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					   Chapter 18

Option Overwriting




                     1
What’s a good way to raise the blood pressure of an
 Investor Relations Manager? Answer: Talk about
         the pros and cons of stock options.

                            - Eilene H. Kirrane



                                                  2
                 Outline
 Introduction
 Using  options to generate income
 Combined hedging/income generation
  strategies
 Multiple portfolio managers




                                       3
               Introduction
 Option overwriting refers to creating and
 selling stock options in conjunction with a
 stock portfolio

 Motives   for overwriting:
  • To generate additional portfolio income
  • To purchase or sell stock at a better-than-
    market price

                                                  4
            Using Options to
            Generate Income
 Writing calls to generate income
 Writing puts to generate income
 Writing index options
 A comparative example




                                     5
            Writing Calls to
            Generate Income
 Writing covered calls
 Writing naked calls




                               6
      Writing Covered Calls
 Writing   covered calls:
  • Occurs when the investor writes options against
    stock he already owns
  • Is the most common use of stock options by
    both individual and institutional investors
  • Has a profit or loss determined by the long
    position and the short position


                                                  7
Writing Covered Calls (cont’d)
 Covered  call writing is very popular with
  foundations, pension funds, and other
  portfolios that need to produce periodic
  cash flows

 In relatively stable or slightly declining
  markets, covered call writing can enhance
  investment returns
                                               8
Writing Covered Calls (cont’d)
                        Example

Nile.com stock currently trades for $116 per share. Call
options with a striking price of $120 and a $6 premium
are available for Nile.com.

Construct a worksheet and a profit and loss diagram to
determine the profit or loss associated with writing a
covered call for Nile.com. Assume the investor purchases
the stock for $116. Use a range for the stock price at
option expiration from $0 to $150.
                                                           9
Writing Covered Calls (cont’d)
                   Example (cont’d)

Solution: A possible worksheet is shown below:
             Stock Price at Option Expiration
               0    50     100 116      120      125   150
Long stock   -116 -66 -16          0     +4      +9    +34
Short call    +6     +6    +6    +6     +6       +1    -24
Total        -110    -60   -10   +6     +10      +10   +10
                                                        10
 Writing Covered Calls (cont’d)
               Example (cont’d)
Maximum gain


         $10
          $0
                    $120


       -$110
Maximum loss
                                  11
        Writing Naked Calls
 Writing   naked calls:
  • Involves writing an option without owning the
    underlying stock
  • Has a potentially unlimited loss
     – Especially if the writer must buy the shares in the
       market
  • Is used by institutional heavyweights to make
    money for their firm

                                                             12
 Writing Naked Calls (cont’d)
 Naked  call writing is not often used by
  individual investors
  • Brokerage houses may enforce high minimum
    account balances


 Fiduciaries should be extremely careful
  about writing naked calls for a client

                                                13
          Writing Puts to
          Generate Income
 Fiduciaryputs
 Put overwriting




                            14
             Fiduciary Puts
A   fiduciary put is a covered (short) put
  • The writer of a fiduciary put must depot the
    striking price of the option in an interest-
    bearing account or hold the necessary cash
    equivalents


 The commission costs of fiduciary puts may
 be lower than writing covered calls
                                                   15
       Fiduciary Puts (cont’d)
                        Example

February put options on Nile.com are available with an
exercise price of $120 and an option premium of $7.25.

Construct a profit and loss diagram for a fiduciary put,
showing the maximum gain and maximum loss.



                                                           16
       Fiduciary Puts (cont’d)
                 Example (cont’d)
Maximum gain


         $7.25
            $0
                      $120


      -$112.75
Maximum loss
                                    17
            Put Overwriting
 Put   overwriting:
  • Involves owning shares of stock and writing put
    options against them
  • Is a bullish strategy
     – Both owning shares and writing puts are bullish
       strategies
  • May be appropriate for portfolio managers who
    don’t want to write calls for fear of opportunity
    losses

                                                         18
      Put Overwriting (cont’d)
                       Example

An investor buys Nile.com stock for $116 per share.
Simultaneously, the investor writes a Nile.com FEB 115
put with an option premium of $4.25 per share.

Construct a worksheet and a profit and loss diagram to
determine the profit or loss associated with put
overwriting. Use a range for the stock price at option
expiration from $0 to $150.

                                                         19
        Put Overwriting (cont’d)
                 Example (cont’d)

Solution: A possible worksheet is shown below:
           Stock Price at Option Expiration
                  0        75    115     116      150
Long stock      -116      -41     -1      0       +34
Short put      -110.75 -35.75 +4.25     +4.25    +4.25
Total          -226.75 -76.75 +3.25     +4.25    +38.35
                                                          20
     Put Overwriting (cont’d)
                Example (cont’d)
                                   Maximum gain
                                    is unlimited



          $0
                     $115


     -$226.75
Maximum loss
                                             21
      Writing Index Options
 Introduction
 Margin   considerations in writing index call
  options
 Using a cash account
 Using a margin account
 The risk of index calls
 What is best?
                                                  22
               Introduction
 Index   options:
  • Are one of the most successful innovations of
    all time

  • Include the S&P 100 and S&P 500 index
    options

  • Have little unsystematic risk
                                                    23
  Margin Considerations in
  Writing Index Call Options
 Using a margin account does not
  necessarily involve borrowing

 Charitablefunds or fiduciary accounts use
  margin accounts to provide the fund
  manager with added flexibility


                                              24
         Using A Cash Account
   A portfolio manager can use a cash account to
    write index options:
    • If a custodian bank issues an OCC index option escrow
      receipt to the broker
    • If the bank certifies that it holds collateral sufficient to
      cover the writing of index calls and
    • If the writer can provide the necessary collateral by the
      deposit of cash, cash equivalents, marginable stock, or
      any combination of these

                                                                 25
       Using A Margin Account
   The required funds in a margin account to write
    index calls:
    • Equal the market value of the options plus 15% of the
      index value times the index multiplier less any out-of-
      the-money amount and

    • Are subject to a minimum amount equal to the market
      value of the options plus 10% of the market value of the
      index times the index multiplier

                                                                26
  Forms of Margin
(Margin Equivalents)




                       27
        The Risk of Index Calls
 The risk of writing index calls is that the
 index will rise above the chosen exercise
 price

 The   lower the striking price:
  • The more income the portfolio receives
  • The higher is the likelihood that the option ends
    up in the money

                                                   28
             The Risk of
         Index Calls (cont’d)
     settlement procedures for in-the-
 Cash
 money index options:
  • Involve the transfer of cash rather than
    securities

  • The writer owes the call holder the intrinsic
    value of the call at option expiration


                                                    29
              The Risk of
          Index Calls (cont’d)
                       Example

A portfolio manager wrote 90 FEB 690 OEX calls. On the
expiration date, the S&P 100 index is at 693.00.

What is the amount the portfolio manager must pay to the
holder of the OEX options?



                                                      30
              The Risk of
          Index Calls (cont’d)
                       Example

Solution: The manager must pay $27,000:

    (693.00 – 690.00) x $100 x 90 contracts = $27,000




                                                        31
               What Is Best?
 Advantages  of writing index options over
 writing calls on portfolio components:
  •   They require only a single option position
  •   They vastly reduce aggregate commission costs
  •   They carry much less unsystematic risk
  •   There is less disruption of the portfolio when
      calls expire in-the-money and are exercised

                                                   32
     A Comparative Example
 Setup
 Covered  equity call writing
 Covered index call writing
 Writing fiduciary puts
 Put overwriting
 Risk/return comparisons


                                 33
                    Setup
 Consider   three market scenarios:
  • An advance of 5%
  • No change
  • A decline of 5%


 We are managing a portfolio of five stocks
 (see next slide)
                                               34
35
 Covered Equity Call Writing
 Individual call options are written against
  each of the five securities in the portfolio

 The  following slide shows the manager’s
  selection of options and the resulting
  performance


                                                 36
37
         Covered Equity
       Call Writing (cont’d)
 Observations:
  • The portfolio makes money in each of the
    scenarios
  • The portfolio makes the most money when the
    market advances
     – The portfolio would lose all five securities
  • ARC and IP are called away when the market
    remains unchanged
                                                      38
  Covered Index Call Writing
 Covered   index calls are written

 The following slide shows the manager’s
 selection and performance




                                            39
40
          Covered Index
       Call Writing (cont’d)
 Observations:
  • The greatest gain occurs when the market
    advances 5%

  • The manager does not have to sell any stocks
    because of cash settlement



                                                   41
        Writing Fiduciary Puts
 Index put options are written in anticipation
 of the underlying stock rising in value

 The following slide shows the selection of
 puts and the resulting performance



                                               42
43
          Put Overwriting
 Putoverwriting is the most aggressive
 strategy

 The following slide shows the selection of
 puts and the resulting performance



                                               44
45
   Risk/Return Comparisons
 Putoverwriting has the largest potential
 losses and gains

 Writingcovered equity calls is not always
 superior to writing covered index calls



                                              46
   Risk/Return
Comparisons (cont’d)




                       47
   Combined Hedging/Income
     Generation Strategies
 Writing  calls to improve on the market
 Writing puts to acquire stock
 Writing covered calls for downside
  protection




                                            48
        Writing Calls to
     Improve on the Market
 Appropriate   for someone who wants to sell
  shares of a stock but has no immediate need
  for the money
 Income can be increased by writing deep-
  in-the money calls
  • The writer attempts to improve on the market
  • The expectation is that the calls will be
    exercised
                                                   49
   Writing Calls to Improve on
      the Market (cont’d)
                         Example

Nile.com stock currently sells for $116 per share. An
institution holds 1,000 shares and would like to sell the
stock. JAN 100 calls on Nile.com are available for $18 per
share.

If the stock price on the expiration is $120, what would be
the cash receipts to the institution if it writes 10 calls and
sells the stock in January? What would be the cash
receipts if it sold the stock today?
                                                             50
   Writing Calls to Improve on
      the Market (cont’d)
                    Example (cont’d)

Solution: If the institution sells the shares immediately, it
would receive $116,000 (1,000 shares x $116).

If it wrote 10 calls, it would receive $118,000 in January:
                        Option premium:
                   $18 x 100 x 10 = $18,000

          Stock sale when options are exercised:
              $100 x 1,000 shares = $100,000                    51
 Writing Puts to Acquire Stock
 Involves   writing in-the-money put options

A manager can improve on the market by
 purchasing the stock when the put options
 are exercised



                                                52
           Writing Puts to
        Acquire Stock (cont’d)
                        Example

You want to buy 500 shares of Western Oil, which
currently trades at $66.75 per share. January 70 puts sells
for $5.

What is the cost of acquiring the shares now? What is the
cost of acquiring the shares if you write 5 WO JAN 70
puts and the options are in-the-money on the expiration
day?
                                                          53
           Writing Puts to
        Acquire Stock (cont’d)
                        Example

Solution: Outright purchase of the shares now would cost
$33,375 (500 shares x $66.75).

If you write 5 puts, you would pay $32,500 for the shares:
                Option premium received:
                    5 x 100 x $5 = $2,500
    Amount paid for shares when options are exercised:
                  5 x 100 x $70 = $35,000
                                                         54
        Writing Covered Calls
       for Downside Protection
   Appropriate for an investor who:
    • Owns shares of stock
    • Suspects the market will turn down in the near future
    • Does not want to sell the shares at the moment


   Provides some downside protection, but
    alternatives are:
    • Buying puts
    • Using portfolio insurance

                                                              55
  Multiple Portfolio Managers
 Separate  responsibilities
 Distinction between option overwriting and
  portfolio splitting
 Integrating options and equity management




                                           56
    Separate Responsibilities
 Assume:
  • A stock portfolio is assembled by a manager for
    a client
  • The stock portfolio is used by a different
    manager for writing covered options


 Management of the stock portfolio is the
 most important concern
                                                 57
      Option Overwriting
    Versus Portfolio Splitting
 Portfolio  splitting means managing a
  portfolio in accordance with more than one
  objective
  • E.g., half is growth of income, half is capital
    appreciation
 Option  overwriting seeks to generate
  additional profits for the fund through the
  receipt of option premiums
                                                      58
      Integrating Options
    and Equity Management
 Hedging  company-specific risk
 Unity of command




                                   59
            Hedging
       Company-Specific Risk
 To  hedge a company-specific risk of a
  particular firm in a portfolio use individual
  equity options
 To hedge industry risk, employ options on
  an industry index
 To hedge the entire portfolio, use index
  options

                                                  60
          Unity of Command
 Indexoptions increase the feasibility of
 using a single portfolio manager for both
 equity and option positions
  • Index options do not require the transfer of
    securities
  • The time requirement to overwrite with index
    options is minimal
  • The manager who has the flexibility of index
    options can exercise more creativity
                                                   61

				
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posted:10/14/2011
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