Gaining Exposure • 207
that if the option expires when the stock price is at either edge of my valu-
ation range, it is far enough in-the-money to pay me back for both legs of
the investment (plus an attractive return).
Portfolio Management
As mentioned earlier, this is naturally amore speculative style of option
investment, and it may well be more beneficial to close the successful leg of
the strategy before expiration than to hold the position to expiration. Com-
pared with the next strategy presented here (the straddle), the strangle ac-
tually generates worse returns if held to expiration, so if you are happy with
your returns midway through the investment, you should close the posi-
tion rather than waiting for expiration. The exception to this rule is that if
news comes out that convinces you that the value of the firm is materially
higher or lower than what you had originally forecast and uncertainty in
the other direction has been removed, you should assess the possibility of
making amore substantial investment in the company.
One common problem with investors—even experienced and sophis-
ticated ones—is that they check the past price history of astock and decide
whether the stock has “more room” to move in aparticular direction. The
most important two things to know when considering an investment are its
value and the uncertainty surrounding that value. Whether the stock was
cheaper three years ago or much more expensive does not matter—these are
backward-looking measures, and you cannot invest with arear-view mirror.
One final note regarding this strategy is what to do with the unused
leg. If the stock moves up strongly and you take profits on the call, what
should you do with the put, in other words. Unfortunately, the unused leg is
almost always worthless, and often it will cost more than it’sworth to close
it. Iusually keep this leg open because you never know what may happen,
and perhaps before it expires, you will be able to close it at abetter price.
This is aspeculative strategy—abit of spice or an after-dinner mint
in the meal of investing. Don’texpect to get rich using it (if you do get rich
using it, it means that you were lucky because you would have had to have
used alot of leverage in the process), but you may be pleasantly surprised
with the boost you get from these every once in awhile.
Let’snow turn briefly to arelated strategy—the straddle.

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:224


208  •   The Intelligent Option Investor
Straddle
GREEN
Downside: Undervalued
Upside: Undervalued
Execute: Simultaneously buy an ATM put and an ATM call
Risk: Amount of premium paid
Reward: Unlimited?
The Gist
Iinclude the straddle here for completeness sake. Ihave not included alot of the fancier multioption strategies in this book because Ihave found
them to be more expensive than they are worth, especially for someone
with adefinite directional view on asecurity. However, the straddle is re-
ferred to commonly and is deceptively attractive, so Iinclude it here to
warn investors against its use, if for no other reason.
The straddle shares many similarities with the strangle, of course, but
straddles are enormously expensive because you are paying for every pos-
sible price the stock will move to over the term of the options. For example,
Ijust looked up option prices for BlackBerry (BBRY), whose stock was
trading at $9.00. For the 86 days to expiry, $9-strike calls (delta = 0.56) and
$9-strike puts (delta = –0.44) were priced at $1.03 and $1.13, respectively.

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:225


Gaining Exposure • 209
The total premium of $2.16 represents 24 percent of the stock’sprice, which
means that if the implied volatility (around 60 percent) remains constant,
the stock would have to move 24 percent before an investor even breaks
even. It is true that during sudden downward stock price moves, implied
volatility usually rises, so it might take alittle less of astock price move-
ment to the downside to break even. However, during sudden upside
moves, implied volatility often drops, which would make it more difficult
to break even to the upside.
Despite this expense, astraddle will still give an investor alower
breakeven point than astrangle on the same stock if held to expiration.
The key is that astrangle will almost always generate ahigher profit than
astraddle if it is closed before expiration simply because the initial cost of
the strangle is lower and the relative leverage of each of its legs is higher.
This is yet another reason to consider closing astrangle early if and when
you are pleased with the profits made.
If you do not know whether astock will move up or down, the best
you can hope for is to make aspeculative bet on the company. When you
make speculative bets, it is best to reduce the amount spent on it or you will
whittle down all your capital on what amounts to aroulette wheel. Reduc-
ing the amount spent on asingle bet is the reason an intelligent investor
should stay away from straddles.
With all the main strategies for gaining exposure covered, let’snow
turn to accepting exposure by selling options.

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:226


211
Chapter 10
Accepting exposure
Brokerages and exchanges treat the acceptance of exposure by counter -
parties in avery different way from counterparties who want to gain expo-
sure. There is agood reason for this: although an investor gaining exposure
has an option to transact in the future, his or her counterparty—an investor
accepting exposure—has acommitment to transact in the future at the sole
discretion of the option buyer. If the investor accepting exposure does not
have the financial wherewithal to carry out the committed transaction, the
broker or exchange is on the hook for the liability.
1
For example, an investor selling aput option struck at $50 per share
is committing to buy the stock in question for $50 ashare at some point
in the future—this is the essence of accepting exposure. If, however,
the investor does not have enough money to buy the stock at $50 at
some point in the future, the investor’scommitment to buy the shares is
economically worthless.
To guard against this eventuality, brokers require exposure-accepting
investors to post asecurity deposit called margin that will fully cover the fi-
nancial obligation to which the investor is committing. In the preceding ex-
ample, for instance, the investor would have to keep $5,000 (= $50 per share ×
100 shares/contract) in reserve and would not be able to spend those reserved
funds for stock or option purchases until the contract has expired worthless.
Because of this margin requirement, it turns out that one of our strat-
egies for accepting leverage—short puts—always carries with it aloss lev-
erage of –1.0—exactly the same as the loss leverage of astock. Think about
it this way: what difference is there between using $50 to buy astock and

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:228


212  •   The Intelligent Option Investor
setting $50 aside in an escrow account you can’ttouch and promising that
you will buy the stock with the escrow funds in the future if requested to
do so? From arisk perspective, “very little” is the answer.
Short calls are more complicated, but Iwill discuss the leverage car -
ried by them using elements of the structure Iset forth in Chapter 8. In the
following overviews, Iadd one new line item to the tables that details the
margin requirements of the positions.
Intelligent option investors accept exposure when the market over -
estimates the likelihood of avaluation that the investor believes is not arational outcome. In graphic terms, this means that either one or both of
the investor’sbest- and worst-case valuation scenarios lie well within the
Black-Scholes-Merton model (BSM) cone.
Simple (one-option) strategies to accept exposure include
1. Short put
2. Short call (call spread)
Complex (multioption) strategies to accept exposure include the following:
1. Short straddle
2. Short strangle
Jargon introduced in this chapter includes the following:
Margin Put-call parity
Early exercise Cover (aposition)
Writing (an option)
Short Put
RED

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:229


Accepting Exposure   • 213
Downside: Overvalued
Upside: Fairly valued
Execute: Sell aput contract
Risk: Strike price minus premium received [same as stock inves-
tor at the effective buy price (EBP)]
Reward: Limited to premium received
Margin: Notional amount of position
The Gist
The market is pricing in arelatively high probability that the stock price
will fall. An investor, from alonger investment time frame perspective,
believes that the value of the stock is likely worth at least the present mar-
ket value and perhaps more. The investor agrees to accept the downside
risk perceived by the market and, in return, receives apremium for doing
so. The premium cannot be fully realized unless the option expires out-
of-the money (OTM). If the option expires in-the-money (ITM), the
investor pays an amount equal to the strike price for the stock but can
partially offset the cost of the stock by the premium received. The inves-
tor thus promises to buy the stock in question at aprice of the strike
price of the option less the premium received—what Icall the effective
buy price.
Ithink of the short-put strategy as being very similar to buying cor -
porate bonds and believe that the two investment strategies share many
similarities. Abond investor is essentially looking to receive aspecific
monetary return (in the form of interest) in exchange for accepting
the risk of the business failing. The only time abond investor owns acompany’sassets is after the value of the firm’sequity drops to zero, and
the assets revert to the control of the creditors. Similarly, ashort-put in-
vestor is looking to receive aspecific monetary return (in the form of an
option premium) in exchange for accepting the risk that the company’sstock will decrease in value. The only time ashort-put investor owns acompany’sshares is after the market value of the shares expires below the
preagreed strike price.
Because the strategies are conceptually similar, Iusually think of short-
put exposure in similar terms and compare the “yield” Iam generating

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:230


214  •   The Intelligent Option Investor
from aportfolio of short puts with the yield Imight generate from acor -
porate bond portfolio. With this consideration, and keeping in mind that
these investments are unlevered, 2 the name of the game is to generate as
high apercentage return as possible over the investing time horizon while
minimizing the amount of real downside risk you are accepting.
Tenor Selection
To maximize percentage return, in general, it is better to sell options with
relatively short-term expirations (usually tenors of from three to nine
months before expiration). This is just the other side of the coin of the
rule to buy long-tenor options: the longer the time to expiration, the less
time value there is on aper-day basis. The rule to sell shorter-tenor options
implies that you will make ahigher absolute return by chaining together
two back-to-back 6-month short puts than you would by selling asingle
12-month option at the beginning of the period.
During normal market conditions, selling shorter-tenor options is
the best tactical choice, but during large market downdrafts, when there
is terror in the marketplace and implied volatilities increase enormously
for options on all companies, you might be able to make more by sell-
ing alonger-tenor option than by chaining together aseries of shorter-
tenor ones (because, presumably, the implied volatilities of options will
drop as the market stabilizes, and this drop means that you will make
less money on subsequent put sales). At these times of extreme market
stress, there are situations where you can find short-put opportunities
on long-tenor options that defy economic logic and should be invested
in opportunistically.
For example, during the terrible market drops in 2009, Ifound acompany whose slightly ITM put long-term equity anticipation securities
(LEAPS) were trading at such ahigh price that the effective buy price of
the stock was less than the amount of cash the firm had on its balance
sheet. Obviously, for afirm producing positive cash flows, the stock should
not trade at less than the value of cash presently on the balance sheet! Ief-
fectively got the chance to buy afirm with $6 of cash on the balance sheet
and the near certainty of generating about $2 more over the economic life
of the options for $5.50. The opportunity to buy $6–$8 worth of cash for

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:231


Accepting Exposure   • 215
$5.50 does not come along very often, so you should take advantage of it
when you see it.
Of course, the absolute value of premium you will receive by writing
(jargon that means selling an option) ashort-term put is less than the ab-
solute value of the premium you will receive by writing along-term one.
3
As such, an investor must balance the effective buy price of the stock (the
strike price of the option less the amount of premium to be received) in
which he or she is investing in the short-put strategy with the percentage
return he or she will receive if the put expires OTM.
Iwill talk more about effective buy price in the next section, but keep
in mind that we would like to generate the highest percentage return pos-
sible and that this usually means choosing shorter-tenor options.
Strike Price Selection
In general, the best policy is to sell options at as close to the 50-delta [at-
the-money (ATM)] mark as one can because that is where time value for
any option is at its absolute maximum. Our expectation is that the option’stime value will be worthless at expiration, and if that is indeed the case,
we will be selling time value at its maximum and “closing” our time value
position at zero—its minimum. In this way, we are obeying (in reverse
order) the old investing maxim “Buy low, sell high. ” Selling ATM puts
means that our effective buy price will be the strike price at which we sold
less the amount of the premium we received. It goes without saying that
an intelligent investor would not agree to accept the downside exposure
to astock if he or she were not prepared to buy the stock at the effective
buy price.
Some people want to sell OTM puts, thereby making the effective buy
price much lower than the present market price. This is an understandable
impulse, but simply attempting to minimize the effective buy price means
that you must ignore the other element of asuccessful short put strategy:
maximizing the return generated. There are times when you might like to
sell puts on acompany but only at alower strike price. Rather than accept-
ing alower return for accepting that risk, Ifind that the best strategy is
simply to wait awhile until the markets make ahiccup and knock down the
price of the stock to your desired strike price.

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:232


216  •   The Intelligent Option Investor
Portfolio Management
As we have discussed, the best percentage returns on short-put investments
come from the sale of short-tenor ATM options. Ifind that each quarter there
are excellent opportunities to find afairly constant stream of this type of short-
term bet that, when strung together in aportfolio, can generate annualized
returns in the high-single-digit to low-teens percentage range. This level of
returns—twice or more the yield recently found on ahigh-quality corporate
bond portfolio and closer to the bond yield on highly speculative small com-
panies with low credit ratings—is possible by investing in strong, high-quality
blue chip stocks. In my mind, it is difficult to allocate much money to corpo-
rate bonds when this type of alternative is available.
Some investors prefer to sell puts on stocks that are not very vola-
tile or that have had asignificant run-up in price,
4 but if you think about
how options are priced, it is clear that finding stocks that the market
perceives as more volatile will allow you to generate higher returns. You
can confirm this by looking at the diagrams of ashort-put investment
given two different volatility scenarios. First, adiagram in which implied
volatility is low:
Advanced Building Corp. (ABC)
80
70
60
50
40
30
20
5/18/2012 5/20/2013 249 499 749 999
Date/Day Count
Stock Price
RED

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:233


Accepting Exposure   • 217
Now adiagram when implied volatility is higher:
RED
Advanced Building Corp. (ABC)
80
70
60
50
40
30
20
5/18/2012 5/20/2013 249 499 749 999
Date/Day Count
Stock Price
Obviously, there is much more of the put option’srange of exposure
bounded by the BSM cone in the second, high-volatility scenario, and this
means that the price received for accepting the same downside risk will be
substantially higher when implied volatility is elevated.
The key to setting up asuccessful allocation of short puts is to find
companies that have relatively low downside valuation risk but that also
have asignificant amount of perceived price risk (as seen by the market)—
even if this risk is only temporary in nature. Quarterly earnings seasons are
nearly custom made for this purpose. Sell-side analysts (and the market
in general) mainly use multiples of reported earnings to generate atarget
price for astock. As such, asmall shortfall in reported earnings as aresult
of atransitory and/or nonmaterial accounting technicality can cause sell-
side analysts and other market participants to bring down their short-term
target price estimates sharply and can cause stock prices to drop sharply
as well.
5
These times, when ahigh-quality company drops sharply as are-
sult of perceived risk by other investors, are awonderful time to replen-
ish aportfolio of short puts. If you time the tenors well, your short-put

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:234


218  •   The Intelligent Option Investor
investment will be expiring just about the time another short-put invest-
ment is becoming attractive, so you can use the margin that has until re-
cently been used to support the first position to support the new one.
Obviously, this strategy only works when markets are generally trend-
ing upward or at least sideways over the investment horizon of your short
puts. If the market is falling, short-put positions expire ITM, so you are left
with aposition in the underlying stocks. For an option trader (i.e., ashort-
term speculator), being put astock is anightmare because he or she has
no concept of the underlying value of the firm. However, for an intelligent
option investor, being put astock simply means the opportunity to receive
adividend and enjoy capital appreciation in astrong stock with very little
downside valuation risk.
The biggest problem arises when an investor sells aput and then re-
vises down his or her lowest-case valuation scenario at alater time. For in-
stance, the preceding diagram shows aworst-case scenario of $55 per share.
What if new material information became known to you that changed your
lower valuation range to $45 per share just as the market price for the stock
dropped, as in the following diagram?
Advanced Building Corp. (ABC)
80
70
60
50 EBP = $47.50
Overvaluation of
downside exposure
40
30
20
5/18/2012 5/20/2013 249 499 749 999
Date/Day Count
Stock Price
RED

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:235


Accepting Exposure   • 219
Looking at this diagram closely, you should be able to see several
things:
1. The investor who is short this put certainly has anotable unrealized
loss on his or her position. You can tell this because the put the
investor sold is now much more valuable than at the time of
the original sale (more of the range of exposure is carved out by
the BSM cone now). When you sell something at one price and the
value of that thing goes up in the future, you suffer an opportunity
loss on your original sale.
2. With the drop in price and the cut in fair value, the downside ex-
posure on this stock still looks overvalued.
3. If the company were to perform so that its share price eventually
hit the new, reduced best-case valuation mark, the original short-
put position would generate aprofit—albeit asmaller profit than
the one originally envisioned.
At this point, there are acouple of choices open to the investor:
1. Convert the unrealized loss on the short-put position to arealized
one by buying $50-strike puts to close the position (a.k.a. cover the
position).
2. Leave the position open and manage it in the same way that the
investor would manage astruggling stock position.
It is rarely asound idea to close ashort put immediately after the re-
lease of information that drives down the stock price (the first choice above,
in other words). At these times, investors are generally panicked, and this
panic will cause the price of the option you buy to cover to be more expen-
sive than justified. Waiting afew days or weeks for the fear to drain out of
the option prices (i.e., for the BSM cone to narrow) and for the stock price
to stabilize some will usually allow you to close the option position at amore
favorable price. There is one exception to this rule: if your new valuation
suggests afair value at or below the present market price, it is better to close
the position immediately and realize those losses. If you do not close the
position, you are simply gambling (as opposed to investing) because you no
longer have abetter than even chance of making money on the investment.

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:236


220  •   The Intelligent Option Investor
The decision to leave the position open must depend on what other
potential investments you are able to make and how the stock position that
will likely be put to you at expiration of the option contract stacks up on arelative basis. For instance, let’sassume that you had received apremium
of $2.50 for writing the puts struck at $50. This gives you an effective buy
price of $47.50. The stock is now trading at $43 per share, so you can think
of your position as an unlevered, unrealized loss of $4.50, or alittle under
10 percent of your EBP . Your new worst-case valuation is $55 per share,
which implies again of about 15 percent on your EBP; your new best-case
valuation is $65 per share, which implies again of 37 percent.
How do these numbers compare with other investments in your port-
folio? How much spare capacity does your portfolio have for additional
investments? (That is, do you have enough spare cash to increase the size
of this investment by selling more puts at the new market price or buying
shares of stock? And if so, would your portfolio be weighted too heavily on asingle industry or sector?) By answering these questions and understanding
how this presently losing investment compares with other existing or poten-
tial investments should govern your portfolio management of the position.
An investor cannot change the price at which he or she transacted
in asecurity. The best he or she can do is to develop arational view of the
value of asecurity and judge that security by its relative merit versus other
possible investments. Whether you ever make an option transaction, this
is agood rule to keep in mind.
Let us now take alook at short calls and short-call spreads—the
strategy used for accepting upside exposure.
Short Call (Call Spread)
RED

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:237


Accepting Exposure   • 221
Downside: Fairly valued
Upside: Overvalued
Execute: Sell acall contract (short call); sell acall contract while
simultaneously buying acall contract at ahigher strike
price (short-call spread)
Risk: Unlimited for short call; difference between strike prices
and premium received (short-call spread)
Reward: Limited to the amount of premium received
Margin: Variable for ashort call; dollar amount equal to the differ-
ence between strike prices for ashort-call spread
The Gist
The market overestimates the likelihood that the value of afirm is above its pre-
sent market price. An investor accepts the overvalued upside exposure in return
for afixed payment of premium. The full amount of the premium will only flow
through to the investor if the price of the stock falls and the option expires OTM.
There are two variations of this investment—the short call and the
short-call spread. This book touches on the former but mainly addresses
the latter. Ashort call opens up the investor to potentially unlimited capital
losses (because stocks theoretically do not have an upper bound for their
price), and abroker will not allow you to invest using this strategy except
for the following conditions:
1. You are ahedge fund manager and have the ability to borrow
stocks through your broker and sell them short.
2. You are short calls not on astock but on adiversified index (such
as the Dow Jones Industrial Index or the Standard and Poor’s 500
Index) through an exchange-traded fund (ETF) or afutures con-
tract and hold adiversified stock portfolio.
For investors fitting the first condition, short calls are margined in the
same way as the rest of your short portfolio. That is, you must deposit initial
margin on the initiation of the investment, and if the stock price goes up, you
must pay in variance margin to support the position. Obviously, as the stock
price falls, this margin account is settled in your favor. For investors fitting the
second condition, when you originally sell the call option, your broker should

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:238


222  •   The Intelligent Option Investor
indicate on your statements that acertain proportion of your account effec-
tively will be treated as margin. This means that you stand to receive the eco-
nomic benefit from your diversified portfolio of securities but will not be able
to liquidate all of it. If the market climbs higher, alarger proportion of your
portfolio will be considered as margin; if it falls lower, asmaller proportion
of your portfolio will be considered as margin. Basically, aproportion of any
gains from your diversified stock portfolio will be reapportioned to serve as
collateral for your short call when the market is rising, and aproportion of any
losses from your diversified stock portfolio will be offset by afreeing of margin
related to your profits on the short call when the market is falling.
Most brokers restrict the ability of individual investors to write un-
covered calls on individual stocks, so the rest of this discussion will cover
the short-call spread strategy for individual stocks.
Tenor Selection
Tenors for short-call spreads should be fairly short under the same reason-
ing as that for short puts—one receives more time value per day for short-
er-tenor options. Look for calls in the three- to nine-month tenor range.
The tenor of the purchased call (at the higher strike price) should be the
same as the tenor of the sold calls (at the lower strike price). Theoretically,
the bought calls could be longer, but it is hard to think of avaluation justifi-
cation for such astructure. By buying alonger-tenor call for the upside leg
of the investment, you are expressing an investment opinion that the stock
will likely rise over the long term—this exactly contradicts the purpose of
this strategy: expressing abearish investment opinion.
Strike Price Selection
Theoretically, you can choose any two strike prices, sell the call at the lower
price, and buy the call at the higher price and execute this investment. If you
sold an ITM call, you would receive premium that consists of both time and
intrinsic value. If the stock fell by expiration, you would realize all the wasted
time value plus the difference between the intrinsic value at initiation and the
intrinsic value at expiration.
Despite the theory, however, in practice, the lower strike option is usually
sold ATM or OTM because of the threat of assignment. Assignment is the pro-
cess the exchange goes through when investors choose to exercise the option

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:239


Accepting Exposure   • 223
they own rather than trade them away for aprofit. Recall from Chapter 2
that experienced option investors do not do this most of the time; they
know that because of the existence of time value, it is usually more beneficial
for them to sell their option in the market and use the proceeds to buy the stock
if they want to hold the underlying. Inexperienced investors, however, often are
not conscious of the time-value nuance and sometimes elect to exercise their
option. In this case, the exchange randomly pairs the option holders who wish
to exercise with an option seller who has promised to sell at that exercise price.
There is one case in which asophisticated investor might chose to
exercise an ITM call option early, related to aprinciple in option pricing
called put-call parity. This rule, which was used to price options before
advent of the BSM, simply states that acertain relationship must exist be-
tween the price of aput at one strike price, the price of acall at that same
strike price, and the market price of the underlying stock. Put-call parity
is discussed in Appendix C. In this appendix, you can learn what the exact
put-call parity rule is (it is ridiculously simple) and then see how it can be
used to determine when it is best to exercise early in case you are long acall and when your short-call (spread) position is in danger of early exercise
because of atrading strategy known as dividend arbitrage.
The assignment process is random, but obviously, the more contracts
you sell, the better the chance is that you will be assigned on some part or all
of your sold contracts. Even if you hold until expiration, there is still achance
that you may be assigned to fulfill acontract that was exercised on settlement.
Clearly, from the standpoint of option sale efficiency, an ATM call is the
most sensible to sell for the same reason that ashort put also was most efficient
ATM. As such, the discussion that follows assumes that you are selling the
ATM strike and buying back ahigher strike to cover.
In acall-spread strategy, the capital you have at risk is the difference be-
tween the two strike prices—this is the amount that must be deposited into
margin. Depending on which strike price you use to cover, the net premium
received differs because the cost of the covering call is cheaper the further
OTM you cover. As the covering call becomes more and more OTM, the ratio
of premium received to capital at risk changes. Put in these terms, it seems
that the short-call spread is alevered strategy because leverage has to do with
altering the capital at risk in order to change the percentage return. This con-
trasts with the short-call spread’smirror strategy on the put side—short puts—
in that the short-put strategy is unlevered.

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:240


224  •   The Intelligent Option Investor
For instance, here are data from ATM and OTM call options on IBM
(IBM) expiring in 80 days. Itook these data when IBM’sshares were trad-
ing at $196.80 per share.
Sell a Call at 195
Cover at ($) Net Premium Received ($) Percent Return Capital at Risk ($)
200 2.40 48 5
205 4.26 43 10
210 5.47 36 15
215 6.17 31 20
220 6.51 26 25
225 6.70 22 30
230 6.91 20 35
235 6.90 17 40
240 6.96 15 45
In this table, net premium received was calculated by selling at the $195
strike’sbid price and buying at each of the listed strike price’sask prices. Percent
return is the proportion of net premium received as apercentage of the capital
at risk—the width of the spread. This table clearly shows that accepting expo-
sure with acall spread is alevered strategy. The potential return on apercent-
age basis can be raised simply by lowering the amount of capital at risk.
However, although accepting exposure with acall spread is un-
deniably levered from this perspective, there is one large difference: un-
like the leverage discussed earlier in this book for apurchase of call op-
tions—in which your returns were potentially unlimited—the short-call
spread investor receives premium up front that represents the maximum
return possible on the investment. As such, in the sense of the investor’spotential gains being limited, the short-call spread position appears to be
an unlevered investment.
Considering the dual nature of ashort-call spread, it is most help-
ful to think about managing these positions using atwo-step process with
both tactical and strategic aspects. We will investigate the tactical aspect
of leverage in the remainder of this section and the strategic aspect in the
portfolio management section.

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:241


Accepting Exposure   • 225
Tactically, once an investor has decided to accept exposure to astock’supside potential using acall spread, he or she has arelatively limited choice
of investments. Let’sassume that we sell the ATM strike; in the IBM ex-
ample shown earlier, there is achoice of nine strike prices at which we
can cover. The highest dollar amount of premium we can receive—what Iwill call the maximum return—is received by covering at the most distant
strike. Every strike between the ATM and the most distant strike will at
most generate some percentage of this maximum return.
Now let’slook at the risk side. Let’ssay that we sell the $195-strike call
and cover using the $210-strike call. Now assume that some bit of good
news about IBM comes out, and the stock suddenly moves to exactly $210.
If the option expires when IBM is trading at $210, we will have lost the
entire amount of margin we posted to support this investment—$15 in all.
This $15 loss will be offset by the amount of premium we received from
selling the call spread—$5.47 in the IBM example—generating anet loss of
$9.53 (= $5.47 − $15). Compare this with the loss that we would suffer if we
had covered using the most distant call strike. In this case, we would have
received $6.96 in premium, so if the option expires when IBM is trading at
the same $210 level as earlier, our net loss would be $8.04 (= $6.96 − $15).
Because our maximum return is generated with the widest spread, it fol-
lows that our minimum loss for the stock going to any intermediate strike
price also will be generated with the widest spread.
At the same time, if we always select the widest spread, we face an
entirely different problem. That is, the widest spread exposes us to the great-
est potential loss. If the stock goes only to $210, it is true that the widest
spread will generate asmaller loss than the $195–$210 spread. However, in
the extreme, if the stock moves up strongly to $240, we would lose the $45
gross amount supporting the margin account and anet amount of $38.04
(= $45 – $6.96). Contrast this with anet loss of $9.53 for the $195–$210
spread. Put simply, if the stock moves up only abit, we will do better with
the wider spread; if it moves up alot, it is better to choose anarrower
spread.
In short, when thinking about call spreads, we must balance our
amount of total exposure against the exposure we would have for an inter-
mediate outcome against the total amount of premium we are receiving. If
we are too protective and initiate the smallest spread possible, our chance

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:242


226  •   The Intelligent Option Investor
of losing the entire margin amount is higher, but the margin amount lost
is smaller. On the other hand, if we attempt to maximize our winnings
and initiate the widest spread possible, our total exposure is greatest, even
though the chance of losing all of it is lower.
Plotting these three variables on agraph, here is what we get:
200 (11%)
0%
20%
40%
60%
80%
106% 102%
94%89%
100%
120%
140%
160%
180%
200%
205 (22%) 210 (33%) 215 (44%) 220 (56%) 225 (67%) 230 (78%) 235 (89%) 240 (100%)
Strike (% of Total Exposure)
Risk & Return of Call Spreads vs. Maximum Spread
Risk Comparison Return Comparison
Here, on the horizontal axis, we have the value of the covering strike and
the size of the corresponding spread as apercentage of the widest spread.
This shows how much proportional capital is at risk (e.g., at the $215-strike,
we are risking atotal of $20 of margin; $20 is 44 percent of total exposure
of $45 if we covered at the $240-strike level). The top line shows how much
greater the loss would be if we used that strike to cover rather than the
maximum strike and the option expired at that strike price (e.g., if we cover
at the $215-strike and the option expires when the stock is trading at $215,
our loss would be 6 percent greater than the loss we would suffer if we
covered at the $240-strike). The bottom line shows the premium we will
realize as income if the stock price declines as apercentage of the total pre-
mium possible if we covered at the maximum strike price. Here are the val-
ues from the graph in tabular format so that you can see the numbers used:

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:243


228  •   The Intelligent Option Investor
With atable like this, you can balance, on the one hand, the degree
you are reducing your overall exposure in aworst-case scenario (by look-
ing at column a) against how much risk you are taking on for abad-case
(intermediary upward move of the stock) scenario (by looking at column
b) against how much less premium you stand to earn if the stock does go
down as expected (by looking at column c).
There are no hard and fast rules for which is the correct covering strike to
select—that will depend on your confidence in the valuation and timing, your
risk profile, and the position size—but looking at the table, Itend to be drawn
to the $215 and $220 strikes. With both of those strikes, you are reducing your
worst-case exposure by about half, increasing your bad-case exposure just
marginally, and taking only asmall haircut on the premium you are receiving.
6
Now that we have an idea of how to think about the potential risk and
return on aper-contract basis, let’sturn to leverage in the strategic sense—
figuring out how much capital to commit to agiven bearish idea.
Portfolio Management
When we thought about leverage from acall buyer’sperspective, we
thought about how large of an allocation we wanted to make to the idea
itself and changed our leverage within that allocation to modify the profits
we stood to make. Let’sdo this again with IBM—again assuming that we are
willing to allocate 5 percent of our portfolio to an investment in the view
that this company’sstock price will not go higher. At aprice of $196.80, a
5 percent allocation would mean controlling alittle more than 25 shares for
every $100,000 of portfolio value.
7 Because options have acontract size of
100 shares, an unlevered 5 percent allocation to this investment would
require aportfolio size of $400,000.
The equation to calculate the leverage ratio on the basis of notional
exposure is
× =Notional valueo fo ne contract
Dollarv alue of allocation number of contractsl everager atio
So, for instance, if we had a $100,000 portfolio of which we were willing to
commit 5 percent to this short-call spread on IBM, our position would have aleverage ratio of

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:245


Accepting Exposure   • 229
×= ≈$19,500
$5,000 13 .9 4: 1leverage
Selling the $195/$220 call spread will generate $651 worth of pre-
mium income and put at risk $2,500 worth of capital. Nothing can change
these two numbers—in this sense, the short-call spread has no leverage.
The 4:1 leverage figure merely means that the percentage return will ap-
pear nearly four times as large on agiven allocation as a 1:1 allocation
would appear. The following table—assuming the sale of one contract of
the $195/$220 call spread—shows this in detail:
Winning Case Losing Case
Premium
Received
($)
Target
Allocation
($) Leverage
Stock
Move ($)
Percent
Return on
Allocation
Stock
Move
($)
Dollar
Return
Percent
Return on
Allocation
651 20,000 1:1 –2 3.3 +25 –1,849 –9.2
651 10,000 2:1 –2 6.5 +25 –1,849 –18.5
651 5,000 4:1 –2 13.0 +25 –1,849 –37.0
Note: The dollar return in the losing case is calculated as the loss of the $2,500 of margin
per contract less than the premium received of $651.
Notice that the premium received never changes, nor does the worst-
case return. Only the perception of the loss changes with the size of our
target allocation.
Now that we have asense of how to calculate what strategic leverage
we are using, let’sthink about how to size the position and about how much
risk we are willing to take. When we are selling acall or call spread, we are
committing to sell astock at the strike price. If we were actually selling the
stock at that price rather than committing to do so, where would we put
our stop loss—in other words, when would we close the position, assuming
that our valuation or our timing was not correct?
Let’ssay that for this stock, if the price rose to $250, you would be
willing to admit that you were wrong and would realize aloss of $55 per share,
or $5,500 per hundred shares. This figure—the $5,500 per hundred shares
you would be willing to lose in an unlevered short stock position—can be
used as aguide to select the size of your levered short-call spread.

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:246


230  •   The Intelligent Option Investor
In this case, you might choose to sell asingle $195–$240 call spread, in
which case your maximum exposure would be $4,500 [= 1 × (240 – 195) × 100]
at the widest spread. This investment would have aleverage ratio of approxi-
mately 1:1. Alternatively, you could choose to sell two $195–$220 spreads, in
which case your maximum exposure would be $5,000 [= 2 × (220 − 195) ×
100], with aleverage ratio of approximately 2:1. Which choice you select will
depend on your assessment of the valuation of the stock, your risk tolerance,
and the composition of your portfolio (i.e., how much of your portfolio is al-
located to the tech sector, in this example of an investment in IBM). Because
the monetary returns from ashort-call or call-spread strategy are fixed and
the potential for losses are rather high, Iprefer to execute bearish investments
using the long-put strategy discussed in the “Gaining Exposure” section.
With this explanation of the short-call spread complete, we have all the
building blocks necessary to understand all the other strategies mentioned
in this book. Let’snow turn to two nonrecommended complex strategies
for accepting exposure—the short straddle and the short strangle—both of
which are included not because they are good strategies but rather for the
sake of completeness.
Short Straddle/Short Strangle
Short Straddle
RED
Downside: Overvalued
Upside: Overvalued
Execute: Sell an ATM put; simultaneously sell an ATM call spread

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:247


Accepting Exposure   • 231
Risk: Amount equal to upper strike price minus premium received
Reward: Limited to premium received
Margin: Dollar amount equal to upper strike price
Short Strangle
RED
RED
Downside: Overvalued
Upside: Overvalued
Execute: Sell an OTM put; simultaneously sell an OTM call spread
Risk: Call-spread leg: Amount equal to difference between
strikes and premium received. Put leg: Amount equal to
strike price minus premium received. Total exposure is
the sum of both legs.
Reward: Limited to premium received
Margin: Call-spread leg: Amount equal to difference between
strikes. Put leg: Amount equal to strike price. Total mar -
gin is the sum of both legs.
The Gist
In my opinion, these are short-term trades rather than investments. Even
though ashort put uses ashort-tenor option, the perspective of the inves-
tor is that he or she is buying shares. These strategies are away to express
the belief that the underlying stock price will not move over ashort time.
In my experience, there is simply no way to develop arational view of how
asingle stock will move over ashort time frame. In the short term, markets

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:248


233
Chapter 11
Mixing ExposurE
Mixing exposure uses combinations of gaining and accepting exposure,
employing strategies that we already discussed to create what amounts to
sort of ashort-term synthetic position in astock (either long or short).
These strategies, nicknamed “diagonals” can be extremely attractive and
extremely financially rewarding in cases where stocks are significantly mis-
priced (in which case, exposure to one direction is overvalued, whereas the
other is extremely undervalued).
Frequently, using one of these strategies, an investor can enter apo-
sition in alevered out-of-the-money (OTM) option for what, over time,
becomes zero cost (or can even net acash inflow) and zero downside expo-
sure. This is possible because the investor uses the sale of one shorter-tenor
at-the-money (ATM) option to subsidize the purchase of another longer-
tenor OTM one. Once the sold option expires, another can be sold again,
and whatever profit is realized from that sale goes to further subsidize the
position.
This strategy works well because of acouple of rules of option pricing
that we have already discussed:
1. ATM options are more expensive than OTM options of the same
tenor.
2. Short-tenor options are worth less than long-tenor options, but
the value per day is higher for the short-tenor options.

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:250


234  •   The Intelligent Option Investor
Iprovide actual market examples of these strategies in this chapter and will
point out the effect of both these points in those examples.
Because these strategies are amix of exposures, it makes sense
that they are just complex (i.e., multioption) positions. Iwill discuss the
following:
1. Long diagonal
2. Short diagonal
Note that the nomenclature Iuse here is abit different from what others
in the market may use. What Iterm adiagonal in this book is what others
might call a “spit-strike synthetic stock. ” Since Bernie Madoff ’sinfamous
“split-strike conversion” fraud, this term doesn’thave avery good ring to
it. For other market participants, adiagonal means simultaneously buying
and selling options of the same type (i.ecalls or puts). In this book, it means
selling an option of one kind and buying the other kind.
Iwill also talk about what is known in the options world as overlays. One
of the most useful things about options is the way that they can be grafted or
overlain onto an existing common stock position in away that alters the port-
folio’soverall risk-reward profile. The strategies Iwill review here are as follows:
1. Covered calls
2. Protective puts
3. Collars
These strategies are popular but often misunderstood ways to alter your
portfolio’srisk-reward profile.
Coming this far in this book, you already have agood understand-
ing about how options work, so the concepts presented here will not be
difficult, but Iwill discuss some nuances that will help you to evaluate
investment choices and make sound decisions regarding the use of these
strategies. Iwill refer to strike selection and tenor selection in the following
pages, but for these, along with “The Gist” section, I’ll include an “Execu-
tion” section and a “Common Pitfalls” section.
Covered calls are an easy strategy to understand once you understand
short puts, so Iwill discuss those first. Protective puts share alot of simi-
larities with in-the-money (ITM) call options, and Iwill discuss those next.

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:251


Mixing Exposure  •  235
Collars are just acombination of the other two overlay strategies and so are
easiest left to the end.
Long Diagonal
GREEN
RED
Downside: Overvalued
Upside: Undervalued
Execute: Sell an ATM put option (short put) and simultaneously
buy an OTM call option (long call)
Risk: Sum of put’sstrike price and net premium paid for call
Reward: Unlimited
Margin: Amount equal to put’sstrike price
The Gist
Other than the blank space in the middle of the diagram and the disparity
between the lengths of the tenors, the preceding diagram looks very much like
the risk-return profile diagram for along stock—accepting downside exposure
in return for gaining upside exposure. As you can see from the diagram, the
range of exposure for the short put lies well within the Black-Scholes-Merton
model (BSM) cone, but the range of exposure for the long call is well outside
the cone. It is often possible to find short-put–long-call combinations that al-
low for an immediate net credit when setting up this investment.

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:252


236  •   The Intelligent Option Investor
Because we must fully margin ashort-put investment, that leg of
the long diagonal carries with it aloss leverage ratio of –1.0. However, the
OTM call leg represents an immediate realized loss coupled with avery
high lambda value for gains. As such, if the put option expires ITM, the
long diagonal is simply alevered strategy; if the put option expires OTM,
the investment is avery highly levered one because the unlevered put
ceases to influence the leverage equation. Another short put may be written
after the previous short put expires; this further subsidizes the cost of the
calls and so greatly increases the leverage on the strategy.
If the stock moves quickly toward the upper valuation range, this
structure becomes extremely profitable on an unrealized basis. If the put
option expires ITM, the investor is left with alevered long investment in
the stock in addition to the long position in the OTM. As in any other
complex structure, the investment may be ratioed—for instance, by buying
one call for every two puts sold or vice versa.
Strike Price Selection
The put should be sold ATM or close to ATM in order to maximize the time
value sold, as explained earlier in the short-put summary. The call strike may be
bought at any level depending on the investor’sappetite for leverage but is usu-
ally purchased OTM. The following table shows the net debit or credit associated
with the long diagonal between the ATM put ($55 strike price, delta of –0.42,
priced at the bid price) with an expiration of 79 days and each call strike (at the
ask price) listed, all of which are long-term equity anticipated securities (LEAPS)
having expirations in 534 days. The lambda figure for the OTM calls is also given
to provide an idea of the comparative leverage of each call option. For this exam-
ple, Iam using JP Morgan Chase (JPM) when its stock was trading for $56.25.
Strike Delta (Debit) Credit Call Lambda (%)
57.50 0.43 (2.52) 5.6
60.00 0.37 (1.57) 6.1
62.50 0.31 (0.76) 6.7
65.00 0.26 (0.25) 7.0
70.00 0.16 0.78 8.4
75.00 0.10 1.28 9.5
80.00 0.06 1.56 10.5

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:253


Mixing Exposure  •  237
Here we can see that for along diagonal using 79-day ATM puts
and 594-day LEAPS that are OTM by just over 15 percent, we are
paying anet of only $25 per contract for notional control of 100
shares. On aper-contract basis, at the following settlement prices,
we would generate the following profits (or losses, in the case of the
first row):
Settlement Price ($) Dollar Profit per Contract
Percentage Return on Original
Investment (%)
65 0 –100
66 100 300
67 200 700
68 300 1,100
69 400 1,500
70 500 1,900
71 600 2,300
72 700 2,700
73 800 3,100
74 900 3,500
75 1,000 3,900
If the stock price moves up very quickly, it might be more beneficial
to close the position or some portion of the position before expiration. Let’ssay that my upper-range estimate for this stock was $75. From the preced-
ing table, Ican see that my profit per contract if the stock settles at my fair
value range is $1,000. If there is enough time value on acontract when
the stock is trading in the upper $60 range to generate arealized profit of
$1,000, Iam likely to take at least some profits at that time rather than wait-
ing for the calls to expire.
In Chapter 9, Idiscussed portfolio composition and likened the use
of leverage as aside dish to amain course. This is an excellent side dish that
can be entered into when we see achance to supplement the main meal of
along stock–ITM call option position with abit more spice. Let’snow turn
to its bearish mirror—the short diagonal.

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:254


238  •   The Intelligent Option Investor
Short Diagonal
RED
GREEN
Downside: Undervalued
Upside: Overvalued
Execute: Sell an ATM call option while buying one to cover at ahigher price (short-call spread) and simultaneously buy
an OTM put option (long put)
Risk: Sum of put’sstrike price and net premium paid for call
Reward: Amount equal to the put’sstrike price minus any net
premium paid for it
Margin: Amount equal to spread between call options
The Gist
The diagram for ashort diagonal is just the inverse of the long diagonal and, of
course, looks very similar to the risk-return profile diagram for ashort stock—
accepting upside exposure in return for gaining downside exposure. The gist
of this strategy is simply the short-exposure equivalent to the long diagonal, so
the comments about the long diagonal are applicable to this strategy as well.
The one difference is that because you must spend money to cover the short
call on the upside, the subsidy that the option sale leg provides to the option
purchase leg is less than in the case of the long diagonal. Also, of course, astock
price cannot turn negative, so your profit upside is capped at an amount equal
to the effective sell price. This investment also may be ratioed (e.g., by using
one short-call spread to subsidize two long puts).

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:255


Mixing Exposure  •  239
Strike Price Selection
Strike price selection for ashort diagonal is more difficult because there
are three strikes to price this time. Looking at the current pricing for acall spread with the short call struck at $55, Iget the following selection of
credits:
Upper Call Strike ($)
Call Spread
Net Credit ($)
Percent Total
Risk Percent Total Return
57.50 1.27 17 49
60.00 2.14 33 83
62.50 2.44 50 94
65.00 2.51 67 97
70.00 2.59 100 100
Looking at this, let’ssay we decide to go with the $55.00/$62.50 call
spread. Doing so, we would receive anet credit of $2.44. Now selecting the
put to purchase is amatter of figuring out the leverage of the position with
which you are comfortable.
Strike ($) Delta (Debit) Credit ($) Put Lambda (%)
20.00 –0.02 2.20 –4.5
23.00 –0.02 2.11 –4.6
25.00 –0.03 2.05 –4.6
28.00 –0.04 1.91 –4.8
30.00 –0.05 1.78 –4.8
33.00 –0.07 1.57 –4.8
35.00 –0.09 1.38 –4.8
38.00 –0.12 0.99 –4.8
40.00 –0.15 0.67 –4.7
42.00 –0.17 0.30 –4.7
45.00 –0.23 (0.43) –4.5
47.00 –0.26 (1.01) –4.4
50.00 –0.33 (1.91) –4.4
52.50 –0.39 (3.11) –4.0

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:256


240  •   The Intelligent Option Investor
Notice that there is much less leverage on the long-put side than on
the long-call side. This is afunction of the volatility smile and the abnor -
mally high pricing on the far OTM put side. It turns out that the $20-strike
puts have an implied volatility of 43.3 percent compared to an ATM im-
plied volatility of 22.0 percent.
Obviously, the lower level of leverage will make closing before expira-
tion less attractive, so it is important to select aput strike price between the
present market price and your worst-case fair value estimate. In this way,
if the option does expire when the stock is at that level, you will at least be
able to realize the profit of the intrinsic value.
With these explanations of the primary mixed-exposure strategies,
now let’sturn to overlays—where an option position is added to astock
position to alter the risk-return characteristics of the investor’sportfolio.
Covered Call
Contingent Upside Exposure
Contingent Downside Exposure
LIGHT GREEN
RED
LIGHT RED
Downside: Overvalued
Upside: Fairly valued or undervalued

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:257


242  •   The Intelligent Option Investor
We accepted
downside
exposure when
we sold this
put, so have no
exposure to the
upside here.
RED
The top of the “Covered call” diagram is grayed out because we have
sold away the upside exposure to the stock by selling the call option, and
we are left only with the acceptance of the stock’sdownside exposure. The
pictures are slightly different, but the economic impact is the same.
The other difference you will notice is that after the option expires, in the
case of the covered call, we have represented the graphic as though there is some
residual exposure. This is represented in this way because if the option expires
ITM, you will have to deliver your stock to the counterparty who bought your
call options. As such, your future exposure to the stock is contingent on another
investor’sactions and the price movement of the stock. This is an important point
to keep in mind, and Iwill discuss it more in the “Common Pitfalls” section.
Execution
Because this strategy is identical from arisk-reward perspective to short
puts, the execution details should be the same as well. Indeed, covered
calls should—like short puts—be executed ATM to get the most time value
possible and preferably should be done on astock that has had arecent fall
and whose implied volatility has spiked. However, these theoretical points
Short put

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:259


Mixing Exposure  •  243
ignore the fact that most people simply want to generate abit of extra in-
come out of the holdings they already have and so are psychologically re-
sistant to both selling ATM (because this makes it more likely for their
shares to be called away) and selling at atime when the stock price sud-
denly drop (because they want to reap the benefit of the shares recovering).
Although Iunderstand these sentiments, it is important to realize
that options are financial instruments and not magical ones. It would be
nice if we could simply find an investment tool that we could bolt onto
our present stock holdings that would increase the dividend anice amount
but that wouldn’tput us at risk of having to deliver our beloved stocks to acomplete stranger; unfortunately, this is not the case for options.
For example, let’ssay that you own stock in acompany that is paying out
avery nice dividend yield of 5 percent at present prices. This is amature firm
that has tons of cash flow but few opportunities for growth, so management
has made the welcome choice to return cash to shareholders. The stock is trad-
ing at $50 per share, but because the dividend is attractive to you, you are loathe
to part with the stock. As such, you would prefer to write the covered call at a
$55 or even a $60 strike price. Aquick look at the BSM cone tells us why you
should not be expecting abig boost in yield from selling the covered calls:
80
Sold call
range of
exposure
70
60
50
40
30
20
5/18/2012 5/20/2013 249 499 749 999
Cash Flows R Us, Inc. (CASH)
Date/Day Count
Stock Price
GREEN
LIGHT GREENGRAY
LIGHT REDRED

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:260


244  •   The Intelligent Option Investor
Clearly, the range of exposure for the $55-strike call is well above the
BSM cone. The BSM cone is pointing downward because the dividend rate
is 5 percent—higher than the risk-free rate. This means that BSM drift will
be lower. In addition, because this is an old, mature, steady-eddy kind of
company, the expected forward volatility is low. Basically, this is aperfect
storm for alow option price.
My suggestion is to either write calls on stocks you don’tmind de-
livering to someone else—stocks for which you are very confident in the
valuation range and are now at or above the upper bound—or simply to
look for aportfolio of short-put/covered-call investments and treat it like
ahigh-yield bond portfolio, as Idescribed in Chapter 10 when explaining
short puts. It goes without saying that if you think that astock has alot of
unappreciated upside potential, it’snot agood idea to sell that exposure
away!
One other note about execution: as Ihave said, short puts and cov-
ered calls are the same thing, but agood many investors do not realize this
fact or their brokerages prevent them from placing any trade other than acovered call. This leads to asituation in which there is atremendous sup-
ply of calls. Any time there is alot of supply, the price goes down, and you
will indeed find covered calls on some companies paying alot less than
the equivalent short put. Because you will be accepting the same downside
exposure, it is better to get paid more for it, so my advice is to write the put
rather than the covered call in such situations.
To calculate returns for covered calls, Icarry out the following steps:
1. Assume that you buy the underlying stock at the market price.
2. Deduct the money you will receive from the call sale as well as
any projected dividends—these are the two elements of your cash
inflow—from the market price of the stock. The resulting figure is
your effective buy price (EBP).
3. Divide your total cash inflow by the EBP .
Ialways include the projected dividend payment as long as Iam writ-
ing ashort-tenor covered call and there are no issues with the company
that would prevent it from paying the dividend. Owners of record have aright to receive dividends, even after they have written acovered call on the

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:261


Mixing Exposure  •  245
stock, so it makes sense to count the dividend inflow as one element that
reduces your EBP . In formula form, this turns out to be
−−Coveredc allr eturn= premiumr eceivedf romc all+ projectedd ividends
stockp rice premiumf romc allp rojected dividends
For ashort put, you have no right to receive the dividend, so Ifind the
return using the following formula:
−Shortp ut return= premiumr eceivedf roms hort put
strikepricep remium from shortp ut
Common Pitfalls
Taking Profit
One mistake Ihear people make all the time is saying that they are going
to “take profit” using acovered call. Writing acovered call is taking profit
in the sense that you no longer enjoy capital gains from the stock’sappre-
ciation, but it is certainly not taking profit in the sense of being immune
to falls in the market price of the stock. The call premium you receive will
cushion astock price drop, but it will certainly not shield you from it. If
you want to take profits on asuccessful stock trade, hit the “Sell” button.
Locking in a Loss
Aperson sent me an e-mail telling me that she had bought astock at $17,
sold covered calls on it when it got to $20 (in order to “take profits”), and
now that the stock was trading for $11, she wanted to know how she could
“repair” her position using options. Unfortunately, options are not magical
tools and cannot make up for aprior decision to buy astock at $17 and ride
it down to $11.
If you are in such aposition, don’tpanic. It will be tempting to write
anew call at the lower ATM price ($11 in this example) because the cash
inflow from that covered call will be the most. Don’tdo it. By writing acovered call at the lower price, you are—if the shares are called away—
locking in arealized loss on the position. You can see this clearly if you list
each transaction in the example separately.

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:262


246  •   The Intelligent Option Investor
No. Buy/Sell Instrument
Price of
Instrument
Effective
Buy (Sell)
Price of
Stock Note
1 Buy Stock $17/share $17/share Original purchase
2 Sell Call option $1/share $16/share Selling acovered call
to take profits when
stock reaches $20/
share leaves the
investor with down-
side exposure and $1
in premium income.
3 Sell Call option $0.75 ($11.75/
share)
Stock falls to $11, and
investor sells another
covered call to
generate income to
ameliorate the loss.
In transaction 1, the investor buys the shares for $17. In transaction 2,
when the stock hits $20 per share, the investor sells acovered call and receives
$1 in premium. This reduces the effective buy price to $16 per share and
means that the investor will have to deliver the shares if the stock is trad-
ing at $20 or above at expiration. When the stock instead falls to $11, the
investor—wanting to cushion the pain of the loss—sells another ATM cov-
ered call for $0.75. This covered call commits the investor to sell the shares
for $11.75. No matter how you look at it, buying at $16 per share and sell-
ing at $11.75 per share is not arecipe for investing success.
The first step in such asituation as this—when the price of astock
on which you have accepted downside exposure falls—is to look back
to your valuation. If the value of the firm has indeed dropped because
of some material negative news and the position no longer makes sense
from an economic perspective, just sell the shares and take the lumps.
If, however, the stock price has dropped but the valuation still makes
for acompelling investment, stay in the position; if the investment is

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:263


Mixing Exposure  •  247
compelling enough, this is the time to figure out aclever way to get more
exposure to it.
You can write calls as long as they are at least at the same strike
price as your previous purchase price or EBP; this just means that you
are buying at $16 and agreeing to sell at at least $16, in other words. Also
keep in mind that any dividend payment you receive you can also think
of as areduction of your EBP—that cash inflow is offsetting the cost of
the shares. Factoring in dividends and the (very small) cash inflow as-
sociated with writing far OTM calls will, as long as you are right about
the valuation, eventually reduce your EBP enough so that you can make
aprofit on the investment.
Over-/Underexposure
Options are transacted in contract sizes of 100 shares. If you hold anumber
of shares that is not evenly divisible by 100, you must decide whether you
are going to sell the next number down of contracts or the next number
up. For example, let’ssay that you own 250 shares of ABC. You can either
choose to sell two call contracts (in which case you will not be receiving
yield on 50 of your shares) or sell three call contracts (in which case you
will be effectively shorting 50 shares). My preference is to sell fewer con-
tracts controlling fewer shares than Ihold, and in fact, your broker may or
may not insist that you do so as well. If not, it is an unpleasant feeling to get
acall from abroker saying that you have amargin call on aposition that
you didn’tknow you had.
Getting Assigned
If you write covered calls, you live with the risk that you will have to deliver
your beloved shares to astranger. You can deliver your shares and use the
proceeds from that sale (the broker will deposit an amount equal to the
strike price times the contract multiplier into your account, and you get
to keep the premium you originally received) to buy the shares again, but
there is no way around delivering the shares if assigned.

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:264


250  •   The Intelligent Option Investor
The graphic conventions are alittle different, but both diagrams show
the acceptance of anarrow band of downside exposure offset by abound-
less gain of upside exposure. The area below the protective put’sstrike price
shows that economic exposure has been neutralized, and the area below
the ITM call shows no economic exposure. The pictures are slightly differ-
ent, but the economic impact is the same.
The objective of aprotective put is obvious—allow yourself the
economic benefits from gaining upside exposure while shielding yourself
from the economic harm of accepting downside exposure. The problem is
that this protection comes at aprice. Iwill provide more infromation about
this in the next section.
Execution
Everyone understands the concept of protective puts—it’sjust like the
home insurance you buy every year to insure your property against dam-
age. If you buy an OTM protective put (let’ssay one struck at 90 percent of
the current market price of the stock), the exposed amount from the stock
price down to the put strike can be thought of as your “deductible” on your
home insurance policy. The premium you pay for your put option can be
thought of as the “premium” you pay on your home insurance policy.
Okay—let’sgo shopping for stock insurance. Apple (AAPL) is trad-
ing for $452.53 today, so I’ll price both ATM and OTM put insurance for
these shares with an expiration of 261 days in the future. I’ll also annualize
that rate.
Strike ($) “Deductible” ($) “Premium” ($)
Premium as
Percent of
Stock Price
Annualized
Premium (%)
450 2.53 40.95 9.1 12.9
405 47.53 20.70 4.6 6.5
360 92.53 8.80 1.9 2.7
Now, given these rates and assuming that you are insuring a $500,000
house, the following table shows what equivalent deductibles, annual
premiums, and total liability to ahome owner would be for deductibles
equivalent to the strike prices I’ve picked for Apple:

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:267


Mixing Exposure  •  251
Equivalent
AAPL Strike ($) Deductible ($) Annual Premium ($)
Total Liability to Home
Owner ($)
450 2,795 64,500 67,295
405 52,516 32,500 85,016
360 102,236 13,500 115,736
Iknow that Iwould not be insuring my house at these rates and under
those conditions! In light of these prices, the first thing you must consider
is whether protecting aparticular asset from unrealized price declines is
worth the huge realized losses you must take to buy put premium. Buying
ATM put protection on AAPL is setting up a 12.9 percent hurdle rate that
the stock must surpass in one year just for you to start making aprofit on
the position, and 13 percent per year is quite ahurdle rate!
If there is some reason why you believe that you need to pay for insurance,
abetter option—cheaper from arealized loss perspective—would be to sell
the shares and use part of the proceeds to buy call options as an option-based
replacement for the stock position. This approach has afew benefits:
1. The risk-reward profile is exactly the same between the two
structures.
2. Any ATM or ITM call will be more lightly levered than any OTM
put, meaning alower realized loss on initiation.
3. For dividend-paying stocks, call owners do not have the right to
receive dividends, but the amount of the projected dividend is de-
ducted from the premium (as part of the drift calculation shown
in the section on covered calls). As such, although not being paid
dividends over time, you are getting what amounts to aone-time
upfront dividend payment.
4. If you do not like the thought of leverage in your portfolio, you can
self-margin the position (i.e., keep enough cash in reserve such that
you are not “borrowing” any money through the call purchase).
Ido not hedge individual positions, but Ido like the ITM call op-
tion as an alternative for people who feel the need to do so. For hedg-
ing of ageneral portfolio, rather than hedging of aparticular holding in
aportfolio, options on sector or index exchange-traded funds (ETFs) are
more reasonably priced. Here are the ask prices for put options on the SPX

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:268


252  •   The Intelligent Option Investor
ETF [tracking the Standard and Poor’s 500 Index (S&P 500), which closed
at 1,685.73 when these data were retrieved] expiring in about 10 months:
Strike/Stock ($) Ask Price ($) Premium as Percent of Stock Price
0.99 106.60 6.3
0.89 50.90 3.0
0.80 25.80 1.5
This is still ahefty chunk of change to pay for protection on an index but
much less than the price of protection on individual stocks.
1
Common Pitfalls
Hedge Timing
Assume that you had talked to me ayear ago and decided to take my ad-
vice and avoid buying protective puts on single-name options. Instead, you
took aprotective put position on the S&P 500. Good for you.
Setting aside for amoment how much of your portfolio to hedge, let’stake alook at what happened since you bought the downside protection:
S&P 500
1,800
1,700
1,600
1,500
1,400
1,300
1,200
1,100
1,000
8/1/20129/1/201210/1/201211/1/201212/1/20121/1/20132/1/20133/1/20134/1/20135/1/20136/1/20137/1/2013
GREEN

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:269


Mixing Exposure  •  253
When you bought the protection, the index was trading at 1,375, so
you bought one-year puts about 5 percent OTM at $1,300. If the market
had fallen heavily or even moderately during the first five months of the
contract, your puts would have served you very well. However, now the
puts are not 5 percent OTM anymore but 23 percent OTM, and it would
take another Lehman shock for the market to make it down to your put
strike.
Keeping in mind that buying longer-tenor options gives you abetter
annualized cost than shorter-tenor options, you should be leery of entering
into ahedging strategy such as the one pictured here:
S&P 500
1,800
1,700
1,600
1,500
1,400
1,300
1,200
1,100
1,000
8/1/20129/1/201210/1/201211/1/201212/1/20121/1/20132/1/20133/1/20134/1/20135/1/20136/1/20137/1/2013
GREEN
Buying short-tenor puts helps in terms of providing nearer to
ATM protection, but the cost is higher, and it gets irritating to keep
buying expensive options and never benefiting from them (funny—
no one ever says this about home insurance). Although there are no
perfect solutions to this quandary, Ibelieve the following approach
has merit:

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:270


254  •   The Intelligent Option Investor
S&P 500
1,800
1,700
1,600
1,500
1,400
1,300
1,200
1,100
1,000
8/1/20129/1/201210/1/201211/1/201212/1/20121/1/20132/1/20133/1/20134/1/20135/1/20136/1/20137/1/2013
GREEN GREENLIGHT GREEN
LIGHT GREEN
LIGHT GREEN
Here Ibought fewer long-term put contracts at the outset and then add-
ed put contracts at higher strikes opportunistically as time passed. Ihave left
myself somewhat more exposed at certain times, and my protection doesn’tall
pick up at asingle strike price, so the insurance coverage is spotty, but Ihave
likely reduced my hedging cost agreat deal while still having apotential source
of investible cash on hand in the form of options with time value on them.
The Unhappy Case of a Successful Hedge
Markets are down across the board. Your brokerage screen is awash in red.
The only bright spot is the two or three lines of your screen showing your
S&P 500 puts, which are strongly positive. You bought your protection
when the market was going up, so it was very cheap to purchase. Now, with
the market in aterror, the implied volatilities have shot up, and you are sit-
ting on ahuge positive unrealized value.
Now what?
The psychological urge to keep that hedge on will be strong. Such apo-
sition is safe after all, and with the rest of the world falling apart, it feels nice to
have somewhere safe to go. What should you do with this unrealized profit?

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:271


258  •   The Intelligent Option Investor
plan like this in place will allow you to size and time your hedges appropri-
ately and will help you to make the most out of whatever temporary crisis
might come your way.
2
Now that you have agood understanding of protective puts and
hedging, let’sturn to the last overlay strategy—the collar.
Collar
Contingent Exposure
Contingent Exposure
Contingent Exposure
GREEN
LIGHT GREEN
LIGHT ORANGE
LIGHT RED
ORANGE
RED
Downside: Irrelevant
Upside: Undervalued
Execute: Sell acall option on astock or index that you own and on
which you have again, and use the proceeds from the call
sale to buy an OTM put
Risk: Flexible, depending on selection of strikes
Reward: Limited to level of sold call strike
Margin: None because the long position in the hedged security
serves as collateral for the sold call option, and the OTM
put option is purchased, so it does not require margining

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:275


Mixing Exposure  •  259
The Gist
This structure is really much simpler and has amuch more straightfor -
ward investment purpose than it may seem when you look at the preceding
diagram. When people talk about “taking profits” using acovered call, the
collar is actually the strategy they should be using.
Imagine that you bought astock some time ago and have anice
unrealized gain on it. The stock is about where you think its likely fair
value is, but you do not want to sell it for whatever reason (e.g., it is
paying anice dividend or you bought it less than ayear ago and do not
want to be taxed on short-term capital gains or whatever). Although you
do not want to sell it, you would like to protect yourself from downside
exposure.
You can do this cheaply using acollar. The collar is acovered call,
which we have already discussed, whose income subsidizes the purchase of
aprotective put at some level that will allow you to keep some of the unre-
alized gains on your securities position. The band labeled “Orange” on the
diagram shows an unrealized gain (or, conversely, apotential unrealized
loss). If you buy aput that is within this orange band or above, you will be
guaranteed of making at least some realized profit on your original stock
or index investment. Depending on how much you receive for the covered
call and what strike you select for the protective put, this collar may rep-
resent completely “free” downside protection or you might even be able to
realize anet credit.
Execution
The execution of this strategy depends agreat deal on personal prefer -
ence and on the individual investor’ssituation. For example, an investor
can sell ashort-tenor covered call and use those proceeds to buy alonger-
tenor protective put. He or she can sell the covered call ATM and buy aprotective put that is close to ATM; this means the maximum and mini-
mum potential return on the previous security purchase is in afairly tight
band. Conversely, the investor might sell an OTM covered call and buy
aprotective put that is also OTM. This would lock in awider range of
guaranteed profits over the life of the option.

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:276


260  •   The Intelligent Option Investor
Ishow acouple of examples below that give you the flavor of the
possibilities of the collar strategy. With these examples, you can experi-
ment yourself with astructure that fits your particular needs. Look on
my website for acollar scenario calculator that will allow you to visualize
the collar and understand the payoff structure given different conditions.
For these examples, Iam assuming that Ibought Qualcomm stock at
$55 per share. Qualcomm is now trading for $64.71—an unrealized gain
of 17.7 percent.
Collar 1: 169 Days to Expiration
Strike Price ($) Bid (Ask) Price ($)
Sold call 65.00 3.40
Purchased put 60.00 (2.14)
Net credit $1.26
This collar yields the following best- and worst-case effective sell prices
(ESPs) and corresponding returns (assuming a $55 buy price):
ESP ($) Return (%)
Best case 66.26 20.5
Worst case 61.26 11.4
Here we sold the $65-strike calls for $3.40 and used those proceeds to
buy the $60-strike put options at $2.14. This gave us anet credit of $1.26,
which we simply add to both strike prices to calculate our ESP . We add the
net credit to the call strike because if the stock moves above the call strike,
we will end up delivering the stock at the strike price while still keeping the
net credit. We add the net credit to the put strike because if the stock closes
below the put strike, we have the right to sell the shares at the strike price
and still keep the net credit. The return numbers are calculated on the basis
of a $55 purchase price and the ESPs listed. Thus, by setting up this collar in

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:277


Mixing Exposure  •  261
this way, we have locked in aworst possible gain of 11.4 percent and abest
possible gain of 20.5 percent for the next five and ahalf months.
Let’slook at another collar with adifferent profit and loss profile:
Collar 2: 78 Days to Expiration
Strike Price ($) Bid (Ask) Price ($)
Sold call 70 0.52
Purchased put 62.50 (1.55)
Net debit (1.03)
This collar yields the following best- and worst-case ESPs and corresponding
returns (assuming a $55 buy price):
ESP ($) Return (%)
Best case 68.97 25.4
Worst case 61.47 11.8
This shows ashorter-tenor collar—about two and ahalf months be-
fore expiration—that allows for more room for capital gains. This might be
the strategy of ahedge fund manager who is long the stock and uncertain
about the next quarterly earnings report. For his or her own business rea-
sons, the manager does not want to show an unrealized loss in case Qual-
comm’sreport is not good, but he or she also doesn’twant to restrict the
potential capital gains much either.
Calculating the ESPs and the returns in the same way as described
here, we get aguaranteed profit range from around 12 to over 25 percent.
One thing to note as well is that the protection is provided by aput, and
aput option can be sold any time before expiry to generate acash inflow
from time value. Let’ssay then that when Qualcomm reports its quarterly
earnings, the stock price drops to $61—amild drop that the hedge fund
manager considers apositive sign. Now that the manager is less worried
about the downside exposure, he or she can sell the put for aprofit.

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:278


263
Chapter 12
Risk and the intelligent
OptiOn investOR
The preceding 11 chapters have given you agreat deal of information about
the mechanics of option investing and stock valuation. In this last chapter,
let’slook at asubject that Ihave mentioned throughout this book—risk—
and see how an intelligent option investor conceives of it.
There are many forms of risk—some of which we discussed earlier
(e.g., the career risk of an investment business agent, solvency risk of aretiree looking to maintain agood quality of life, and liquidity risk of aparent needing to make abig payment for achild’swedding). The two risks
Idiscuss here are those that are most applicable to an owner of capital
making potentially levered investments in complex, uncertain assets such
as stocks. These two risks are market risk and valuation risk.
Market Risk
Market risk is unavoidable for anyone investing capital. Markets fluctuate, and
in the short term, these fluctuations often have little to do with the long-term
value of agiven stock. Short term, it must be noted, is also relative. In words
attributed to John Maynard Keynes, but which is more likely an anonymous
aphorism, “The market can remain irrational longer than you can remain sol-
vent. ” Indeed, it is this observation and my own painful experience of the truth
of it that has brought me to my appreciation for in-the-money (ITM) options
as away to preserve my capital and cushion the blow of timing uncertainty.

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:280


264  •   The Intelligent Option Investor
Market risk is afactor that investors in levered instruments must
always keep in mind. Even an ITM call long-term equity anticipated
security (LEAPS) in the summer of 2007 might have become ashort-tenor
out-of-the-money (OTM) call by the fall of 2008 after the Lehman shock
because of the sharp decline in stock prices in the interim. Unexpected
things can and do happen. Aportfolio constructed oblivious to this fact is
adangerous thing.
As long as market fluctuations only cause unrealized losses, market
risk is manageable. But if alevered loss must be realized, either because of
an option expiration or in order to fund another position, it has the poten-
tial to materially reduce your available investment capital. You cannot ma-
terially reduce your investment capital too many times before running out.
A Lehman shock is aworst-case scenario, and some investors live
their entire lives without experiencing such severe and material market
risk. In most cases, rather than representing amaterial threat, market risk
represents awonderful opportunity to an intelligent investor.
Most human decision makers in the market are looking at either
technical indicators—which are short term by nature—or some sort of
multiple value (e.g., price-to-something ratio). These kinds of measures are
wonderful for brokers because they encourage brokerage clients to make
frequent trades and thus pay the brokerages frequent fees.
The reaction of short-term traders is also wonderful for intelligent
investors. This is so because amarket reaction that might look sensible or
rational to someone with an investment time horizon measured in days or
months will often look completely ridiculous to an investor with alonger-
term perspective. For example, let’ssay that acompany announces that its
earnings will be lower next quarter because of adelay in the release of anew product. Investors who are estimating ashort-term value for the stock
based on an earnings multiple will sell the stock when they see that earn-
ings will likely fall. Technical traders see that the stock has broken through
some line of “resistance” or that one moving average has crossed another
moving average, so they sell it as well. Perhaps an algorithmic trading
engine recognizes the sharp drop and places aseries of sell orders that are
covered almost as soon as they are filled. In the meantime, someone who
has held the stock for awhile and has again on it gets protective of this gain
and decides to buy aput option to protect his or her gains.

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:281


Risk and the Intelligent Option Investor   • 265
For an intelligent option investor who has along-term worst-case
valuation that is now 20 percent higher than the market price, there is awonderful opportunity to sell aput and receive afat premium (with the
possibility of owning the stock at an attractive discount to the likely fair
value), sell aput and use the proceeds to buy an OTM call LEAPS, or sim-
ply buy the stock to open aposition.
Indeed, this strategy is perfectly in keeping with the dictum, “Be fear-
ful when others are greedy and greedy when others are fearful. ” This strat-
egy is also perfectly reasonable but obviously rests on the ability of the
investor to accurately estimate the actual intrinsic value of astock. This
brings us to the next form of risk—valuation risk.
Valuation Risk
Although valuation is not adifficult process, it is one that necessarily in-
cludes unknowable elements. In our own best- and worst-case valuation
methodology, we have allowed for these unknowns by focusing on plausi-
ble ranges rather than precise point estimates. Of course, our best- or worst-
case estimates might be wrong. This could be due to our misunderstanding
of the economic dynamics of the business in which we have invested or
may even come about because of the way we originally framed the problem.
Thinking back to how we defined our ranges, recall that we were focusing
on one-standard-deviation probabilities—in other words, scenarios that
might plausibly be expected to materialize two times out of three. Obvi-
ously, even if we understand the dynamics of the business very well, one
time out of three, our valuation process will generate afair value range that
is, in fact, materially different from the actual intrinsic value of the stock.
In contrast to market risk, which most often is anonmaterial and tem-
porary issue, misestimating the fair value of astock represents amaterial
risk to capital, whether our valuation range is too low or too high. If we esti-
mate avaluation range that is too low, we are likely to end up not allocating
enough capital to the investment or using inappropriately light leverage.
This means that we will have missed the opportunity to generate as much
return on this investment as we may have. If we estimate avaluation range
that is too high, we are likely to end up allocating too much capital to the

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:282


Risk and the Intelligent Option Investor   • 267
Let’sassume that the present market value of the shares is $16 per
share. This share price assumes agrowth in FCFO of 8 percent per year for
the next 5 years and 5 percent per year in perpetuity after that—roughly
equal to what we consider our most likely operational performance
scenario. We see the possibility of faster growth but realize that this faster
growth is unlikely—the valuation layer associated with this faster growth
is the $18 to $20 level. We also see the possibility of aslowdown, and the
valuation layer associated with this worst-case growth rate is the $11 to
$13 level.
Now let’sassume that because of some market shock, the price of the
shares falls to the $10 range. At the same time, let’sassume that the likely
economic scenario, even after the stock price fall, is still the same as before—
most likely around $16 per share; the best case is $20 per share, and the worst
case is $11 per share. Let’salso say that you can sell aput option, struck at
$10, for $1 per share—giving you an effective buy price of $9 per share.
In this instance, the valuation risk is indeed small as long as we are
correct about the relative levels of our valuation layers. Certainly, in this
type of scenario, it is easier to commit capital to your investment idea than
it would be, say, to sell puts struck at $16 for $0.75 per share!
Thinking of stock prices in this way, it is clear that when the market
price of astock is within avaluation layer that implies unrealistic economic
assumptions, you will more than likely be able to use acombination of
stocks and options to tilt the balance of risk and reward in your own
favor—the very definition of intelligent option investing.
Intelligent Option Investing
In my experience, most stocks are mostly fairly priced most of the time.
There may be scenarios at one tail or the other that might be inappropriately
priced by the option market (and, by extension, by the stock market), but
by and large, it is difficult to find profoundly mispriced assets—an asset
whose market price is significantly different from its most likely valuation
layer.
Opportunities tend to be most compelling when the short-term pic-
ture is the most uncertain. Short-term uncertainties make investing boldly

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:284