{[626.01×15% × 100] - [(626.01 - 600) × 100] + [37.50 ×
  100]} = .5 × $5 million

N = 237 contracts
237 contracts × $37.50 × 100 = $88,750
               Problem 18 - 10
• The market rose by (660 - 626.01)/626.01 = 5.43%

• The portfolio should rise by 1.15 × 5.43% = 6.24%, or
  $124,800

  Gain on the 650 calls: 2 × 100 × ($27.5 - 10) =    3,500
  Gain on the 600 puts: 2 × 100 × (22.5 - 0) =       4,500
  Total                                           $132,800
               Problem 18 - 11


N{[626.01 × 15% × 100] - [(626.01 - 610) × 100] + [23.50 ×
  100]} = .5 × $5 million

N = 246 contracts
246 contracts × $23.50 × 100 = $578,100
               Problem 18 - 12


N{[626.01 × 15% × 100] - [(680 - 626.01) × 100] + [7 ×
  100]} = .5 × $5 million

N = 532 contracts
532 contracts × $7.00 × 100 = $372,400

				
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