94 Part II: Call Option Strategies
The selection of which call to write should be made on acomparison of avail
able returns and downside protection. One can sometimes write part of his position
out-of-the-money and the other part in-the-money to force abalance between return
and protection that might not otherwise exist. Finally, one should not write against an
underlying stock if he is bearish on the stock. The writer should be slightly bullish, or
at least neutral, on the underlying stock.
Follow-up action can be as important as the selection of the initial position
itself. By rolling down if the underlying stock drops, the investor can add downside
protection and current income. If one is unwilling to limit his upside potential too
severely, he may consider rolling down only part of his call writing position. As the
written call expires, the writer should roll forward into amore distant expiration
month if the stock is relatively close to the original striking price. Higher consistent
returns are achieved in this manner, because one is not spending additional stock
commissions by letting the stock be called away. An aggressive follow-up action can
also be taken when the underlying stock rises in price: The writer can roll up to ahigher striking price. This action increases the maximum profit potential but also
exposes the position to loss if the stock should subsequently decline. One would want
to take no follow-up action and let his stock be called if it is above the striking price
and if there are better returns available elsewhere in other securities.
Covered call writing can also be done against convertible securities - bonds or
preferred stocks. These convertibles sometimes offer higher dividend yields and
therefore increase the overall return from covered writing. Also, the use of warrants
or LEAPS in place of the underlying stock may be advantageous in certain circum
stances, because the net investment is lowered while the profit potential remains the
same. Therefore, the overall return could be higher.
Finally, the larger individual stockholder or institutional investor who wants to
achieve acertain price for his stock holdings should operate his covered writing strat
egy under the incremental return concept. This will allow him to realize the full prof
it potential of his underlying stock, up to the target sale price, and to earn additional
positive income from option writing.

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Call Buying
The success of acall buying strategy depends primarily on one'sability to select
stocks that will go up and to time the selection reasonably well. Thus, call buying is
not astrategy in the same sense of the word as most of the other strategies discussed
in this text. Most other strategies are designed to remove some of the exactness of
stock picking, allowing one to be neutral or at least to have some room for error and
still make aprofit. Techniques of call buying are important, though, because it is nec
essary to understand the long side of calls in order to understand more complex
strategies correctly.
Call buying is the simplest form of option investment, and therefore is the most
frequently used option "strategy" by the public investor. The following section out
lines the basic facts that one needs to know to implement an intelligent call buying
program.
WHY BUY?
The main attraction in buying calls is that they provide the speculator with agreat
deal of leverage. One could potentially realize large percentage profits from only amodest rise in price by the underlying stock. Moreover, even though they may be
large percentagewise, the risks cannot exceed afixed dollar amount - the price orig
inally paid for the call. Calls must be paid for in full; they have no margin value and
do not constitute equity for margin purposes. Note: The preceding statements
regarding payment for an option in full do not necessarily apply to LEAPS options,
which were declared marginable in 1999. The following simple example illustrates
how acall purchase might work.
95

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96 Part II: Call Option Strategies
Example: Assume that XYZ is at 48 and the 6-month call, the July 50, is selling for
3. Thus, with an investment of $300, the call buyer may participate, for 6 months, in
amove upward in the price ofXYZ common. IfXYZ should rise in price by 10 points
(just over 20%), the July 50 call will be worth at least $800 and the call buyer would
have a 167% profit on amove in the stock of just over 20%. This is the leverage that
attracts speculators to call buying. At expiration, if XYZ is below 50, the buyer'sloss
is total, but is limited to his initial $300 investment, even if XYZ declines in price sub
stantially. Although this risk is equal to 100% of his initial investment, it is still small
dollarwise. One should nornwlly not invest more than 15% of his risk capital in call
buying, because of the relatively large percentage risks involved.
Some investors participate in call buying on alimited basis to add some upside
potential to their portfolios while keeping the risk to afixed amount. For example, if
an investor normally only purchased low-volatility, conservative stocks because he
wanted to limit his downside risk, he might consider putting asmall percentage of his
cash into calls on more volatile stocks. In this manner, he could "trade" higher-risk
stocks than he might normally do. If these volatile stocks increase in price, the
investor will profit handsomely. However, if they decline substantially - as well they
might, being volatile - the investor has limited his dollar risk by owning the calls
rather than the stock.
Another reason some investors buy calls is to be able to buy stock at areason
able price without missing amarket.
Example: With XYZ at 75, this investor might buy acall on XYZ at 80. He would like
to own XYZ at 80 if it can prove itself capable of rallying and be in-the-money at expi
ration. He would exercise the call in that case. On the other hand, if XYZ declines in
price instead, he has not tied up money in the stock and can lose only an amount
equal to the call premium that he paid, an amount that is generally much less than
the price of the stock itself.
Another approach to call buying is sometimes utilized, also by an investor who
does not want to "miss the market." Suppose an investor knows that, in the near
future, he will have an amount of money large enough to purchase aparticular stock;
perhaps he is closing the sale of his house or acertificate of deposit is maturing.
However, he would like to buy the stock now, for he feels arally is imminent. He
might buy calls at the present time if he had asmall amount of cash available. The
call purchases would require an investment much smaller than the stock purchase.
Then, when he receives the cash that he knew was forthcoming, he could exercise the
calls and buy the stock. In this way, he might have participated in arally by the stock
before he actually had the money available to pay for the stock in full.

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Cl,opter 3: Call Buying 97
RISK AND REWARD FOR THE CALL BUYER
The most important fact for the call buyer to realize is that he will normally win only
if the stock rises in price. All the worthwhile analysis in the world spent in selecting
which call to buy will not produce profits if the underlying stock declines. However,
this fact should not dissuade one from making reasonable analyses in his call buying
selections. Too often, the call buyer feels that astock will move up, and is correct in
that part of his projection, but still loses money on his call purchase because he failed
to analyze the risk and rewards involved with the various calls available for purchase
at the time. He bought the wrong call on the right stock.
Since the best ally that the call buyer has is upward movement in the underly
ing stock, the selection of the underlying stock is the most important choice the call
buyer has to make. Since timing is so important when buying calls, the technical fac
tors of stock selection probably outweigh the fundamentals; even if positive funda
mentals do exist, one does not know how long it will take in order for them to be
reflected in the price of the stock. One must be bullish on the underlying stock in
order to consider buying calls on that stock. Once the stock selection has been made,
only then can the call buyer begin to consider other factors, such as which striking
price to use and which expiration to buy. The call buyer may have another ally, but
not one that he can normally predict: If the stock on which he owns acall becomes
more volatile, the call'sprice will rise to reflect that change.
The purchase of an out-of-the-money call generally offers both larger potential
risk and larger potential reward than does the purchase of an in-the-money call.
Many call buyers tend to select the out-of-the-money call merely because it is cheap
er in price. Absolute dollar price should in no way be adeciding factor for the call
buyer. If one'sfunds are so limited that he can only afford to buy the cheapest calls,
he should not be speculating in this strategy. If the underlying stock increases in price
substantially, the out-of-the-money call will naturally provide the largest rewards.
However, if the stock advances only moderately in price, the in-the-money call may
actually perform better.
Example: XYZ is at 65 and the July 60 sells for 7 while the July 70 sells for 3. If the
stock moves up to 68 relatively slowly, the buyer of the July 70 - the out-of-the
money call - may actually experience aloss, even if the call has not yet expired.
However, the holder of the in-the-money July 60 will definitely have aprofit because
the call will sell for at least 8 points, its intrinsic value. The point is that, percentage
wise, an in-the-rrwney call will offer better rewards for arrwdest stock gain, and an
out-ofthe-rrwney call is better for larger stock gains.

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98 Part II: Call Option Strategies
When risk is considered, the in-the-money call clearly has less probability of
risk. In the prior example, the in-the-money call buyer would not lose his entire
investment unless XYZ fell by at least 5 points. However, the buyer of the out-of-the
money July 70 would lose all of his investment unless the stock advanced by more
than 5 points by expiration. Obviously, the probability that the in-the-money call will
expire worthless is much smaller than that for the out-of-the-money call.
The time remaining to expiration is also relevant to the call buyer. If the stock
is fairly close to the striking price, the near-term call will most closely follow the price
movement of the underlying stock, so it has the greatest rewards and also the great
est risks. The far-term call, because it has alarge amount of time remaining, offers
the least risk and least percentage reward. The intermediate-temi call offers amod
erate amount of each, and is therefore often the most attractive one to buy. Many
times an investor will buy the longer-term call because it only costs apoint or apoint
and ahalf more than the intermediate-term call. He feels that the extra price is abar
gain to pay for three extra months of time. This line of thought may prove somewhat
misleading, however, because most call buyers don'thold calls for more than 60 or 90
days. Thus, even though it looks attractive to pay the extra point for the long-term
call, it may prove to be an unnecessary expense if, as is usually the case, one will be
selling the call in two or three months.
CERTAINTY OF TIMING
The certainty with which one expects the underlying stock to advance may also help
to play apart in his selection of which call to buy. If one is fairly sure that the under
lying stock is about to rise immediately, he should strive for more reward and not be
as concerned about risk. This would mean buying short-term, slightly out-of-the
money calls. Of course, this is only ageneral rule; one would not normally buy an out
of-the-money call that has only one week remaining until expiration, in any case. At
the opposite end of the spectrum, if one is very uncertain about his timing, he should
buy the longest-term call, to moderate his risk in case his timing is wrong by awide
margin. This situation could easily result, for example, if one feels that apositive fun
damental aspect concerning the company will assert itself and cause the stock to
increase in price at an unknown time in the future. Since the buyer does not know
whether this positive fundamental will come to light in the next month or six months
from now, he should buy the longer-term call to allow room for error in timing.
In many cases, one is not intending to hold the purchased call for any signifi
cant period of time; he is just looking to capitalize on aquick, short-term movement
by the underlying stock. In this case, he would want to buy arelatively short-term in
the-money call. Although such acall may be more ex-pensive than an out-of-the-

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Cl,apter 3: Call Buying 99
money call on the same underlying stock, it will most surely move up on any increase
in price by the underlying stock. Thus, the short-term trader would profit.
THE DELTA
The reader should by now be familiar with basic facts concerning call options: The
time premium is highest when the stock is at the striking price of the call; it is lowest
deep in- or out-of-the-money; option prices do not decay at alinear rate -the time pre
mium disappears more rapidly as the option approaches expiration. As afurther means
of review, the option pricing curve introduced in Chapter 1 is reprinted here. Notice
that all the facts listed above can be observed from Figure 3-1. The curves are much
nearer the "intrinsic value" line at the ends than they are in the middle, implying that
the time value premium is greatest when the stock is at the strike, and is least when
the stock moves away from the strike either into- or out-of-the-money. Furthermore,
the fact that the curve for the 3-month option lies only about halfway between the
intrinsic value line and the curve of the 9-month option implies that the rate of decay
of an at- or near-the-money option is not linear. The reader may also want to refer back
to the graph of time value premium decay in Chapter 1 (Figure 1-4).
There is another property of call options that the buyer should be familiar with,
the delta of the option (also called the hedge ratio). Simply stated, the delta of an
option is the arrwunt by which the call will increase or decrease in price if the under
lying stock moves by 1 point.
FIGURE 3-1.
Option pricing curve; 3-, 6-, and 9-month calls.
Q)
0
~
C:
0
a
0
9-Month Curve
6-Month Curve
3-Month Curve
/
Intrinsic Value
Striking Price
Stock Price
As expiration date draws
closer, the lower curve
merges with the intrinsic
value line. The option
price then equals its
intrinsic value.

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100 Part II: Call Option Strategies
Example: The delta of acall option is close to 1 when the underlying stock is well
above the striking price of the call. If XYZ were 60 and the XYZ July 50 call were
101/s, the call would change in price by nearly 1 point ifXYZ moved by 1 point, either
up or down. Adeeply out-of-the-money call has adelta of nearly zero. If XYZ were
40, the July 50 call might be selling at¼ of apoint. The call would change very little
in price if XYZ moved by one point, to either 41 or 39. When the stock is at the strik
ing price, the delta is usually between one-half of apoint and five-eighths of apoint.
Very long-term calls may have even larger at-the-money deltas. Thus, if XYZ were 50
and the XYZ July 50 call were 5, the call might increase to 5½ if XYZ rose to 51 or
decrease to 4½ if XYZ dropped to 49.
Actually, the delta changes each time the underlying stock changes even frac
tionally in price; it is an exact mathematical derivation that is presented in alater
chapter. This is most easily seen by the fact that adeep in-the-money option has adelta of 1. However, if the stock should undergo aseries of I-point drops down to the
striking price, the delta will be more like½, certainly not 1 any longer. In reality, the
delta changed instantaneously all during the price decline by the stock. For those
who are geometrically inclined, the preceding option price curve is useful in deter
mining agraphic representation of the delta. The delta is the slope of the tangent line
to the price curve. Notice that adeeply in-the-money option lies to the upper right
side of the curve, very nearly on the intrinsic value line, which has aslope of 1 above
the strike. Similarly, adeeply out-of-the-money call lies to the left on the price curve,
again near the intrinsic value line, which has aslope of zero below the strike.
Since it is more common to relate the option'sprice change to afull point
change in the underlying stock (rather than to deal in "instantaneous" price changes),
the concepts of up delta and down delta arise. That is, if the underlying stock moves
up by 1 full point, acall with adelta of .50 might increase by 5/s. However, should the
stock fall by one full point, the call might decrease by only 3/s. There is adifferent net
price change in the call when the stock moves up by 1 full point as opposed to when
it falls by apoint. The up delta is observed to be 5/swhile the down delta is 3/s. In the
true mathematical sense, there is only one delta and it measures "instantaneous"
price change. The concepts of up delta and down delta are practical, rather than the
oretical, concepts that merely illustrate the fact that the true delta changes whenev
er the stock price changes, even by as little as 1 point. In the following examples and
in later chapters, only one delta is referred to.
The delta is an important piece of information for the call buyer because it can
tell him how much of an increase or decrease he can expect for short-term moves by
the underlying stock. This piece of information may help the buyer decide which call
to buy.

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Chapter 3: Call Buying 101
Example: If XYZ is 4 7½ and the call buyer expects aquick, but possibly limited, rise
in price in the underlying stock, should he buy the 45 call or the 50 call? The delta
may help him decide. He has the following information:
XYZ: 471/2 XYZ July 45 call: price = 31/2,
XYZ July 50 call: price = 1,
delta = 5/adelta = 1/4
It will make matters easier to make aslightly incorrect, but simplifying, assumption
that the deltas remain constant over the short term. Which call is the better buy if
the buyer expects the stock to quickly rise to 49? This would represent a 1 ½-point
increase in XYZ, which would translate into a 15/16 increase in the July 45 (l½ times
5/s) or a 3/sincrease in the July 50 (1 ½ times ¼). Consequently, the July 45, if it
increased in price by 15/16, would appreciate by 27%. The July 50, if it increased by
3/a, would appreciate by over 37%. Thus, the July 50 appears to be the better buy in
this simple example. Commissions should, of course, be included when making an
analysis for actual investment.
The investor does not have to bother with computing deltas for himself. Any
good call-buying data service will supply the information, and some brokerage hous
es provide this information free of charge.
More advanced applications of deltas are described in many of the succeeding
chapters, as they apply to avariety of strategies.
WHICH OPTION TO BUY?
There are various trading strategies, some short-term, some long-term (even buy and
hold). If one decides to use an option to implement atrading strategy, the time hori
zon of the strategy itself often dictates the general category of option that should be
bought - in-the-money versus out-of-the-money, near-term versus long-term, etc.
This statement is true whether one is referring to stock, index, or futures options.
The general rule is this: The shorter-term the strategy, the higher the delta should be
of the instrument being used to trade the strategy.
DAY TRADING
For example, day trading has become apopular endeavor. Statistics have been pro
duced that indicate that most day traders lose money. In fact, there are profitable day
traders; it simply requires more and harder work than many are willing to invest.
Many day traders have attempted to use options in their strategies. These day traders

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102 Part II: Call Option Strategies
apparently are attracted by the leverage available from options, but they often lose
money via option trading as well.
What many of these option-oriented day traders fail to realize is that, for day
trading purposes, the instrument with the highest possible delta should be used. That
instrument is the underlying, for it has adelta of 1.0. Day trading is hard enough
without complicating it by trying to use options. So of you're day trading Microsoft
(MSFT), trade the stock, not an option.
What makes options difficult in such ashort-term situation is their relatively
wide bid-asked spread, as compared to that of the underlying instrument itself. Also,
aday trader is looking to capture only asmall part of the underlying'sdaily move; an
at-the-money or out-of-the-money option just won'trespond well enough to those
movements. That is, if the delta is too low, there just isn'tenough room for the option
day trader to make money.
If aday trader insists on using options, ashort-term, in-the-money should be
bought, for it has the largest delta available - preferably something approaching .90
or higher. This option will respond quickly to small movements by the underlying.
SHORT-TERM TRADING
Suppose one employs astrategy whereby he expects to hold the underlying for
approximately aweek or two. In this case, just as with day trading, ahigh delta is
desirable. However, now that the holding period is more than aday, it may be appro
priate to buy an option as opposed to merely trading the underlying, because the
option lessens the risk of asurprisingly large downside move. Still, it is the short
term, in-the-money option that should be bought, for it has the largest delta, and will
thus respond most closely to the movement in the underlying stock. Such an option
has avery high delta, usually in excess of .80. Part of the reason that the high-delta
options make sense in such situations is that one is fairly certain of the timing of day
trading or very short-term trading systems. When the system being used for selection
of which stock to trade has ahigh degree of timing accuracy, then the high-delta
option is called for.
INTERMEDIATE-TERM TRADING
As the time horizon of one'strading strategy lengthens, it is appropriate to use an
option with alesser delta. This generally means that the timing of the selection
process is less exact. One might be using atrading system based, for ernmple, on sen
timent, which is generally not an exact timing indicator, but rather one that indicates
ageneral trend change at major turning points. The timing of the forthcoming move

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Gapter 3: Call Buying 103
is not exact, because it often takes time for an extreme change in sentiment to reflect
itself in achange of direction by the underlying.
Hence, for astrategy such as this, one would want to use an option with asmall
er delta. The investor would limit his risk by using such an option, knowing that large
moves are possible since the position is going to be held for several weeks or perhaps
even acouple of months or more. Therefore, an at-the-money option can be used in
such situations.
I.ONG-TERM TRADING
If one'sstrategy is even longer-term, an option with alower delta can be considered.
Such strategies would generally have only vague timing qualities, such as selecting astock to buy based on the general fundamental outlook for the company. In the
extreme, it would even apply to "buy and hold" strategies.
Generally, buying out-of-the-money options is not recommended; but for very
long-term strategies, one might consider something slightly out-of-the-money, or at
least afairly long-term at-the-money option. In either case, that option will have alower delta as compared to the options that have been recommended for the other
strategies mentioned above. Alternatively, LEAPS options might be appropriate for
stock strategies of this type.
ADVANCED SELECTION CRITERIA
The criteria presented previously represented elementary techniques for selecting
which call to buy. In actual practice, one is not usually bullish on just one stock at atime. In fact, the investor would like to have alist of the "best" calls to buy at any
given time. Then, using some method of stock selection, either technical or funda
mental, he can select three or four calls that appear to offer the best rewards. This
list should be ranked in order of the best potential rewards available, but the con
struction of the list itself is important.
Call option rankings for buying purposes must be based on the volatilities of the
underlying stocks. This is not easy to do mathematically, and as aresult many pub
lished rankings of calls are based strictly on percentage change in the underlying
stock. Such alist is quite misleading and can lead one to the wrong conclusions.
Example: There are two stocks with listed calls: NVS, which is not volatile, and VVS,
which is quite volatile. Since acall on the volatile stock will be higher-priced than acall on the nonvolatile stock, the following prices might exist:

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104 Part II: Call Option Strategies
NVS: 40 VVS: 40
NVS July 40 call: 2 VVS July 40 call: 4
If these two calls are ranked for buying purposes, based strictly on apercentage
change in the underlying stock, the NVS call will appear to be the better buy. For
example, one might see alist such as "best call buys if the underlying stock advances
by 10%." In this example, if each stock advanced 10% by expiration, both NVS and
WS would be at 44. Thus, the NVS July 40 would be worth 4, having doubled in
price, for a 100% potential profit. Meanwhile, the WS July 40 would be worth 4 also,
for a 0% profit to the call buyer. This analysis would lead one to believe that the NVS
July 40 is the better buy. Such aconclusion may be wrong, because an incorrect
assumption was made in the ranking of the potentials of the two stocks. It is not right
to assume that both stocks have the same probability of moving 10% by expiration.
Certainly, the volatile stock has amuch better chance of advancing by 10% ( or more)
than the nonvolatile stock does. Any ranking based on equal percentage changes in
the underlying stock, without regard for their volatilities, is useless and should be
avoided.
The correct method of comparing these two July 40 calls is to utilize the actual
volatilities of the underlying stocks. Suppose that it is known that the volatile stock,
WS, could expect to move 15% in the time to July expiration. The nonvolatile stock,
NVS, however, could only expect amove of 5% in the same period. Using this infor
mation, the call buyer can arrive at the conclusion that WS July 40 is the better call
to buy:
Stock Price in July
VVS: 46 (up 15%)
NVS: 42 (up 5%)
Coll Price
VVS July 40: 6 (up 50%)
NVS July 40: 2 (unchanged)
By assuming that each stock can rise in accordance with its volatility, we can see that
the WS July 40 has the better reward potential, despite the fact that it was twice as
expensive to begin with. This method of analysis is much more realistic.
One more refinement needs to be made in this ranking process. Since most call
purchases are made for holding periods of from 30 to 90 days, it is not correct to
assume that the calls will be held to expiration. That is, even if one buys a 6-month
call, he will normally liquidate it, to take profits or cut losses, in 1 to 3 months. The
call buyer'slist should thus be based on how the call will peiform if held for arealis
tic time period, such as 90 days.

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Chapter 3: Call Buying 105
Suppose the volatile stock in our example, WS, has the potential to rise by 12%
in 90 days, while the less volatile stock, NVS, has the potential of rising only 4% in 90
days. In 90 days, the July 40 calls will not be at parity, because there will be some time
remaining until July expiration. Thus, it is necessary to attempt to predict what their
prices will be at the end of the 90-day holding period. Assume that the following
prices are accurate estimates of what the July 40 calls will be selling for in 90 days, if
the underlying stocks advance in relation to their volatilities:
Stock Price in 90 Days
VVS: 44.8 (up 12%)
NVS: 41 .6 (up 4%)
Coll Price
VVS July 40: 6 (up 50%)
NVS July 40: 21/2 (up 25%)
With some time remaining in the calls, they would both have time value premium at
the end of 90 days. The bigger time premium would be in the WS call, since the
underlying stock is more volatile. Under this method of analysis, the WS call is still
the better one to buy.
The correct method of ranking potential reward situations for call buyers is as
follows:
1. Assume each underlying stock can advance in accordance with its volatility over
afixed period (30, 60, or 90 days).
2. Estimate the call prices after the advance.
3. Rank all potential call purchases by highest percentage reward opportunity for
aggressive purchases.
4. Assume each stock can decline in accordance with its volatility.
5. Estimate the call prices after the decline.
6. Rank all purchases by reward/risk ratio ( the percentage gain from item 2 divided
by the percentage loss from item 5).
The list from item 3 will generate more aggressive purchases because it incorporates
potential rewards only. The list from item 6 would be aless speculative one. This
method of analysis automatically incorporates the criteria set forth earlier, such as
buying short-term out-of-the-money calls for aggressive purchases and buying
longer-term in-the-money calls for amore conservative purchase. The delta is also afunction of the volatility and is essentially incorporated by steps 1 and 4.
It is virtually impossible to perform this sort of analysis without acomputer. The
call buyer can generally obtain such alist from abrokerage firm or from adata serv
ice. For those individuals who have access to acomputer and would like to generate

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106 Part II: Call Option Strategies
such an analysis for themselves, the details of computing astock'svolatility and pre
dicting the call prices are provided in Chapter 28 on mathematical techniques.
OVERPRICED OR UNDERPRICED CALLS
Formulae exist that are capable of predicting what acall should be selling for, based
on the relationship of the stock price and the striking price, the time remaining to
expiration, and the volatility of the underlying stock. These are useful, for example,
in performing the second step in the foregoing analysis, estimating the call price after
an advance in the underlying stock. In reality, acall'sactual price may deviate some
what from the price computed by the formula. If the call is actually selling for more
than the "fair" ( computed) price, the call is said to be overvalued. An undervalued
call is one that is actually trading at aprice that is less than the "fair" price.
If the calls are truly overpriced, there may be astrategy that can help reduce
their cost while still preserving upside profit potential. This strategy, however,
requires the addition of aput spread to the call purchase, so it is beyond the scope
of the subject matter at the current time. It is described in Chapter 23 on spreads
combining calls and puts.
Generally, the amount by which acall is overvalued or undervalued may be only
asmall fraction of apoint, such as 10 or 20 cents. In theory, the call buyer who pur
chases an undervalued call has gained aslight advantage in that the call should return
to its "fair" value. However, in practice, this information is most useful only to mar
ket-makers or firm traders who pay little or no commissions for trading options. The
general public cannot benefit directly from the knowledge that such asmall discrep
ancy exists, because of commission costs.
One should not base his call buying decisions merely on the fact that acall is
underpriced. It is small solace to the call buyer to find that he bought a "cheap" call
that subsequently declined in price. The method of ranking calls for purchase that
has been described does, in fact, give some slight benefit to underpriced calls.
However, under the recommended method of analysis, acall will not automatically
appear as an attractive purchase just because it is slightly undervalued.
TIME VALUE PREMIUM IS A MISNOMER
This is atopic that will be mentioned several times throughout the book, most
notably in conjunction with volatility trading. It is introduced here because even the
inexperienced option trader must understand that the portion of an option'sprice
that is not intrinsic value - the part that we routinely call "time value premium" - is
really composed of much more than just time value. Yes, time will eventually wear

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Chpter 3: Call Buying 107
away that portion of the option'sprice as expiration approaches. However, when an
option has aconsiderable amount of time remaining until its expiration, the more
important component of the option value is really volatility. If traders expect the
underlying stock to be volatile, the option will be expensive; if they expect the oppo
site, the option will be cheap. This expensiveness and cheapness is reflected in the
portion of the option that is not intrinsic value. For example, asix-month option will
not decay much in one day'stime, but aquick change in volatility expectations by
option traders can heavily affect the price of the option, especially one with agood
deal of time remaining. So an option buyer should carefully assess his purchases, not
just view them as something that will waste away. With careful analysis, option buy
ers can do very well, if they consider what can happen during the life of the option,
and not merely what will happen at expiration.
CALL BUYERS' FRUSTRATIONS
Despite one'sbest efforts, it may often seem that one does not make much money
when afairly volatile stock makes aquick move of 3 or 4 points. The reasons for this
are somewhat more complex than can be addressed at this time, although they relate
strongly to delta, time decay, and the volatility of the underlying stock. They are dis
cussed in Chapter 36, 'The Basics of Volatility Trading." If one plans to conduct aserious call buying strategy, he should read that chapter before embarking on apro
gram of extensive call buying.
FOLLOW-UP ACTION
The simplest follow-up action that the call buyer can implement when the underly
ing stock drops is to sell his call and cut his losses. There is often anatural tendency
to hold out hope that the stock can rally back to or above the striking price. Most of
the time, the buyer does best by cutting his losses in situations in which the stock is
performing poorly. He might use a "mental" stop price or could actually place asell
stop order, depending on the rules of the exchange where the call is traded. In gen
eral, stop orders for options result in poor executions, so using a "mental" stop is bet
ter. That is, one should base his exit point on the technical pattern of the underlying
stock itself. If it should break down below support, for example, then the option
holder should place amarket (not held) order to sell his call option.
If the stock should rise, the buyer should be willing to take profits as well. Most
buyers will quite readily take aprofit if, for example, acall that was bought for 5
points had advanced to be worth 10 points. However, the same investor is often

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108 Part II: Call Option Strategies
reluctant to sell acall at 2 that he had previously bought for 1 point, because "I've
only made apoint." The similarity is clear - both cases resulted in approximately a
100% profit - and the investor should be as willing to accept the one as he is the
other. This is not to imply that all calls that are bought at 1 should be sold when and
if they get to 2, but the same factors that induce one to sell the 10-point call after
doubling his money should apply to the 2-point call as well.
In fact, taking partial profits after acall holding has increased in value is often
awise plan. For example, if someone bought anumber of calls at aprice of 3, and
they later were worth 5, it might behoove the call holder to sell one-third to one-half
of his position at 5, thereby taking apartial profit. Having done that, it is often easi
er to let the profits run on the balance, and letting profits run is generally one of the
keys to successful trading.
It is rarely to the call buyer'sbenefit to exercise the call if he has to pay com
missions. When one exercises acall, he pays astock commission to buy the stock at
the striking price. Then when the stock is sold, astock sale commission must also be
paid. Since option commissions are much smaller, dollarwise, than stock commis
sions, the call holder will usually realize more net dollars by selling the call in the
option market than by exercising it.
LOCKING IN PROFITS
When the call buyer is fortunate enough to see the underlying stock advance rela
tively quickly, he can implement anumber of strategies to enhance his position.
These strategies are often useful to the call buyer who has an unrealized profit but is
torn between taking the profit or holding on in an attempt to generate more profits
if the underlying stock should continue to rise.
Example: Acall buyer bought an XYZ October 50 call for 3 points when the stock
was at 48. Then the stock rises to 58. The buyer might consider selling his October
50 (which would probably be worth about 9 points) or possibly taking one of several
actions, some of which might involve the October 60 call, which may be selling for 3
points. Table 3-1 summarizes the situation. At this point, the call buyer might take
one of four basic actions:
1. Liquidate the position by selling the long call for aprofit.
2. Sell the October 50 that he is currently long and use part of the proceeds to pur
chase October 60's.
3. Create aspread by selling the October 60 call against his long October 50.
4. Do nothing and remain long the October 50 call.

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Gapter 3: Call Buying
TABLE 3-1.
Present situation on XYZ October calls.
Original Trade
XYZ common: 48
Bought XYZ October 50 at 3
109
Current Prices
XYZ Common: 58
XYZ October 50: 9
XYZ October 60: 3
Each of these actions would produce different levels of risk and reward from
this point forward. If the holder sells the October 50 call, he makes a 6-point profit,
less commissions, and terminates the position. He can realize no further appreciation
from the call, nor can he lose any of his current profits; he has realized a 6-point gain.
This is the least aggressive tactic of the four: If the underlying stock continues to
advance and rises above 63, any of the other three strategies will outperform the
complete liquidation of the call. However, if the underlying stock should instead
decline below 50 by expiration, this action would have provided the most profit of the
four strategies.
The other simple tactic, the fourth one listed, is to do nothing. If the call is then
held to expiration, this tactic would be the riskiest of the four: It is the only one that
could produce aloss at expiration if XYZ fell back below 50. However, if the under
lying stock continues to rise in price, more profits would accrue on the call. Every call
buyer realizes the ramifications of these two tactics - liquidating or doing nothing
and is generally looking for an alternative that might allow him to reduce some of his
risk without cutting off his profit potential completely. The remaining two tactics are
geared to this purpose: limiting the total risk while providing the opportunity for fur
ther profits of an amount greater than those that could be realized by liquidating.
The strategy in which the holder sells the call that he is currently holding, the
October 50, and uses part of the proceeds to buy the call at the next higher strike is
called rolling up. In this example, he could sell the October 50 at 9, pocket his initial
3-point investment, and use the remaining proceeds to buy two October 60 calls at 3
points each. Thus, it is sometimes possible for the speculator to recoup his entire
original investment and still increase the number of calls outstanding by rolling up.
Once this has been done, the October 60 calls will represent pure profits, whatever
their price. The buyer who "rolls up" in this rrwnner is essentially speculating with
someone else'smoney. He has put his own money back in his pocket and is using
accrued profits to attempt to realize further gains. At expiration, this tactic would
perform best if XYZ increased by asubstantial amount. This tactic turns out to be the

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110 Part II: Call Option Strategies
worst of the four at expiration if XYZ remains near its current price, staying above 53
but not rising above 63 in this example.
The other alternative, the third one listed, is to continue to hold the October 50
call but to sell the October 60 call against it. This would create what is known as abull
spread, and the tactic can be used only by traders who have amargin account and can
meet their firm'sminimum equity requirement for spreading (generally $2,000). This
spread position has no risk, for the long side of the spread - the October 50 cost 3
points, and the short side of the spread - the October 60 - brought in 3 points via its
sale. Even if the underlying stock drops below 50 by expiration and all the calls expire
worthless, the trader cannot lose anything except commissions. On the other hand, the
maximum potential of this spread is 10 points, the difference between the striking
prices of 50 and 60. This maximum potential would be realized if XYZ were anywhere
above 60 at expiration, for at that time the October 50 call would be worth 10 points
more than the October 60 call, regardless of how far above 60 the underlying stock
had risen. This strategy will be the best peiformer of the four if XYZ remains relative
ly unchanged, above the lower strike but not much above the higher strike by expira
tion. It is interesting to note that this tactic is never the worst peiforrner of the four
tactics, no matter where the stock is at expiration. For example, if XYZ drops below
50, this strategy has no risk and is therefore better than the "do nothing" strategy. If
XYZ rises substantially, this spread produces aprofit of 10 points, which is better than
the 6 points of profit offered by the "liquidate" strategy.
There is no definite answer as to which of the four tactics is the best one to
apply in agiven situation. However, if acall can be sold against the currently long call
to produce abull spread that has little or no risk, it may often be an attractive thing
to do. It can never tum out to be the worst decision, and it would produce the largest
profits if XYZ does not rise substantially or fall substantially from its current levels.
Tables 3-2 and 3-3 summarize the four alternative tactics, when acall holder has an
unrealized profit. The four tactics, again, are:
1. "Do nothing" - continue to hold the currently long call.
2. "Liquidate" - sell the long call to take profits and do not reinvest.
3. "Roll up" - sell the long call, pocket the original investment, and use the remain
ing proceeds to purchase as many out-of-the-money calls as possible.
4. "Spread" - create abull spread by selling the out-of-the-money call against the
currently profitable long call, preferably taking in at least the original cost of the
long call.

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Cl,apter 3: Call Buying 111
TABLE 3-2.
Comparison of the four alternative strategies.
If the underlying stock then. . . The best tactic was. . . And the worst tactic was ...
continues to rise dramatic
ally ...
"roll up"
rises moderately above the do nothing
next strike ...
remains relatively unchanged . .. spread
falls back below the original liquidate
strike ...
TABLE 3-3.
Results at expiration.
XYZ Price at "Roll-up" "Do Nothing"
Expiration Profit Profit
50 or below $ 0 -$ 300(W)
53 0(W) 0(W)
56 0(W) + 300
60 0(W) + 700
63 + 600(W) + 1,000(B)
67 + 1,400(B) + 1,400(B)
70 + 2,000(B) + 1,700
liquidate
liquidate or "roll up"
"roll up"
do nothing
"Spread"
Profit
$ 0
+ 300
+ 600(B)
+ 1,000(B)
+ 1,000(B)
+ 1,000
+ 1,000
Liquidating
Profit
+$600(B)
+ 600(B)
+ 600(B)
+ 600
+ 600(W)
+ 600(W)
+ 600(W)
Note that each of the four tactics proves to be the best tactic in one case or another,
but that the spread tactic is never the worst one. Tables 3-2 and 3-3 represent the
results from holding until expiration. For those who prefer to see the actual numbers
involved in making these comparisons between the four tactics, Table 3-3 summa
rizes the potential profits and losses of each of the four tactics using the prices from
the example above. 'W" indicates that the tactic is the worst one at that price, and
"B" indicates that it is the best one.
There are, of course, modifications that an investor might make to any of these
tactics. For example, he might decide to sell out half of his long call position, recov
ering amajor part of his original cost, and continue to hold the remainder of the long
calls. This still leaves room for further appreciation.

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112 Part II: Call Option Strategies
DEFENSIVE ACTION
Two follow-up strategies are sometimes employed by the call buyer when the under
lying stock declines in price. Both involve spread strategies; that is, being long and
short two different calls on the same underlying stock simultaneously. Spreads are
discussed in detail in later chapters. This discussion of spreads applies only to their
use by the call buyer.
·"Rolling Down." If an option holder owns an option at acurrently unreal
ized loss, it may be possible to greatly increase the chances of making alimited
profit on arelatively small rebound in the stock price. In certain cases, the
investor may be able to implement such astrategy at little or no increase in risk.
Many call buyers have encountered asituation such as this: An XYZ October 35
call was originally bought for 3 points in hopes of aquick rise in the stock price.
However, because of downward movements in the stock- to 32, say- the call is now
at 1 ½ with October expiration nearer. If the call buyer still expects amild rally in the
stock before expiration, he might either hold the call or possibly "average down" (buy
more calls at I½). In either case he will need arally to nearly 38 by expiration in
order to break even. Since this would necessitate at least a 15% upward move by the
stock before expiration, it cannot be considered very likely. Instead, the buyer should
consider implementing the following strategy, which will be explained through the
use of an example.
Example: The investor is long the October 35 call at this time:
XYZ, 32;
XYZ October 35 call, 1 ½; and
XYZ October 30 call, 3.
One could sell two October 35'sand, at the same time, buy one October 30 for no
additional investment before commissions. That is, the sale of 2 October 35'sat $150
each would bring in $300, exactly the cost, before commissions, of buying the
October 30 call. This is the key to implementing the roll-down strategy: that one be
able to buy the lower strike call and sell two of the higher strike calls for nearly even
money.
Note that the investor is now short the call that he previously owned, the
October 35. Where he previously owned one October 35, he has now sold two of
them. He is also now long one October 30 call. Thus, his position is:

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0.,,., 3: Call Buying
long 1 XYZ October 30 call,
1hort 1 XYZ October 35 call.
113
This is technically known as abull spread, but the terminology is not important.
Table 3-4 summarizes the transactions that the buyer has made to acquire this
spread. The trader now "owns" the spread at acost of $300, plus commissions. By
making this trade, he has lowered his break-even point significantly without increas
ing his risk. However, the maximum profit potential has also been limited; he can no
longer capitalize on astrong rebound by the underlying stock.
In order to see that the break-even point has been lowered, consider what the
results are~ is at 33 at October expiration. The October 30 call would be worth
3 points and the October 35 would expire worthless with XYZ at 33. Thus, the
October 30 call could be sold to bring in $300 at that time, and there would not be
any expense to buy back the October 35. Consequently, the spread could be liqui
dated for $300, exactly the amount for which it was "bought." The spread then breaks
even at 33 at expiration. If the call buyer had not rolled down, his break-even point
would be 38 at expiration, for he paid 3 points for the original October 35 call and he
would thus need XYZ to be at 38 in order to be able to liquidate the call for 3 points.
Clearly, the stock has abetter chance of recovering to 33 than to 38. Thus, the call
buyer significantly lowers his break-even point by utilizing this strategy.
Lowering the break-even point is not the investor'sonly concern. He must also
be aware of what has happened to his profit and loss opportunities. The risk remains
essentially the same the $300 in debits, plus commissions, that has been paid out.
The risk has actually increased slightly, by the amount of the commissions spent in
"rolling down." However, the stock price at which this maximum loss would be real
ized has been lowered. With the original long call, the October 35, the buyer would
lose the entire $300 investment anywhere below 35 at October expiration. The
TABLE 3-4.
Transactions in bull spread.
Original trade
Later trade
Net position
Trade
Buy 1 October 35 call at 3
Sell 2 October 35 calls at 1 1/2
Buy 1 October 30 call at 3
Long 1 October 30 call
Short 1 October 35 call
Cost before Commissions
$300 debit
$300 credit
$300 debit
$300 debit

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114 Part II: Call Option Strategies
spread strategy, however, would result in atotal loss of $300 only if XYZ were below
30 at October expiration. With XYZ above 30 in October, the long side of the spread
could be liquidated for some value, thereby avoiding atotal loss. The investor has
reduced the chance of realizing the maximum loss, since the stock price at which that
loss would occur has been lowered by 5 points.
As with most investments, the improvement of risk exposure - lowering the
break-even point and lowering the maximum loss price - necessitates that some
potential reward be sacrificed. In the original long call position (the October 35), the
maximum profit potential was unlimited. In the new position, the potential profit is
limited to 2 points if XYZ should rally back to, or anywhere above, 35 by October
expiration. To see this, assume XYZ is 35 at expiration. Then the long October 30 call
would be worth 5 points, while the October 35 would expire worthless. Thus, the
spread could be liquidated for 5 points, a 2-point profit over the 3 points paid for the
spread. This is the limit of profit for the spread, however, since if XYZ is above 35 at
expiration, any further profits in the long October 30 call would be offset by acorre
sponding loss on the short October 35 call. Thus, if XYZ were to rally heavily by expi
ration, the "rolled down" position would not realize as large aprofit as the original
long call position would have realized.
Table 3-5 and Figure 3-2 summarize the original and new positions. Note that
the new position is better for stock prices between 30 and 40. Below 30, the two posi
tions are equal, except for the additional commissions spent. If the stock should rally
back above 40, the original position would have worked out better. The new position
is an improvement, provided that XYZ does not rally back above 40 by expiration.
The chances that XYZ could rally 8 points, or 25%, from 32 to 40 would have to be
considered relatively remote. Rolling the long call down into the spread would thus
appear to be the correct thing to do in this case.
This example is particularly attractive, because no additional money was
required to establish the spread. In many cases, however, one may find that the long
call cannot be rolled into the spread at even money. Some debit may be required.
This fact should not necessarily preclude making the change, since asmall addition
al investment may still significantly increase the chance of breaking even or making
aprofit on arebound.
Example: The following prices now exist, rather than the ones used earlier. Only the
October 30 call price has been altered:
XYZ, 32;
XYZ October 35 call, 1 ½; and
XYZ October 30 call, 4.

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O.,ter 3: Call Buying
TABLE 3-5.
Original and spread positions compared.
Stock Price Long Call
at Expiration Result
25 -$300
30 - 300
33 - 300
35 - 300
38 0
40 + 200
45 + 700
FIGURE 3-2.
Companion: original call purchase vs. spread.
§
~ +$200
·5..
~
al
tJ)
.3
0
:1:
ec.. -$300
Stock Price at Expiration
Spread
Result
-$300
- 300
0
+ 200
+ 200
+ 200
+ 200
115
With these prices, a 1-point debit would be required to roll down. That is, selling 2
October 35 calls would bring in $300 ($150 each), but the cost of buying the October
30 call is $400. Thus, the transaction would have to be done at acost of $100, plus
commissions. With these prices, the break-even point after rolling down would be 34,
still well below the original break-even price of 38. The risk has now been increased
by the additional 1 point spent to roll down. If XYZ should drop below 30 at October
expiration, the investor would have atotal loss of 4 points plus commissions. The
maximum loss with the original long October 35 call was limited to 3 points plus asmaller amount of commissions. Finally, the maximum amount of money that the

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116 Part II: Call Option Strategies
spread could make is now $100, less commissions. The alternative in this example is
not nearly as attractive as the previous one, but it might still be worthwhile for the
call buyer to invoke such aspread if he feels that XYZ has limited rally potential up
to October expiration.
One should not automatically discard the use of this strategy merely because adebit is required to convert the long call to aspread. Note that to "average down" by
buying an additional October 35 call at 1 ½ would require an additional investment
of $150. This is more than the $100 required to convert into the spread position in
the immediately preceding example. The break-even point on the position that was
"averaged down" would be over 37 at expiration, whereas the break-even point on the
spread is 34. Admittedly, the averaged-down position has much more profit potential
than the spread does, but the conversion to the spread is less expensive than "aver
aging down" and also provides alower break-even price.
In summary, then, if the call buyer finds himself with an unrealized loss because
the stock has declined, and yet is unwilling to sell, he may be able to improve his
chances of breaking even by "rolling down" into aspread. That is, he would sell 2 of
the calls that he is currently long - the one that he owns plus another one - and
simultaneously buy one call at the next lower striking price. If this transaction of sell
ing 2 calls and buying 1 call can be done for approximately even money, it could def
initely be to the buyer'sbenefit to implement this strategy, because the break-even
point would be lowered considerably and the buyer would have amuch better
chance of getting out even or making asmall profit should the underlying stock have
asmall rebound.
Creating a Calendar Spread. Adifferent type of defensive spread strategy
is sometimes used by the call buyer who finds that the underlying stock has declined.
In this strategy, the holder of an intermediate- or long-term call sells anear-term call,
with the same striking price as the call he already owns. This creates what is known
as acalendar spread. The idea behind doing this is that if the short-term call expires
worthless, the overall cost of the long call will be reduced to the buyer. Then, if the
stock should rally, the call buyer has abetter chance of making aprofit.
Example: Suppose that an investor bought an XYZ October 35 call for 3 points some
time in April. By June the stock has fallen to 32, and it appears that the stock might
remain depressed for awhile longer. The holder of the October 35 call might con
sider selling a July 35 call, perhaps for aprice of 1 point. Should XYZ remain below
35 until July expiration, the short call would expire worthless, earning asmall, 1-point
profit. The investor would still own the October 35 call and would then hope for arally by XYZ before October in order to make profits on that call. Even if XYZ does

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Chpter 3: Call Buying 117
not rally by October, he has decreased his overall loss by the amount received for the
sale of the July 35 call.
This strategy is not as attractive to use as the previous one. If XYZ should rally
before July expiration, the investor might find himself with two losing positions. For
example, suppose that XYZ rallied back to 36 in the next week. His short call that he
sold for 1 point would be selling for something more than that, so he would have an
unrealized loss on the short July 35. In addition, the October 35 would probably not
have appreciated back to its original price of 3, and he would therefore have an unre
alized loss on that side of the spread as well.
Consequently, this strategy should be used with great caution, for if the under
lying stock rallies quickly before the near-term expiration, the spread could be at aloss on both sides. Note that in the former spread strategy, this could not happen.
Even if XYZ rallied quickly, some profit would be made on the rebound.
A FURTHER COMMENT ON SPREADS
Anyone not familiar with the margin requirements for spreads, under both the
exchange margin rules and the rules of the brokerage firm he is dealing with, should
not attempt to utilize aspread transaction. Later chapters on spreads outline the
more common requirements for spread transactions. In general, one must have amargin account to establish aspread and must have aminimum amount of equity in
the account. Thus, the call buyer who operates in acash account cannot necessarily
use these spread strategies. To do so might incur amargin call and possible restric
tion of one'strading account. Therefore, check on specific requirements before uti
lizing aspread strategy. Do not assume that along call can automatically be "rolled"
into any sort of spread.

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Other Call Buying Strategies
In this chapter, two additional strategies that utilize the purchase of call options are
described. Both of these strategies involve buying calls against the short sale of the
underlying stock. When listed puts are traded on the underlying stock, these strate
gies are often less effective than when they are implemented with the use of put
options. However, the concept is important, and sometimes these strategies are more
viable in markets where calls are ve:iy liquid but puts are not. These strategies are
generally known as "synthetic" strategies.
THE PROTECTED SHORT SALE (OR SYNTHETIC PUT)
Purchasing acall at the same time that one is short the underlying stock is ameans
of limiting the risk of the short sale to afixed amount. Since the risk is theoretically
unlimited in ashort sale, many investors are reluctant to use the strategy. Even for
those investors who do sell stock short, it can be rather upsetting if the stock rises in
price. One may be forced into an emotional - and perhaps incorrect - decision to
cover the short sale in order to relieve the psychological pressure. By owning acall
at the same time he is short, the investor limits the risk to afixed and generally small
amount.
Example: An investor sells XYZ short at 40 and simultaneously purchases an XYZ
July 40 call for 3 points. If XYZ falls in price, the short seller will make his profit on
the short sale, less the 3 points paid for the call, which will expire worthless. Thus, by
buying the call for protection, asmall amount of profit potential is sacrificed.
However, the advantage of owning the call is demonstrated when the results are
examined for astock rise. IfXYZ should rise to any price above 40 by July expiration,
118

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Cl,apter 4: Other Call Buying Strategies 119
the short seller can cover his short by exercising the long call and buying stock at 40.
Thus, the maximum risk that the short seller can incur in this example is the 3 points
paid for the call. Table 4-1 and Figure 4-1 depict the results at expiration from uti
lizing this strategy. Commissions are not included. Note that the break-even point is
37 in this example. That is, if the stock drops 3 points, the protected short sale posi
tion will break even because of the 3-point loss on the call. The short seller who did
not spend the extra money for the long call would, of course, have a 3-point profit at
37. To the upside, however, the protected short sale outperforms aregular short sale
if the stock climbs anywhere above 43. At 43, both types of short sales have $300 loss
es. But above that level, the loss would continue to grow for aregular short sale, while
it is fixed for the short seller who also bought acall. In either case, the short seller'srisk is increased slightly by the fact that he is obligated to pay out the dividends on
the underlying stock, if any are declared.
Asimple formula is available for determining the maximum amount of risk
when one protects ashort sale by buying acall option:
Risk = Striking price of purchased call + Call price - Stock price
Depending on how much risk the short seller is willing to absorb, he might want to
buy an out-of-the-money call as protection rather than an at-the-money call, as was
shown in the example above. Asmaller dollar amount is spent for the protection
when one buys an out-of-the-money call, so that the short seller does not give away
as much of his profit potential. However, his risk is larger because the call does not
start its protective qualities until the stock goes above the striking price.
Example: With XYZ at 40, the short seller of XYZ buys the July 45 call at ½ for pro
tection. His maximum possible loss, if XYZ is above 45 at July expiration, would be
TABLE 4-1.
Results at expiration-protected short sale.
XYZ Price at Profit Call Price at Profit Total
Expiration on XYZ Expiration on Call Profit
20 +$2,000 0 -$ 300 +$1,700
30 + 1,000 0 - 300 + 700
37 + 300 0 - 300 0
40 0 0 - 300 300
50 - 1,000 10 + 700 300
60 - 2,000 20 + 1,700 300

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120
FIGURE 4-1.
Protected short sale.
C:
0 .:;
~
'a.. X
UJ
1o +$0 en en
0
...J
0
-e
0.-$300
40'
',
Stock Price at Expiration
'
Part II: Call Option Strategies
43
', ', ' ', ' ',
Short ',
' Sale 'll
5½ points - the five points between the current stock price of 40 and the striking
price of 45, plus the amount paid for the call. On the other hand, if XYZ declines, the
protected short seller will make nearly as much as the short seller who did not pro
tect, since he only spent ½ point for the long call.
If one buys an in-the-nwney call as protection for the short sale, his risk will be
quite minimal. However, his profit potential will be severely limited. As an example,
with XYZ at 40, if one had purchased a July 35 call at 5½, his risk would be limited
to½ point anywhere above 35 at July expiration. Unfortunately, he would not realize
any profit on the position until the stock went below 34½, adrop of 5½ points. This
is too much protection, for it limits the profit so severely that there is only asmall
hope of making aprofit.
Generally, it is best to buy acall that is at-the-nwney or only slightly out-of the
money as the protection for the short sale. It is not of much use to buy adeeply out
of-the-money call as protection, since it does very little to moderate risk unless the
stock climbs quite dramatically. Normally, one would cover ashort sale before it went
heavily against him. Thus, the money spent for such adeeply out-of-the-money call
is wasted. However, if one wants to give ashort sale plenty of room to "work" and

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Cl,opter 4: Other Call Buying Strategies 121
feels ve:ry certain that his bearish view of the stock is the correct view, he might then
buy afairly deep out-of-the-money call just as disaster protection, in case the stock
suddenly bolted upward in price (if it received atakeover bid, for example).
MARGIN REQUIREMENTS
The newest margin rules now allow one to receive favorable margin treatment when
ashort sale of stock is protected by along call option. The margin required is the
lower of (1) 10% of the call'sstriking price plus any out-of-the-money amount, or (2)
30% of the current short stock'smarket value. The position will be marked to market
daily, and most brokers will require that the short sale be margined at "normal" rates
if the stock is below the strike price.
Example: Suppose the following prices exist:
XYZ Common stock: 47
Oct 40 call: 8
Oct 50 call: 3
Oct 60 call: 1
Suppose that one is considering ashort sale of 100 shares of XYZ at 47 and the
purchase of one of the calls as protection. Here are the margin requirements for the
various strike prices. (Note that the option price, per se, is not part of the margin
requirement, but all options must be paid for in full, initially).
Position
Short XYZ, long Oct 40 call
Short XYZ, long Oct 50 call
Short XYZ, long Oct 60 call
l 0% strike + out-of-the-money
400 + 0 = 400*
500 + 300 = 800*
600 + 1,300 = 1,900
30% stock price
1,410
1,410
1,41 0*
*Since the margin requirement is the lower of the two figures, the items marked with an asterisk in
this table are the margin requirements.
Again, remember that the long call would have to be paid for in full, and that most
brokers impose amaintenance requirement of at least the value of the short sale itself
as long as the stock is below the strike price of the long call, in addition to the above
requirements.

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122 Part II: Call Option Strategies
FOLLOW-UP ACTION
There is little that the protected short seller needs to perform in the way of follow
up action in this strategy, other than closing out the position. If the underlying stock
moves down quickly and it appears that it might rebound, the short sale could be cov
ered without selling the long call. In this manner, one could potentially profit on the
call side as well if the stock came back above the original striking price. If the under
lying stock rises in price, asimilar strategy of taking off only the profitable call side
of the transaction is not recommended. That is, if XYZ climbed from 40 to 50 and the
July 40 call also rose from 3 to 10, it is not advisable to take the 7-point profit in the
call, hoping for adrop in the stock price. The reason for this is that one is entering
into ahighly risk-oriented situation by removing his protection when the call is in
the-money. Thus, when the stock drops, it is all right - perhaps even desirable - to
take the profit, because there is little or no additional risk if the stock continues to
drop. However, when the stock rises, it is not an equivalent situation. In that case, if
the short seller sells his call for aprofit and the stock subsequently rises even further,
large losses could result.
It may often be advisable to close the position if the call is at or near parity,
in-the-money, by exercising the call. In most strategies, the option holder has no
advantage in exercising the call because of the large dollar difference between
stock commissions and option commissions. However, in the protected short sale
strategy, the short seller is eventually going to have to cover the short stock in any
case and incur the stock commission by so doing. It may be to his advantage to
exercise the call and buy his stock at the striking price, thereby buying stock at alower price and perhaps paying aslightly lower commission amount.
Example: XYZ rises to 50 from the original short sale price of 40, and the XYZ July
40 call is selling at 10 somewhere close to expiration. The position could be liquidat
ed by either (1) buying the stock back at 50 and selling the call at 10, or (2) exercis
ing the call to buy stock at 40. In the first case, one would pay astock commission at
aprice of $50 per share plus an option commission on a $10 option. In the second
case, the only commission would be astock commission at the price of $40 per share.
Since both actions accomplish the same end result - closing the position entirely for
40 points plus commissions - clearly the second choice is less costly and therefore
more desirable. Of course, if the call has time value premium in it of an amount
greater than the commission savings, the first alternative should be used.

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Orapter 4: Other Call Buying Strategies 123
THE REVERSE HEDGE (SIMULATED STRADDLE)
There is another strategy involving the purchase of long calls against the short sale of
stock. In this strategy, one purchases calls on more shares than he has sold short. The
strategist can profit if the underlying stock rises far enough or falls far enough dur
ing the life of the calls. This strategy is generally referred to as areverse hedge or sim
ulated straddle. On stocks for which listed puts are traded, this strategy is outmoded;
the same results can be better achieved by buying astraddle (acall and aput).
Hence, the name "simulated straddle" is applied to the reverse hedge strategy.
This strategy has limited loss potential, usually amounting to amoderate per
centage of the initial investment, and theoretically unlimited profit potential. When
properly selected (selection criteria are described in great detail in Chapter 36,
which deals with volatility trading), the percentage of success can be quite high in
straddle or synthetic straddle buying. These features make this an attractive strategy,
especially when call premiums are low in comparison to the volatility of underlying
stock.
Example: XYZ is at 40 and an investor believes that the stock has the potential to
move by arelatively large distance, but he is not sure of the direction the stock will
take. This investor could short XYZ at 40 and buy 2 XYZ July 40 calls at 3 each to set
up areverse hedge. If XYZ moves up by alarge distance, he will incur aloss on his
short stock, but the fact that he owns two calls means that the call profits will outdis
tance the stock loss. If, on the other hand, XYZ drops far enough, the short sale prof
it will be larger than the loss on the calls, which is limited to 6 points. Table 4-2 and
Figure 4-2 show the possible outcomes for various stock prices at July expiration. If
XYZ falls, the stock profits on the short sale will accumulate, but the loss on the two
calls is limited to $600 (3 points each) so that, below 34, the reverse hedge can make
ever-increasing profits. To the upside, even though the short sale is incurring losses,
the call profits grow faster because there are two long calls. For example, at 60 at
expiration, there will be a 20-point ($2,000) loss on the short stock, but each XYZ July
40 call will be worth 20 points with the stock at 60. Thus, the two calls are worth
$4,000, representing aprofit of $3,400 over the initial cost of $600 for the calls.
Table 4-2 and Figure 4-2 illustrate another important point: The maximum loss
would occur if the stock were exactly at the striking price at expiration of the calls. This
maximum loss would occur if XYZ were at 40 at expiration and would amount to $600.
In actual practice, since the short seller must pay out any dividends paid by the under
lying stock, the risk in this strategy is increased by the amount of such dividends.

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124
TABLE 4-2.
Reverse hedge at July expiration.
XYZ Price at Stock
Expiration Profit
20 +$2,000
25 + 1,500
30 + 1,000
34 + 600
40 0
46 600
50 - 1,000
55 - 1,500
60 - 2,000
FIGURE 4-2.
Reverse hedge {simulated straddle).
C:
0
~
!
co
(/)
(/)
.3
~-$600
ea.
Profit on
2 Calls
-$ 600
600
600
600
600
+ 600
+ 1,400
+ 2,400
+ 3,400
Stock Price at Expiration
Part II: Call Option Strategies
Total
Profit
+$ l ,400
+ 900
+ 400
0
600
0
+ 400
+ 900
+ 1,400
The net margin required for this strategy is 50% of the underlying stock plus
the full purchase price of the calls. In the example above, this would be an initial
investment of $2,000 (50% of the stock price) plus $600 for the calls, or $2,600 total
plus commissions. The short sale is marked to market, so the collateral requirement
would grow if the stock rose. Since the maximum risk, before commissions, is $600,
this means that the net percentage risk in this transaction is $600/$2,600, about 23%.

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Cl,opter 4: Other Call Buying Strategies 125
This is arelatively small percentage risk in aposition that could have very large prof
its. There is also very little chance that the entire maximum loss would ever be real
ized since it occurs only at one specific stock price. One should not be deluded into
thinking that this strategy is asure money-maker. In general, stocks do not move very
far in a 3- or 6-month period. With careful selection, though, one can often find sit
uations in which the stock will be able to move far enough to reach the break-even
points. Even when losses are taken, they are counterbalanced by the fact that signif
icant gains can be realized when the stock moves by agreat distance.
It is obvious from the information above that profits are made if the stock moves
far enough in either direction. In fact, one can determine exactly the prices beyond
which the stock would have to move by expiration in order for profits to result. These
prices are 34 and 46 in the foregoing example. The downside break-even point is 34
and the upside break-:even point is 46. These break-even points can easily be com
puted. First, the maximum risk is computed. Then the break-even points are deter
mined.
Maximum risk = Striking price + 2 x Call price - Stock price
Upside break-even point = Striking price + Maximum risk
Downside break-even point = Striking price - Maximum risk
In the preceding example, the striking price was 40, the stock price was also 40,
and the call price was 3. Thus, the maximum risk = 40 + 2 x 3 - 40 = 6. This con
firms that the maximum risk in the position is 6 points, or $600. The upside break
even point is then 40 + 6, or 46, and the downside break-even point is 40 - 6, or 34.
These also agree with Table 4-2 and Figure 4-2.
Before expiration, profits can be made even closer to the striking price, because
there will be some time value premium left in the purchased calls.
Example: IfXYZ moved to 45 in one month, each call might be worth 6. If this hap
pened, the investor would have a 5-point loss on the stock, but would also have a 3-
point gain on each of the two options, for anet overall gain of 1 point, or $100. Before
expiration, the break-even point is clearly somewhere below 46, because the position
is at aprofit at 45.
Ideally, one would like to find relatively underpriced calls on afairly volatile
stock in order to implement this strategy most effectively. These situations, while not
prevalent, can be found. Normally, call premiums quite accurately reflect the volatil
ity of the underlying stock. Still, this strategy can be quite viable, because nearly
every stock, regardless of its volatility, occasionally experiences astraight-line, fairly
large move. It is during these times that the investor can profit from this strategy.

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126 Part II: Call Option Strategies
Generally, the underlying stock selected for the reverse hedge should be
volatile. Even though option premiums are larger on these stocks, they can still be
outdistanced by astraight-line move in avolatile situation. Another advantage of uti
lizing volatile stocks is that they generally pay little or no dividends. This is desirable
for the reverse hedge, because the short seller will not be required to pay out as
much.
The technical pattern of the underlying stock can also be useful when selecting
the position. One generally would like to have little or no technical support and
resistance within the loss area. This pattern would facilitate the stock'sability to make
afairly quick move either up or down. It is sometimes possible to find astock that is
in awide trading range, frequently swinging from one side of the range to the other.
If areverse hedge can be set up that has its loss area well within this trading range,
the position may also be attractive.
Example: The XYZ stock in the previous example is trading in the range 30 to 50,
perhaps swinging to one end and then the other rather frequently. Now the reverse
hedge example position, which would make profits above 46 or below 34, would
appear more attractive.
FOLLOW-UP ACTION
Since the reverse hedge has abuilt-in limited loss feature, it is not necessary to take
any follow-up action to avoid losses. The investor could quite easily put the position
on and take no action at all until expiration. This is often the best method of follow
up action in this strategy.
Another follow-up strategy can be applied, although it has some disadvantages
associated with it. This follow-up strategy is sometimes known as trading against the
straddle. When the stock moves far enough in either direction, the profit on that side
can be taken. Then, if the stock swings back in the opposite direction, aprofit can
also be made on the other side. Two examples \vill show how this type of follow-up
strategy works.
Example 1: The XYZ stock in the previous example quickly moves down to 32. At
that time, an 8-point profit could be taken on the short sale. This would leave two
long calls. Even if they expired worthless, a 6-point loss is all that would be incurred
on the calls. Thus, the entire strategy would still have produced aprofit of 2 points.
However, if the stock should rally above 40, profits could be made on the calls as well.
Aslight variation would be to sell one of the calls at the same time the stock profit is
taken. This would result in aslightly larger realized profit; but if the stock rallied back

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Cl,apter 4: Other Call Buying Strategies 127
above 40, the resulting profits there would be smaller because the investor would be
long only one call instead of two.
Example 2: XYZ has moved up to aprice at which the calls are each worth 8 points.
One of the calls could then be sold, realizing a 5-point profit. The resulting position
would be short 100 shares of stock and long one call, aprotected short sale. The pro
tected short sale has alimited risk, above 40, of 3 points (the stock was sold short at
40 and the call was purchased for 3 points). Even if XYZ remains above 40 and the
maximum 3-point loss has to be taken, the overall reverse hedge would still have
made aprofit of 2 points because of the 5-point profit taken on the one call.
Conversely, if XYZ drops below 40, the protected short sale position could add to the
profits already taken on the call.
There is avariation of this upside protective action.
Example 3: Instead of selling the one call, one could instead short an additional 100
shares of stock at 48. If this was done, the overall position would be short 200 shares
of stock (100 at 40 and the other 100 at 48) and long two calls - again aprotected
short sale. If XYZ remained above 40, there would again be an overall gain of 2
points. To see this, suppose that XYZ was above 40 at expiration and the two calls
were exercised to buy 200 shares of stock at 40. This would result in an 8-point prof
it on the 100 shares sold short at 48, and no gain or loss on the 100 shares sold short
at 40. The initial call cost of 6 points would be lost. Thus, the overall position would
profit by 2 points. This means of follow-up action to the upside is more costly in com
missions, but would provide bigger profits if XYZ fell back below 40, because there
are 200 shares of XYZ short.
In theory, if any of the foregoing types of follow-up action were taken and the
underlying stock did indeed reverse direction and cross back through the striking
price, the original position could again be established. Suppose that, after covering
the short stock at 32, XYZ rallied back to 40. Then XYZ could be sold short again,
reestablishing the original position. If the stock moved outside the break-even points
again, further follow-up action could be taken. This process could theoretically be
repeated anumber of times. If the stock continued to whipsaw back and forth in atrading range, the repeated follow-up actions could produce potentially large profits
on asmall net change in the stock price. In actual practice, it is unlikely that one
would be fortunate enough to find astock that moved that far that quickly.
The disadvantage of applying these follow-up strategies is obvious: One can
never make alarge profit if he continually cuts his profits off at asmall, limited

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128 Part II: Call Option Strategies
amount . .. When XYZ falls to 32, the stock can be covered to ensure an overall profit
of 2 points on the transaction. However, if XYZ continued to fall to 20, the investor
who took no follow-up action would make 14 points while the one who did take fol
low-up action would make only 2 points. Recall that it was stated earlier that there is
ahigh probability of realizing limited losses in the reverse hedge strategy, but that
this is balanced by the potentially large profits available in the remaining cases. If one
takes follow-up action and cuts off these potentially large profits, he is operating at adistinct disadvantage unless he is an extremely adept trader.
Proponents of using the follow-up strategy often counter with the argument
that it is frustrating to see the stock fall to 32 and then return back to nearly 40 again.
If no follow-up action were taken, the unrealized profit would have dissolved into aloss when the stock rallied. This is true as far as it goes, but it is not an effective
enough argument to counterbalance the negative effects of cutting off one'sprofits.
ALTERING THE RATIO OF LONG CALLS
TO SHORT STOCK
Another aspect of this strategy should be discussed. One does not have to buy exact
ly two calls against 100 shares of short stock. More bullish positions could be con
structed by buying three or four calls against 100 shares short. More bearish positions
could be constructed by buying three calls and shorting 200 shares of stock. One
might adopt aratio other than 2:1, because he is more bullish or bearish. He also
might use adifferent ratio if the stock is between two striking prices, but he still
wants to create aposition that has break-even points spaced equidistant from the cur
rent stock price. Afew examples will illustrate these points.
Example: XYZ is at 40 and the investor is slightly bullish on the stock but still wants
to employ the reverse hedge strategy, because he feels there is achance the stock
could drop sharply. He might then short 100 shares of XYZ at 40 and buy 3 July 40
calls for 3 points apiece. Since he paid 9 points for the calls, his maximum risk is that
9 points if XYZ were to be at 40 at expiration. This means his downside break-even
price is 31, for at 31 he would have a 9-point profit on the short sale to offset the 9-
point loss on the calls. To the upside, his break-even is now 44½. IfXYZ were at 44½
and the calls at 4½ each at expiration, he would lose 4½ points on the short sale, but
would make l ½ on each of the three calls, for atotal call profit of 4½.
Amore bearish investor might short 200 XYZ at 40 and buy 3 July 40 calls at 3.
His break-even points would be 35½ on the downside and 49 on the upside, and his
maximum risk would be 9 points. There is ageneral formula that one can always

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130
Example: The following prices exist:
XYZ, 37½;
XYZ July 40 call, 2; and
XYZ July 35 call, 4.
Part II: Call Option Strategies
If one were to short 100 XYZ at 37½ and to buy one July 40 call for 2 and one July
35 call for 4, he would have aposition that is similar to areverse hedge except that
the maximum risk would be realized anywhere between 35 and 40 at expiration.
Although this risk is over amuch wider range than in the normal reverse hedge, it is
now much smaller in dimension. Table 4-3 and Figure 4-3 show the results from this
type of position at expiration. The maximum loss is 3½ points ($350), which is asmaller amount than could be realized using any ratio strictly with the July 35 or the
July 40 call. However, this maximum loss is realizable over the entire range, 35 to 40.
Again, large potential profits are available if the stock moves far enough either to the
upside or to the downside.
This form of the strategy should only be used when the stock is nearly centered
between two strikes and the strategist wants aneutral positioning of the break-even
points. Similar types of follow-up action to those described earlier can be applied to
this form of the reverse hedge strategy as well.
TABLE 4-3.
Reverse hedge using two strikes.
XYZ Price at Stock July 40 Coll July 35 Coll Total
Expiration Profit Profit Profit Profit
25 +$1,250 -$200 -$ 400 +$ 650
30 + 750 - 200 400 + 150
31 1/2 + 600 - 200 400 0
35 + 250 - 200 400 350
371/2 0 - 200 150 350
40 - 250 - 200 + 100 350
431/2 - 600 + 150 + 450 0
45 - 750 + 300 + 600 + 150
50 - 1,250 + 800 + 1,100 + 650

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Gapter 4: Other Call Buying Strategies 131
FIGURE 4-3.
Reverse hedge using two strikes (simulated combination purchase).
C:
~ ·5.
in
~
l/l
.3
0
i.l::-$350
ea.
SUMMARY
40
Stock Price at Expiration
The strategies described in this chapter would not normally be used if the underly
ing stock has listed put options. However, if no puts exist, or the puts are very illiq
uid, and the strategist feels that avolatile stock could move arelatively large distance
in either direction during the life of acall option, he should consider using one of the
forms of the reverse hedge strategy - shorting aquantity of stock and buying calls on
more shares than he is short. If the desired movement does develop, potentially large
profits could result. In any case, the loss is limited to afixed amount, generally
around 20 to 30% of the initial investment. Although it is possible to take follow-up
action to lock in small profits and attempt to gain on areversal by the stock, it is wiser
to let the position run its course to capitalize on those occasions when the profits
become large. Normally a 2:1 ratio (long 2 calls, short 100 shares of stock) is used in
this strategy, but this ratio can be adjusted if the investor wants to be more bullish or
more bearish. If the stock is initially between two striking prices, aneutral profit
range can be set up by shorting the stock and buying calls at both the next higher
strike and the next lower strike.

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CHAPTER 5
Naked Call Writing
The next two chapters will concentrate on various aspects of writing uncovered call
options. These strategies have risk ofloss if the underlying stock should rise in price,
but they offer profits if the underlying stock declines in price. This chapter on
naked, or uncovered, call writing - demonstrates some of the risks and rewards
inherent in this aggressive strategy. Novice option traders often think that selling
naked options is the "best" way to make money, because of time decay. In addition,
they often assume that market-makers and other professionals sell alot of naked
options. In reality, neither is true. Yes, options do eventually lose their premium if
held all the way until expiration. However, when an option has agood deal of life
remaining, its excess value above intrinsic value what we call "time value premium"
- is, in reality, heavily influenced by the volatility estimate of the stock. This is called
implied volatility and is discussed at length later in the book. For now, though, it is
sufficient to understand that alot can go wrong when one writes anaked option,
before it eventually expires. As to professionals selling alot of naked options, the fact
is that most market-makers and other full-time option traders attempt to reduce their
exposure to large stock price movements if possible. Hence, they may sell some
options naked, but they generally try to hedge them by buying other options or by
buying the underlying stock.
Many novice option traders hold these misconceptions, probably because there
is ageneral belief that most options expire worthless. Occasionally, one will even hear
or see astatement to this effect in the mainstream media, but it is not true that most
options expire worthless. In fact, studies conducted by McMillan Analysis Corp. in
both bull and bear months indicate that about 65% to 70% of all options have some
value (at least half apoint) when they expire. This is not to say that all option buyers
make money, either, but it does serve to show that many more options do not expire
worthless than do.
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