does not.
Also, the stockholder is forced to pay substantially more for his position than is the call
holder, and he also receives dividends whereas the call holder does not. Therefore,
"equivalent" does not mean exactly the same when comparing call-oriented and put
oriented strategies, but rather denotes that they have similar profit potentials.
In Chapter 3, it was determined that the slightly in-the-money call often offers
the best ratio between 1isk and reward. When the call is slightly in-the-money, the
stock is above the striking price. Similarly, the slightly out-of-the-money put often
offers the best ratio between risk and reward for the common stockholder who is buy
ing the put for protection. Again, the stock is slightly above the striking price. Actually,
since the two positions are equivalent, the same conclusions should be arrived at; that
is why it was stated that the reader has been through this analysis previously.
0.,,,,, I 7: Put Buying in Conjundion with Common Stock Ownership
JAX CONSIDERATIONS
275
Although tax considerations are covered in detail in a later chapter, an important tax
law concerning the purchase of puts against a common stock holding should be men
tioned at this time. If the stock owner is already a long-term holder of the stock at the
time that he buys the put, the put purchase has no effect on his tax status. Similarly,
if the stock buyer buys the stock at the time that he buys the put and identifies the
position as a hedge, there is no effect on the tax status of his stock. However, if one
is currently a short-term holder of the comrrwn stock at the time that he buys a put,
he eliminates any accrued holding period on his comrrwn stock. Moreover, the hold
ing period for that stock does not begin again until the put is sold.
Example: Assume the long-term holding period is 6 months. That is, a stock owner
must own the stock for 6 months before it can be considered a long-term capital gain.
An investor who bought the stock and held it for 5 months and then purchased a put
would wipe out his entire holding period of 5 months. Suppose he then held the put
and the stock simultaneously for 6 months, liquidating the put at the end of 6 months.
His holding period would start all over again for that common stock. Even though he
has owned the stock for 11 months - 5 months prior to the put purchase and 6
months more while he simultaneously owned the put - his holding period for tax pur
poses is considered to be zero!
This law could have important tax ramifications, and one should consult a tax advisor
if he is in doubt as to the effect that a put purchase might have on the taxability of
his common stock holdings.
PUT BUYING AS PROTECTION FOR THE COVERED CALL WRITER
Since put purchases afford protection to the owner of common stock, some investors
naturally feel that the same protective feature could be used to limit their downside
risk in the covered call writing strategy. Recall that the covered call writing strategy
involves the purchase of stock and the sale of a call option against that stock. The cov
ered write has limited upside profit potential and offers protection to the downside in
the amount of the call premium. The covered writer will make money if the stock falls
a little, remains unchanged, or rises by expiration. The covered writer can actually lose
money only if the stock falls by more than the call premium received. He has poten
tially large downside losses. This strategy is known as a protective collar or, more sim
ply, a "collar." (It is also called a "hedge wrapper," although that is an outdated term.)
276 Part Ill: Put Option Strategies
The purchase of an out-of the-money put option can eliminate the risk of large
potential losses for the covered write, although the money spent for the put purchase
will reduce the overall return from the covered write. One must therefore include
the put cost in his initial calculations to determine if it is worthwhile to buy the put.
Example: X'YZ is at 39 and there is an XYZ October 40 call selling for 3 points and an
XYZ October 35 put selling for ½ point. A covered write could be established by buy
ing the common at 39 and selling the October 40 call for 3. This covered write would
have a maximum profit potential of 4 points if XYZ were anywhere above 40 at expi
ration. The write would lose money if XYZ were anywhere below 36, the break-even
point, at October expiration. By also purchasing the October 35 put at the time the
covered write is initiated, the covered writer will limit his profit potential slightly, but
will also greatly reduce his risk potential. If the put purchase is added to the covered
write, the maximum profit potential is reduced to 3½ points at October expiration. The
break-even point moves up to 36½, and the writer will experience some loss if XYZ is
below 36½ at expiration. However, the most that the writer could lose would be 1 ¼
points if XYZ were below 35 at expiration. The purchase of the put option produces
this loss-limiting effect. Table 17-2 and Figure 17-2 depict the profitability of both the
regular covered write and the covered write that is protected by the put purchase.
Commissions should be carefully included in the covered writer's return calcula
tions, as well as the cost of the put. It was demonstrated in Chapter 2 that the covered
writer must include all commissions and margin interest expenses as well as all divi
dends received in order to produce an accurate "total return" picture of the covered
write. Figure 17-2 shows that the break-even point is raised slightly and the overall prof
it potential is reduced by the purchase of the put. However, the maximum risk is quite
small and the writer need never be forced to roll down in a disadvantageous situation.
Recall that the covered writer who does not have the protective put in place is
forced to roll down in order to gain increased downside protection. R


2 shows that the break-even point is raised slightly and the overall prof
it potential is reduced by the purchase of the put. However, the maximum risk is quite
small and the writer need never be forced to roll down in a disadvantageous situation.
Recall that the covered writer who does not have the protective put in place is
forced to roll down in order to gain increased downside protection. Rolling down
merely means that he buys back the call that is currently written and writes another
call, with a lower striking price, in its place. This rolling-down action can be helpful
if the stock stabilizes after falling; but if the stock reverses and climbs upward in price
again, the covered writer who rolled down would have limited his gains. In fact, he
may even have "locked in" a loss. The writer who has the protective put need not be
bothered with such things. He never has to roll down, for he has a limited maximum
loss. Therefore, he should never get into a "locked-in" loss situation. This can be a
great advantage, especially from an emotional viewpoint, because the writer is never
forced to make a decision as to the future price of the stock in the middle of the
stock's decline. With the put in place, he can feel free to take no action at all, since
his overall loss is limited. If the stock should rally upward later, he will still be in a
position to make his maximum profit.
Chapter 17: Put Buying in Conjundion with Common Stock Ownership
TABLE 17·2.
Comparison of regular and protected covered writes.
XYZ Price at Stock October 40 October 35
Expiration Profit Call Profit Put Profit
25 -$1,400 +$300 +$950
30 900 + 300 + 450
35 400 + 300 - 50
36.50 250 + 300 - 50
38 100 + 300 - 50
40 + 100 + 300 - 50
45 + 600 - 200 - 50
50 + 1,100 - 700 - 50
FIGURE 17-2.
Covered call write protected by a put purchase.
C
0
e ·5.
X
LU
co $0 CJ)
CJ)
0 .J
0
~ -$150 a..
,,
},.,,'
;
,,
Regular
Covered ,,'
Write/
36 / , ,
;
,,'
+$400
,----------➔ ,,,' _____ ...,..
, +$350
,,,'
40
Stock Price at Expiration
277
Total
Profit
-$150
- 150
- 150
0
+ 150
+ 350
+ 350
+ 350
The longer-term effects of buying puts in combination with covered writes are
not easily definable, but it would appear that the writer reduces his overall rate of
return slightly by buying the puts. This is because he gives something away if the
stock falls slightly, remains unchanged, or rises in price. He only "gains" something if
the stock falls heavily. Since the odds of a stock falling heavily are small in compari
son to the other events (falling slightly, remaining unchanged, or rising), the writer
will be gaining something in only a small percentage of cases. However, the put buy
ing strategy may still prove useful in that it removes the emotional uncertainty of
278 Part Ill: Put Option Strategies
large losses. The covered writer who buys puts may often find it easier to operate in
a more rational manner when he has the protective put in place.
This strategy is equivalent to one that has been described before, the bull
spread. Notice that the profit graph in Figure 17-2 has the same shape as the bull
spread profit graph (Figure 7-1). This means that the two strategies are equivalent.
In fact, in Chapter 7 it was pointed out that the bull spread could sometimes be con
sidered a "substitute" for covered writing. Actually, the bull spread is more akin to
this strategy - the covered write protected by a put purchase. There are, of course,
differences between the strategies. They are equivalent in profit and loss potential,
but the covered writer could never lose all his investment in a short period of time,
although the spreader could. In order to actually use bull spreads as substitutes for
covered writes, one would invest only a small portion of his available funds in the
spread and would place the remainder of his funds in fixed-income securities. That
strategy was discussed in more depth in Chapter 7.
NO-COST COLLARS
The "collar" strategy is often arrived at in another manner: a stockholder begins
to worry about the downside potential of the stock market and decides to buy puts
on his stock as protection. However, he is dismayed by the cost of the puts and so he
also considers the sale of calls. If he buys an out-of-the-money put, it is quite possi
ble that he might be able to sell an out-of-the-money call whose proceeds complete
ly cover the cost of the put. Thus, he has established a protective collar at no cost -
at least no debit. His "cost" is the fact that he has forsaken the upside profit poten
tial on his stock, above the striking price of the written call.
In fact, certain large institutional traders are able to transact collars through
large over-the-counter option brokers, such as Goldman Sachs or Morgan Stanley.
They might even give the broker instructions such as this: "I own XYZ and I want to
buy a put 10 percent out of the money that expires in a year. What would the strik
ing price of a one-year call have to be in order to create a no-cost collar?" The bro
ker might then tell him that such a call would have to be struck 30 percent out of the
money. The actual strike price of the call would depend on the volatility estimate for
the underlying stock, as well as interest rates and dividends. These types of transac
tions occur with a fair amount of frequency.
Some very interesting situations can be created with long-term options. One of
the most interesting occurred in 1999, when a company that owned 5 million shares
of Cisco ( CSCO) decided it would like to hedge them by creating a no-cost collar
over the next three years. At the time, CSCO was trading at about 130, and its volatil
ity was about 50%. It turns out that a three-year put struck at 130 sells for about the
278 Part Ill: Put Option Strategies
large losses. The covered writer who buys puts may often find it easier to operate in
a more rational manner when he has the prot

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf


t would like to hedge them by creating a no-cost collar
over the next three years. At the time, CSCO was trading at about 130, and its volatil
ity was about 50%. It turns out that a three-year put struck at 130 sells for about the
278 Part Ill: Put Option Strategies
large losses. The covered writer who buys puts may often find it easier to operate in
a more rational manner when he has the protective put in place.
This strategy is equivalent to one that has been described before, the bull
spread. Notice that the profit graph in Figure 17-2 has the same shape as the bull
spread profit graph (Figure 7-1). This means that the two strategies are equivalent.
In fact, in Chapter 7 it was pointed out that the bull spread could sometimes be con
sidered a "substitute" for covered writing. Actually, the bull spread is more akin to
this strategy- the covered write protected by a put purchase. There are, of course,
differences between the strategies. They are equivalent in profit and loss potential,
but the covered writer could never lose all his investment in a short period of time,
although the spreader could. In order to actually use bull spreads as substitutes for
covered writes, one would invest only a small portion of his available funds in the
spread and would place the remainder of his funds in fixed-income securities. That
strategy was discussed in more depth in Chapter 7.
NO-COST COLLARS
The "collar" strategy is often arrived at in another manner: a stockholder begins
to worry about the downside potential of the stock market and decides to buy puts
on his stock as protection. However, he is dismayed by the cost of the puts and so he
also considers the sale of calls. If he buys an out-of-the-money put, it is quite possi
ble that he might be able to sell an out-of-the-money call whose proceeds complete
ly cover the cost of the put. Thus, he has established a protective collar at no cost -
at least no debit. His "cost" is the fact that he has forsaken the upside profit poten
tial on his stock, above the striking price of the written call.
In fact, certain large institutional traders are able to transact collars through
large over-the-counter option brokers, such as Goldman Sachs or Morgan Stanley.
They might even give the broker instructions such as this: "I own XYZ and I want to
buy a put 10 percent out of the money that e.:\.J)ires in a year. What would the strik
ing price of a one-year call have to be in order to create a no-cost collar?" The bro
ker might then tell him that such a call would have to be struck 30 percent out of the
money. The actual strike price of the call would depend on the volatility estimate for
the underlying stock, as well as interest rates and dividends. These types of transac
tions occur with a fair amount of frequency.
Some very interesting situations can be created with long-term options. One of
the most interesting occurred in 1999, when a company that owned 5 million shares
of Cisco (CSCO) decided it would like to hedge them by creating a no-cost collar
over the next three years. At the time, CSCO was trading at about 130, and its volatil
ity was about 50%. It turns out that a three-year put struck at 130 sells for about the
278 Part Ill: Put Option Strategies
large losses. The covered writer who buys puts may often find it easier to operate in
a more rational manner when he has the protective put in place.
This strategy is equivalent to one that has been described before, the bull
spread. Notice that the profit graph in Figure 17-2 has the same shape as the bull
spread profit graph (Figure 7-1). This means that the two strategies are equivalent.
In fact, in Chapter 7 it was pointed out that the bull spread could sometimes be con
sidered a "substitute" for covered writing. Actually, the bull spread is more akin to
this strategy - the covered write protected by a put purchase. There are, of course,
differences between the strategies. They are equivalent in profit and loss potential,
but the covered writer could never lose all his investment in a short period of time,
although the spreader could. In order to actually use bull spreads as substitutes for
covered ,vrites, one would invest only a small portion of his available funds in the
spread and would place the remainder of his funds in fixed-income securities. That
strategy was discussed in more depth in Chapter 7.
NO-COST COLLARS
The "collar" strategy is often arrived at in another manner: a stockholder begins
to worry about the downside potential of the stock market and decides to buy puts
on his stock as protection. However, he is dismayed by the cost of the puts and so he
also considers the sale of calls. If he buys an out-of-the-money put, it is quite possi
ble that he might be able to sell an out-of-the-money call whose proceeds complete
ly cover the cost of the put. Thus, he has established a protective collar at no cost -
at least no debit. His "cost" is the fact that he has forsaken the upside profit poten
tial on his stock, above the striking price of the written call.
In fact, certain large institutional traders are able to transact collars through
large over-the-counter option brokers, such as Goldman Sachs or Morgan Stanley.
They might even give the broker instructions such as this: "I own XYZ and I want to
buy a put 10 percent out of the money that expires in a year. What would the strik
ing p1ice of a one-year call have to be in order to create a no-cost collar?" The bro
ker might then tell him that such a call would have to be struck 30 percent out of the
money. The actual strike price of the call would depend on the volatility estimate for
the underlying stock, as well as interest rates and dividends. These types of transac
tions occur with a fair amount of frequency.
Some very interesting situations can be created with long-term options. One of
the most interesting occurred in 1999, when a company that owned 5 million shares
of Cisco (


the
money. The actual strike price of the call would depend on the volatility estimate for
the underlying stock, as well as interest rates and dividends. These types of transac
tions occur with a fair amount of frequency.
Some very interesting situations can be created with long-term options. One of
the most interesting occurred in 1999, when a company that owned 5 million shares
of Cisco ( CSCO) decided it would like to hedge them by creating a no-cost collar
over the next three years. At the time, CSCO was trading at about 130, and its volatil
ity was about 50%. It turns out that a three-year put struck at 130 sells for about the
Cltapter 17: Put Buying in Conjunction with Common Stock Ownership
TABLE 17-3.
Highest Call Strike That Pays for an At-the-Money Put
(Assuming 2.5 years to expiration)
Volatility Coll Strike
30%
40%
50%
70%
100%
of Underlying
30% out of money
35% out of money
40% out of money
50% out of money
70% out of money
279
same price as a three-year call struck at 200! That may seem illogical, but the figures
can be checked out with the aid of an option-pricing model. Thus, this company was
able to hedge all of its CSCO stock, with no downside risk ( the striking price of the
puts was the same as the current stock price) and still had profit potential of over 50%
to the upside over the next three years.
Thus, one should consider using LEAPS options when he establishes a collar -
even ifhe is not an institutional trader - because the striking price of the calls can be
quite high in comparison to that of the put' s strike or in comparison to the price of
the underlying stock. Table 17-3 shows how far out-of-the-money a written call could
be that still covers the cost of buying an at-the-money put. The time to expiration in
this table is 2.5 years - the longest term listed option that currently exists as a LEAPS
option.
USING LOWER STRIKES AS A PARTIAL COVERED WRITE
It should also be pointed out that one does not necessarily have to forsake all of
the profit potential from his stock. He might buy the puts, as usual, and then sell calls
with a somewhat lower strike than needed for a low-cost collar, but the quantity of
calls sold would be less than that of stock owned. In that way, there would be unlim
ited profit potential on some of the shares of the underlying stock.
Example: Suppose that the following prices exist:
XYZ:61
Apr 55 put: 1
Apr 65 call: 2
Furthermore, suppose that one owns 1000 shares of XYZ. Thus, the purchase
of 10 Apr 55 puts at 1 point apiece would protect the downside. In order to cover the
cost of those puts ($1000), one need only sell five of the Apr 65 calls at 2 points
280 Part Ill: Put Option Strategies
apiece. Thus, the protection would have cost nothing and there would still be unlim
ited profit potential on 500 of the shares of XYZ, since only five calls were sold against
the 1000 shares that are owned.
In this manner, one could get quite creative in constructing collars - deciding
what call strike to use in order to strike a balance between paying for the puts and
allowing upside profit potential. The lower the strike he uses for the written calls, the
fewer calls he will have to write; the higher the strike of the written calls, the more
calls will be necessary to cover the cost of the purchased puts. The tradeoff is that a
lower call strike allows for more eventual upside profit potential, but it limits what
has been written against to a lower price.
Using the above example once again, these facts can be demonstrated:
Example (continued): As before, the same prices exist, but now one more call will
be brought into the picture:
XYZ: 61
Apr55 put: l
Apr 65 call: 2
Apr 70 call: l
As before one could sell five of the Apr 65 calls to cover the cost of ten puts, or
as an alternative he could sell ten of the Apr 70 calls. If he sells the five, he has unlim
ited profit potential on 500 shares, but the other 500 shares will be called away at 65.
In the alternative strategy, he has limited upside profit potential, but nothing will be
called away until the stock reaches 70. Which is "better?" It's not easy to say. In the
former strategy, if the stock climbs all the way to 75, it results in the same profit as if
the stock is called away at 70 in the latter strategy. This is true because 500 shares
would be worth 75, but the other 500 would have been called away at 65 - making
for an average of 70. Hence, the former strategy only outperforms the latter if the
stock actually climbs above 75 - a rather unlikely event, one would have to surmise.
Still, many investors prefer the former strategy because it gives them protection with
out asking them to surrender all of their upside profit potential.
In summary, one can often be quite creative with the "collar" strategy. One thing
to keep in mind: if one sells options against stock that he has no intention of selling, he
is actually writing naked calls in his ovm mind. That is, if one owns stock that "can't"
be sold - perhaps the capital gains would be devastating or the stock has been "in the
family" for a long time - then he should not sell covered calls against it, because he will
be forced into treating the calls as naked (if he refuses to sell the stock). This can cause
quite a bit of consternation if the underlying stock rises significantly in price, that could
have easily been avoided by not writing calls against the stock in the first place.
CHAPCIJER 18
Buying Puts in Conjunction
with Call Purchases
There are several ways in which the purchases of both puts and calls can be used to
the speculator's advantage. One simple method is actually a follow-up strategy for the
call buyer. If the stock has advanced and the call buyer has a profit, he might con
sider buying a put as a means of locking in his call profits while still allowing for more
potential upside appreciation. In Chapter 3, four basic alternatives were list


hich the purchases of both puts and calls can be used to
the speculator's advantage. One simple method is actually a follow-up strategy for the
call buyer. If the stock has advanced and the call buyer has a profit, he might con
sider buying a put as a means of locking in his call profits while still allowing for more
potential upside appreciation. In Chapter 3, four basic alternatives were listed for the
call buyer who had a profit: He could liquidate the call and take his profit; he could
do nothing; he could "roll up" by selling the call for a profit and using part of the pro
ceeds to purchase more out-of-the-money calls; or he could create a bull spread by
selling the out-of-the-money call against the profitable call that he holds. If the
underlying stock has listed puts, he has another alternative: He could buy a put. This
put purchase would serve to lock in some of the profits on the call and would still
allow room for further appreciation if the stock should continue to rise in price.
Example: An investor initially purchased an XYZ October 50 call for 3 points when
the stock was at 48. Sometime later, after the stock had risen to 58, the call would be
worth about 9 points. If there was an October 60 put, it might be selling for 4 points,
and the call holder could buy this put to lock in some of his profits. His position, after
purchasing the put, would be:
Long l October 50 call at 3 points N t t 7 • t - e cos: pom s Long l October 60 put at 4 points
He would own a "strangle" - any position consisting of both a put and a call with dif
fering terms - that is always worth at least 10 points. The combination will be worth
exactly 10 points at expiration if XYZ is anywhere between 50 and 60. For example,
281
282 Part Ill: Put Option Strategies
if xyz is at 52 at expiration, the call will be worth 2 points and the put will be wort Ii
8 points. Alternatively, if the stock is at 58 at expiration, the put will be worth 2 points
and the call worth 8 points. Should xyz be above 60 at expiration, the combination's
value will be equal to the call's value, since the put will expire worthless with XYZ
above 60. The call would have to be worth more than 10 points in that case, since it
has a striking price of 50. Similarly, if xyz were below 50 at expiration, the combi
nation would be worth more than 10 points, since the put would be more than 10
points in-the-money and the call would be worthless.
The speculator has thus created a position in which he cannot lose money,
because he paid only 7 points for the combination (3 points for the call and 4 points
for the put). No matter what happens, the combination will be worth at least 10
points at e:x-piration, and a 3-point profit is thus locked in. If xyz should continue to
climb in price, the speculator could make more than 3 points of profit whenever xyz
is above 60 at expiration. Moreover, if xyz should suddenly collapse in price, the
speculator could make more than 3 points of profit if the stock was below 50 by expi
ration. The reader must realize that such a position can never be created as an initial
position. This desirable situation arose only because the call had built up a substan
tial profit before the put was purchased. The similar strategy for the put buyer who
might buy a call to protect his unrealized put profits was described in Chapter 16.
STRADDLE BUYING
A straddle purchase consists of buying both a put and a call with the same terms -
sarne underlying stock, striking price, and expiration date. The straddle purchase
allows the buyer to make large potential profits if the stock moves far enough in
either direction. The buyer has a predetermined maximum loss, equal to the amount
of his initial investment.
Example: The following prices exist:
xyz common, 50;
XYZ July 50 call, 3; and
XYZ July 50 put, 2.
If one purchased both the July 50 call and the July 50 put, he would be buying a
straddle. This would cost 5 points plus commissions. The investment required to
purchase a straddle is the net debit. If the underlying stock is exactly at 50 at expi
ration, the buyer would lose all his investment, since both the put and the call would
expire worthless. If the stock were above .55 at expiration, the call portion of the
18: Buying Puts in Conjundion with Call Purchases 283
dle would be worth more than 5 points and the straddle buyer would make
y, even though his put expired worthless. To the downside, a similar situation
Mists. If XYZ were below 45 at expiration, the put would be worth more than 5
points and he would have a profit despite the fact that the call expired worthless.
Table 18-1 and Figure 18-1 depict the results of this example straddle purchase at
expiration. The straddle buyer can immediately determine his break-even points at
expiration - 45 and 55 in this example. He will lose money if the underlying stock is
between those break-even points at expiration. He has potentially large profits if
XYZ should move a great distance away from 50 by expiration.
One would normally purchase a straddle on a relatively volatile stock that has
the potential to move far enough to make the straddle profitable in the allotted time.
This strategy is particularly attractive when option premiums are low, since low pre
miums will mean a cheaper straddle cost. Although losses may occur in a relatively
large percentage of cases that are held all the way until their expiration date, there is
actually only a minute probability of losing one's entire investment. Even if XYZ
should be at 50 at expiration, there would still be the opportunity to sell the straddle
for a small amount on the final day of trading.
TABLE 18-1.
Results of straddle purchase at expiration.
XYZ Price at Total Straddle
Expiration Coll Profit Put Profit Profit
30 -$ 300 +$1,800 + $1,500
40 300 + 800 + 500
45 300 + 300 0
50 300 200 500
55 + 200 200 0
60 + 700 200 + 500
70 + 1,700 200 + 1,500
EQUIVALENCE


expiration, there would still be the opportunity to sell the straddle
for a small amount on the final day of trading.
TABLE 18-1.
Results of straddle purchase at expiration.
XYZ Price at Total Straddle
Expiration Coll Profit Put Profit Profit
30 -$ 300 +$1,800 + $1,500
40 300 + 800 + 500
45 300 + 300 0
50 300 200 500
55 + 200 200 0
60 + 700 200 + 500
70 + 1,700 200 + 1,500
EQUIVALENCES
Straddle buying is equivalent to the reverse hedge, a strategy described in Chapter 4
in which one sells the underlying stock short and purchases two calls on the under
lying stock. Both strategies have similar profit characteristics: a limited loss that
would occur at the striking price of the options involved, and potentially large prof
its if the underlying stock should rise or fall far enough in price. The straddle pur-
284
FIGURE 18-1.
Straddle purchase.
C:
.Q
I!! ·a.
X
w
ro $0 en en 0
..J
0
-e a..
-$500
Part Ill: Put Option Strategies
Stock Price at Expiration
chase is superior to the reverse hedge, however, and where listed puts exist on a stock,
the reverse hedge strategy becomes obsolete. The reasons that the straddle purchase
is superior are that dividends are not paid by the holder and that commission costs
are much smaller in the straddle situation.
REVERSE HEDGE WITH PUTS
A third strategy is equivalent to both the straddle purchase and the reverse hedge.
It consists of buying the underlying stock and buying two put options. If the stock
rises substantially in price, large profits will accrue, for the stock profit will more
than offset the fixed loss on the purchase of two put options. If the stock declines in
price by a large amount, profits will also be generated. In a decline, the profits gen
erated by 2 long puts will more than offset the loss on 100 shares of long stock. This
form of the straddle purchase has limited risk as well. The worst case would occur
if the stock were exactly at the striking price of the puts at their expiration date - the
puts would both expire worthless. The risk is limited, percentagevvise and dollar
wise, since the cost of two put options would normally be a relatively small per
centage of the total cost of buying the stock. Furthermore, the investor may receive
some dividends if the underlying stock is a dividend-paying stock. Buying stock and
buying two puts is superior to the reverse hedge strategy, but is still inferior to the
straddle purchase.
ter 18: Buying Puts in Conjunction with Call Purchases
IILECTING A STRADDLE BUY
285
In theory, one could find the best straddle purchases by applying the analyses for best
call purchases and best put purchases simultaneously. Then, if both the puts and calls
on a particular stock showed attractive opportunity, the straddle could be bought.
The straddle should be viewed as an entire position. A similar sort of analysis to that
proposed for either put or call purchases could be used for straddles as well. First,
one would assume the stock would move up or down in accordance with its volatili
ty within a fixed time period, such as 60 or 90 days. Then, the prices of both the put
and the call could be predicted for this stock movement. The straddles that off er the
best reward opportunity under this analysis would be the most attractive ones to buy.
To demonstrate this sort of analysis, the previous example can be utilized again.
Example: XYZ is at 50 and the July 50 call is selling for 3 while the July 50 put is sell
ing for 2 points. If the strategist is able to determine that XYZ has a 25% chance of
being above 54 in 90 days and also has a 25% chance of being below 46 in 90 days,
he can then predict the option prices. A rigorous method for determining what per
centage chance a stock has of making a predetermined price movement is presented
in Chapter 28 on mathematical applications. For now, a general procedure of analy
sis is more important than its actual implementation. If XYZ were at 54 in 90 days, it
might be reasonable to assume that the call would be worth 5½ and the put would
be worth 1 point. The straddle would therefore be worth 6½ points. Similarly, if the
stock were at 46 in 90 days, the put might be worth 4½ points, and the call worth 1
point, making the entire straddle worth 5½ points. It is fairly common for the strad
dle to be higher-priced when it is a fixed distance in-the-money on the call side (such
as 4 points) than when it is in-the-money on the put side by that same distance. In
this example, the strategist has now determined that there is a 25% chance that the
straddle will be worth 6½ points in 90 days on an upside movement, and there is a
25% chance that the straddle will be worth 5½ points on a downside movement. The
average price of these two expectations is 6 points. Since the straddle is currently sell
ing for 5 points, this would represent a 20% profit. If all potential straddles are
ranked in the same manner - allowing for a 25% chance of upside and downside
movement by each underlying stock - the straddle buyer will have a common basis
for comparing various straddle opportunities.
FOLLOW-UP ACTION
It has been mentioned frequently that there is a good chance that a stock will remain
relatively unchanged over a short time period. This does not mean that the stock will
286 Part Ill: Put Option Strategies
never move much one way or the other, but that its net movement over the time peri
od will generally be small.
Example: If XYZ is currently at 50, one might say that its chances of being over .5.5
at the end of 90 days are fairly small, perhaps 30%. This may even be supported by
mathematical analysis based on the volatility of the underlying stock. This does not
imply, however, that the stock has only a 30% chance of ever reaching 55 during the
90-day period. Rather, it implies that it has only a 30% chance of being over 55 at the
end of the 90-day period. These are two distinctly different events, with di


s are fairly small, perhaps 30%. This may even be supported by
mathematical analysis based on the volatility of the underlying stock. This does not
imply, however, that the stock has only a 30% chance of ever reaching 55 during the
90-day period. Rather, it implies that it has only a 30% chance of being over 55 at the
end of the 90-day period. These are two distinctly different events, with different
probabilities of occurrence. Even though the probability of being over 55 at the end
of 90 days might be only 30%, the probability of ever being over 55 during the 90-
day period could be amazingly high, perhaps as high as 80%. It is important for the
straddle buyer to understand the differences between these events occurring, for he
might often be able to take follow-up action to improve his position.
Many times, after a straddle is bought, the underlying stock will begin to move
strongly, making it appear that the straddle is immediately going to become prof
itable. However, just as things are going well, the stock reverses and begins to change
direction, perhaps so quickly that it would now appear that the straddle will become
profitable on the other side. These volatile stock movements often result in little net
change, however, and at expiration the straddle buyer may have a loss. One might
think that he would take profits on the call side when they became available in a
quick upward movement, and then hope for a downward reversal so that he could
take profits on the put side as well. Taking small profits, however, is a poor strategy.
Straddle buying has limited losses and potentially unlimited profits. One might have
to suffer through a substantial number of small losses before hitting a big winner, but
the magnitude of the gain on that one large stock movement can offset many small
losses. By taking small profits, the straddle buyer is immediately cutting off his
chances for a substantial gain; that is why it is a poor strategy to limit the profits.
This is one of those statements that sounds easier in theory than it is in practice.
It is emotionally distressing to watch the straddle gain 2 or 3 points in a short time
period, only to lose that and more when the stock fails to follow through. By using a
different example, it is possible to demonstrate the types of follow-up action that the
straddle buyer might take.
Example: One had initially bought an XYZ January 40 straddle for 6 points when the
stock was 40. After a fairly short time, the stock jumps up to 45 and the following
prices exist:
Cl,apter 18: Buying Puts in Conjunction with Call Purchases
XYZ common, 45:
XYZ January 40 call, 7;
XYZ January 40 put, l; and
XYZ January 45 put, 3.
287
The straddle itself is now worth 8 points. The January 45 put price is included
because it will be part of one of the follow-up strategies. What could the straddle
buyer do at this time? First, he might do nothing, preferring to let the straddle run
its course, at least for three months or so. Assuming that he is not content to sit tight,
however, he might sell the call, taking his profit, and hope for the stock to then drop
in price. This is an inferior course of action, since he would be cutting off potential
large profits to the upside.
In the older, over-the-counter option market, one might have tried a technique
known as trading against the straddle. Since there was no secondary market for
over-the-counter options, straddle buyers often traded the stock itself against the
straddle that they owned. This type of follow-up action dictated that, if the stock
rose enough to make the straddle profitable to the upside, one would sell short the
underlying stock. This involved no extra risk, since if the stock continued up, the
straddle holder could always exercise his call to cover the short sale for a profit.
Conversely, if the underlying stock fell at the outset, making the straddle profitable
to the downside, one would buy the underlying stock. Again, this involved no extra
risk if the stock continued down, since the put could always be exercised to sell the
stock at a profit. The idea was to be able to capitalize on large stock price reversals
with the addition of the stock position to the straddle. This strategy worked best for
the brokers, who made numerous commissions as the trader tried to gauge the
whipsaws in the market. In the listed options market, the same strategic effect can
be realized ( without as large a commission expense) by merely selling out the long
call on an upward move, and using part of the proceeds to buy a second put similar
to the one already held. On a downside move, one could sell out the long put for a
profit and buy a second call similar to the one he already owns. In the example
above, the call would be sold for 7 points and a second January 40 put purchased for
1 point. This would allow the straddle buyer to recover his initial 6-point cost and
would allow for large downside profit potential. This strategy is not recommended,
however, since the straddle buyer is limiting his profit in the direction that the stock
is moving. Once the stock has moved from 40 to 45, as in this example, it would be
more reasonable to expect that it could continue up rather than experience a drop
of more than 5 points.
288 Part Ill: Put Option Strategies
A rrwre desirable sort off allow-up action would be one whereby the straddle
buyer could retain much of the profit already built up without limiting further poten
tial profits if the stock continues to run. In the example above, the straddle buyer
could use the January 45 put - the one at the higher price - for this purpose.
Example: Suppose that when the stock got to 45, he sold the put that he owned, the
January 40, for 1 point, and simultaneously bought the January 45 put for 3 points.
This transaction would cost 2 points, and would leave him in the following position:
Long 1 January 40 call C b· d t 8 . t -


bove, the straddle buyer
could use the January 45 put - the one at the higher price - for this purpose.
Example: Suppose that when the stock got to 45, he sold the put that he owned, the
January 40, for 1 point, and simultaneously bought the January 45 put for 3 points.
This transaction would cost 2 points, and would leave him in the following position:
Long 1 January 40 call C b· d t 8 . t - om me cos : porn s Long 1 January 45 put
He now owns a combination at a cost of 8 points. However, no matter where the
underlying stock is at expiration, this combination will be worth at least 5 points,
since the put has a striking price 5 points higher than the call's striking price. In fact,
if the stock is above 45 at expiration or is below 40 at expiration, the straddle will be
worth more than 5 points. This follow-up action has not limited the potential profits.
If the stock continues to rise in price, the call will become more and more valuable.
On the other hand, if the stock reverses and falls dramatically, the put will become
quite valuable. In either case, the opportunity for large potential profits remains.
Moreover, the investor has improved his risk exposure. The most that the new posi
tion can lose at expiration is 3 points, since the combination cost 8 points originally,
and can be sold for 5 points at worst.
To summarize, if the underlying stock moves up to the ne:t"t strike, the straddle
buyer should consider rolling his put up, selling the one that he is long and buying
the one at the next higher striking price. Conversely, if the stock starts out with a
downward move, he should consider rolling the call down, selling the one that he is
long and buying the one at the next lower strike. In either case, he reduces his risk
exposure without limiting his profit potential - exactly the type of follow-up result
that the straddle buyer should be aiming for.
BUYING A STRANGLE
A strangle is a position that consists of both a put and a call, which generally have the
same expiration date, but different striking prices. The fallowing example depicts a
strangle.
Example: One might buy a strangle consisting of an XYZ January 45 put and an XYZ
January 50 call. Buying such a strangle is quite similar to buying a straddle, although
O.,,ter 18: Buying Puts in Conjunction with Call Purchases 289
there are some differences, as the following discussion will demonstrate. Suppose the
following prices exist:
XYZ common, 47;
XYZ January 45 put, 2; and
XYZ January 50 call, 2.
In this example, both options are out-of-the-money when purchased. This, again, is
the most normal application of the strangle purchase. If XYZ is still between 45 and
50 at January expiration, both options will expire worthless and the strangle buyer
will lose his entire investment. This investment - $400 in the example - is generally
smaller than that required to buy a straddle on XYZ. If XYZ moves in either direc
tion, rising above 50 or falling below 45, the strangle will have some value at expira
tion. In this example, ifXYZ is above 54 at expiration, the call will be worth more than
4 points (the put will expire worthless) and the buyer will make a profit. In a similar
manner, if XYZ is below 41 at expiration, the put will have a value greater than 4
points and the buyer would make a profit in that case as well. The potential profits
are quite large if the underlying stock should nwve a great deal before the options
expire. Table 18-2 and Figure 18-2 depict the potential profits or losses from this
position at January expiration. The maximum loss is possible over a much wider range
than that of a straddle. The straddle achieves its maximum loss only if the stock is
exactly at the striking price of the options at expiration. However, the strangle has its
maximum loss anywhere between the two strikes at expiration. The actual amount of
the loss is smaller for the strangle, and that is a compensating factor. The potential
profits are large for both strategies.
The example above is one in which both options are out-of-the money. It is also
possible to construct a very similar position by utilizing in-the-money options.
Example: With XYZ at 47 as before, the in-the-money options might have the fol
lowing prices: XYZ January 45 call, 4; and XYZ January 50 put, 4. If one purchased
this in-the-rrwney strangle, he would pay a total cost of 8 points. However, the value
of this strangle will always be at least 5 points, since the striking price of the put is 5
points higher than that of the call. The reader has seen this sort of position before,
when protective follow-up strategies for straddle buying and for call or put buying
were described. Because the strangle will always be worth at least 5 points, the most
that the in-the-money strangle buyer can lose is 3 points in this example. His poten
tial profits are still unlimited should the underlying stock move a large distance.
Thus, even though it requires a larger initial investment, the in-the-rrwney strangle
may often be a superior strategy to the out-of the-rrwney strangle, from a buyer's
290
TABLE 18-2.
Results at expiration of a strangle purchase.
XYZ Price at
Expiration
25
35
41
43
45
47
50
54
60
70
FIGURE 18-2.
Strangle purchase.
C:
0
~ ·c.
X
w
1ii
(/) $0 (/)
0
..J
6
il= -$400 e a.
Put Call
Profit Profit
+$1,800 -$ 200
+ 800 200
+ 200 200
0 200
200 200
200 200
200 200
200 + 200
200 + 800
200 + 1,800
Stock Price at Expiration
Part Ill: Put Option Strategies
Total
Profit
+$1,600
+ 600
0
200
400
400
400
0
+ 600
+ 1,600
viewpoint. The in-the-money strangle purchase certainly involves less percentage
risk: The buyer can never lose all his investment, since he can always get back 5
points, even in the worst case (when XYZ is behveen 45 and 50 at expiration). His
percentage profits are lower with the in-the-money strangle purchase, since he paid
more for the strangle to


0
200
400
400
400
0
+ 600
+ 1,600
viewpoint. The in-the-money strangle purchase certainly involves less percentage
risk: The buyer can never lose all his investment, since he can always get back 5
points, even in the worst case (when XYZ is behveen 45 and 50 at expiration). His
percentage profits are lower with the in-the-money strangle purchase, since he paid
more for the strangle to begin with. These observations should come as no surprise,
\O.,ter 18: Buying Puts in Conjunction with Call Purchases 291
since when the outright purchase of a call was discussed, it was shown that the
purchase of an in-the-money call was more conservative than the purchase of an out
of-the-money call, in general. The same was true for the outright purchase of puts,
perhaps even more so, because of the smaller time value of an in-the-money put.
Therefore, the strangle created by the two an in-the-money call and an in-the
money put - should be more conservative than the out-of-the-money strangle.
If the underlying stock moves quickly in either direction, the strangle buyer
may sometimes be able to take action to protect some of his profits. He would do so
in a manner similar to that described for the straddle buyer. For example, if the stock
moved up quickly, he could sell the put that he originally bought and buy the put at
the next higher striking price in its place. If he had started from an out-of-the-money
strangle position, this would then place him in a straddle. The strategist should not
blindly take this sort of follow-up action, however. It may be overly expensive to "roll
up" the put in such a manner, depending on the amount of time that has passed and
the actual option prices involved. Therefore, it is best to analyze each situation on a
case-by-case basis to see whether it is logical to take any follow-up action at all.
As a final point, the out-of-the-money strangles may appear deceptively cheap,
both options selling for fractions of a point as expiration nears. However, the proba
bility of realizing the maximum loss equal to one's initial investment is fairly large
with strangles. This is distinctly different from straddle purchases, whereby the prob
ability of losing the entire investment is small. The aggressive speculator should not
place a large portion of his funds in out-of-the-money strangle purchases. The per
centage risk is smaller with the in-the-money strangle, being equal to the amount of
time value premium paid for the options initially, but commission costs will be some
what larger. In either case, the underlying stock still needs to move by a relatively
large amount in order for the buyer to profit.
CH.APTER 19
The Sale of a Put
The buyer of a put stands to profit if the underlying stock drops in price. As might
then be expected, the seller of a put will make money if the underlying stock increas
es in price. The uncovered sale of a put is a more common strategy than the covered
sale of a put, and is therefore described first. It is a bullishly-oriented strategy.
THE UNCOVERED PUT SALE
Since the buyer of a put has a right to sell stock at the striking price, the writer of a
put is obligating himself to buy that stock at the striking price. For assuming this obli
gation, he receives the put option premium. If the underlying stock advances and the
put expires worthless, the put writer will not be assigned and he could make a maxi
mum profit equal to the premium received. He has large downside risk, since the
stock could fall substantially, thereby increasing the value of the written put and caus
ing large losses to occur. An example will aid in explaining these general statements
about risk and reward.
Example: XYZ is at 50 and a 6-month put is selling for 4 points. The naked put writer
has a fixed potential profit to the upside - $400 in this example and a large poten
tial loss to the downside (Table 19-1 and Figure 19-1). This downside loss is limited
only by the fact that a stock cannot go below zero.
The collateral requirement for writing naked puts is the same as that for writ
ing naked calls. The requirement is equal to 20% of the current stock price plus the
put premium minus any out-of-the-money amount.
Example: If XYZ is at 50, the collateral requirement for writing a 4-point put with a
striking price of 50 would be $1,000 (20% of 5,000) plus $400 for the put premium
292
Cl,opter 19: The Sale of a Put
TABLE 19-1.
Results from the sale of an uncovered put.
XYZ Price at Put Price at
Expiration Expiration (Parity)
30 20
40 10
46 4
50 0
60 0
70 0
f IGURE 19-1.
Uncovered sale of a put.
$400
C
0
~ ·5.
X
w
'lii
(/l $0 (/l
.3 50
0
~ a.
Stock Price at Expiration
293
Put Sale
Profit
-$1,600
600
0
+ 400
+ 400
+ 400
for a total of $1,400. If the stock were above the striking price, the striking price dif
forential would be subtracted from the requirement. The minimum requirement is
I 0% of the put' s striking price, plus the put premium, even if the computation above
yields a smaller result.
The uncovered put writing strategy is similar in many ways to the covered call
writing strategy. Note that the profit graphs have the same shape; this means that the
two strategies are equivalent. It may be helpful to the reader to describe the aspects
of naked put writing by comparing them to similar aspects of covered call writing.
294 Part Ill: Put Option Strategies
In either strategy, one needs to be somewhat bullish, or at least neutral, on the
underlying stock. If the underlying stock moves upward, the uncovered put writer
will make a profit, possibly the entire amount of the premium received. If the under
lying stock should be unchanged at expiration - a neutral situation - the put writer
will profit by the amount of the time value premium received when he initially wrote
the put. This could represent the maximum profit if the put was out-of-the-money
initially, since that would mean that t


uncovered put writer
will make a profit, possibly the entire amount of the premium received. If the under
lying stock should be unchanged at expiration - a neutral situation - the put writer
will profit by the amount of the time value premium received when he initially wrote
the put. This could represent the maximum profit if the put was out-of-the-money
initially, since that would mean that the entire put premium was composed of time
value premium. For an in-the-money put, however, the time value premium would
represent something less than the entire value of the option. These are similar qual
ities to those inherent in covered call writing. If the stock moves up, the covered call
writer can make his maximum profit. However, if the stock is unchanged at expira
tion, he will make his maximum profit only if the stock is above the call's striking
price. So, in either strategy, if the position is established with the stock above the
striking price, there is a greater probability of achieving the maximum profit. This
represents the less aggressive application: writing an out-of-the-money put initially,
which is equivalent to the covered write of an in-the-money call.
The more aggressive application of naked put writing is to write an in-the
money put initially. The writer will receive a larger amount of premium dollars for
the in-the-money put and, if the underlying stock advances far enough, he will thus
make a large profit. By increasing his profit potential in this manner, he assumes
more risk. If the underlying stock should fall, the in-the-money put writer will lose
money more quickly than one who initially wrote an out-of-the-money put. Again,
these facts were demonstrated much earlier with covered call writing. An in-the
money covered call write affords more downside protection but less profit potential
than does an out-of-the-money covered call write.
It is fairly easy to summarize all of this by noting that in either the naked put
writing strategy or the covered call writing strategy, a less aggressive position is estab
lished when the stock is higher than the striking price of the written option. If the
stock is below the striking price initially, a more aggressive position is created.
There are, of course, some basic differences between covered call writing and
naked put writing. First, the naked put write will generally require a smaller invest
ment, since one is only collateralizing 20% of the stock price plus the put premium,
as opposed to 50% for the covered call write on margin. Also, the naked put writer is
not actually investing cash; collateral is used, so he may finance his naked put writing
through the value of his present portfolio, whether it be stocks, bonds, or government
securities. However, any losses would create a debit and might therefore cause him
to disturb a portion of this portfolio. It should be pointed out that one can, ifhe wish
es, write naked puts in a cash account by depositing cash or cash equivalents equal to
the striking price of the put. This is called "cash-based put writing." The covered call
O.,,ter 19: The Sale of a Put 295
writer receives the dividends on the underlying stock, but the naked put writer does
not. In certain cases, this may be a substantial amount, but it should also be pointed
out that the puts on a high-yielding stock will have more value and the naked put
writer will thus be taking in a higher premium initially. From strictly a rate of return
viewpoint, naked put writing is superior to covered call writing. Basically, there is a
different psychology involved in writing naked puts than that required for covered call
writing. The covered call write is a comfortable strategy for most investors, since it
involves common stock ownership. Writing naked options, however, is a more foreign
concept to the average investor, even if the strategies are equivalent. Therefore, it is
relatively unlikely that the same investor would be a participant in both strategies.
FOLLOW-UP ACTION
The naked put writer would take protective follow-up action if the underlying stock
drops in price. His simplest form of follow-up action is to close the position at a small
loss if the stock drops. Since in-the-money puts tend to lose time value premium rap
idly, he may find that his loss is often quite small if the stock goes against him. In the
example above, XYZ was at 50 with the put at 4. If the stock falls to 45, the writer
may be able to quite easily repurchase the put for 5½ or 6 points, thereby incurring
a fairly small loss.
In the covered call writing strategy, it was recommended that the strategist roll
down wherever possible. One reason for doing so, rather than closing the covered call
position, is that stock commissions are quite large and one cannot generally afford to
be moving in and out of stocks all the time. It is more advantageous to try to preserve
the stock position and roll the calls down. This commission disadvantage does not
exist with naked put writing. When one closes the naked put position, he merely buys
in the put. Therefore, rolling down is not as advantageous for the naked put writer.
For example, in the paragraph above, the put writer buys in the put for 5½ or 6
points. He could roll down by selling a put with striking price 45 at that time.
However, there may be better put writing situations in other stocks, and there should
be no reason for him to continue to preserve a position in XYZ stock
In fact, this same reasoning can be applied to any sort of rolling action for the
naked put writer. It is extremely advantageous for the covered call writer to roll for
ward; that is, to buy back the call when it has little or no time value premium remain
ing in it and sell a longer-term call at the same striking price. By doing so, he takes in
additional premium without having to disturb his stock position at all. However, the
naked put writer has little advantage in rolling


aked put writer. It is extremely advantageous for the covered call writer to roll for
ward; that is, to buy back the call when it has little or no time value premium remain
ing in it and sell a longer-term call at the same striking price. By doing so, he takes in
additional premium without having to disturb his stock position at all. However, the
naked put writer has little advantage in rolling forward. He can also take in addition
al premium, but when he closes the initial uncovered put, he should then evaluate
296 Part Ill: Put Option Strategies
other available put writing positions before deciding to write another put on the sam<'
underlying stock. His commission costs are the same if he remains in XYZ stock or if
he goes on to a put writing position in a different stock.
EVALUATING A NAKED PUT WRITE
The computation of potential returns from a naked put write is not as straightforward
as were the computations for covered call writing. The reason for this is that the col
lateral requirement changes as the stock moves up or down, since any naked option
position is marked to the market. The most conservative approach is to allow enough
collateral in the position in case the underlying stock should fall, thus increasing the
requirement. In this way, the naked put writer would not be forced to prematurely
close a position because he cannot maintain the margin required.
Example: XYZ is at 50 and the October 50 put is selling for 4 points. The initial col
lateral requirement is 20% of 50 plus $400, or $1,400. There is no additional require
ment, since the stock is exactly at the striking price of the put. Furthermore, let us
assume that the writer is going to close the position should the underlying stock fall
to 43. To maintain his put write, he should therefore allow enough margin to collat
eralize the position if the stock were at 43. The requirement at that stock price would
be $1,560 (20% of 43 plus at least 7 points for the in-the-money amount). Thus, the
put writer who is establishing this position should allow $1,560 of collateral value for
each put written. Of course, this collateral requirement can be reduced by the
amount of the proceeds received from the put sale, $400 per put less commissions in
this example. If we assume that the writer sells 5 puts, his gross premium inflow
would be $2,000 and his commission expense would be about $75, for a net premi
um of $1,925.
Once this information has been determined, it is a simple matter to determine
the maximum potential return and also the downside break-even point. To achieve
the maximum potential return, the put would expire worthless with the underlying
stock above the striking price. Therefore, the maximum potential profit is equal to
the net premium received. The return is merely that profit divided by the collateral
used. In the example above, the maximum potential profit is $1,925. The collateral
required is $1,560 per put (allowing for the stock to drop to 43) or $7,800 for 5 puts,
reduced by the $1,925 premium received, for a total requirement of $5,875. The
potential return is then $1,925 divided by $5,875, or 32.8%. Table 19-2 summarizes
these calculations.
t,r 19: The Sale of a Put
ILE 19-2.
297
lculation of the potential return of uncovered put writing.
50
4
less commissions
Potential maximum profit (premium received)
Striking price
Less premium per put ($1,925/5)
Break-even stock price
Collateral required (allowing for stock to drop to 43):
20% of 43
Plus put premium
Requirement for 5 puts
Less premium received
Net collateral
Potential return:
Premium divided by net collateral
$2,000
75
$1,925
$50.00
3.85
46.15
$ 860
+ 700
$1,560
X 5
$7,800
- 1,925
$5,875
$1,925/$5,875 = 32.8%
There are differences of opinion on how to compute the potential returns from
naked put writing. The method presented above is a more conservative one in that it
takes into consideration a larger collateral requirement than the initial requirement.
Of course, since one is not really investing cash, but is merely using the collateral
value of his present portfolio, it may even be correct to claim that one has no invest
ment at all in such a position. This may be true, but it would be impossible to com
pare various put writing opportunities without having a return computation available.
One other important feature of return computations is the return if unchanged.
If the put is initially out-of-the-money, the return if unchanged is the same as the
maximum potential return. However, if the put is initially in-the-money, the compu
tation must take into consideration what the writer would have to pay to buy back the
put when it expires.
298 Part Ill: Put Option Strategies
Example: XYZ is 48 and the XYZ January 50 put is selling for 5 points. The profit
that could be made if the stock were unchanged at expiration would be only 3 points,
less commissions, since the put would have to be repurchased for 2 points with XYZ
at 48 at expiration. Commissions for the buy-back should be included as well, to
make the computation as accurate as possible.
As was the case with covered call writing, one can create several rankings of
naked put writes. One list might be the highest potential returns. Another list could
be the put writes that provide the rrwst downside protection; that is, the ones that
have the least chance of losing money. Both lists need some screening applied to
them, however. When considering the maximum potential returns, one should take
care to ensure at least some room for downside movement.
Example: If XYZ were at 50, the XYZ January 100 put would be selling at 50 also and
would most assuredly have a tremendously large maximum potential return.
However, there is no room for downside movement at all, and one would surely not
write such a put. One simple way of allowing for such cases would be to reject any
put that did not offer at least 5% downside protec


for downside movement.
Example: If XYZ were at 50, the XYZ January 100 put would be selling at 50 also and
would most assuredly have a tremendously large maximum potential return.
However, there is no room for downside movement at all, and one would surely not
write such a put. One simple way of allowing for such cases would be to reject any
put that did not offer at least 5% downside protection. Alternatively, one could also
reject situations in which the return if unchanged is below 5%.
The other list, involving maximum downside protection, also must have some
screens applied to it.
Example: With XYZ at 70, the XYZ January 50 put would be selling for½ at most.
Thus, it is extremely unlikely that one would lose money in this situation; the stock
would have to fall 20 points for a loss to occur. However, there is practically nothing
to be made from this position, and one would most likely not ever write such a deeply
out-of-the-money put.
A minimum acceptable level of return must accompany the items on this list of
put writes. For example, one might decide that the return would have to be at least
12% on an annualized basis in order for the put write to be on the list of positions
offering the most downside protection. Such a requirement would preclude an
extreme situation like that shown above. Once these screens have been applied, the
lists can then be ranked in a normal manner. The put writes offering the highest
returns would be at the top of the more aggressive list, and those offering the high
est percentage of downside protection would be at the top of the more conservative
list. In the strictest sense, a more advanced technique to incorporate the volatility of
the underlying stock should rightfully be employed. As mentioned previously, that
technique is presented in Chapter 28 on mathematical applications.
19: The Sale of a Put 299
YING STOCK BELOW ITS MARKET PRICE
addition to viewing naked put writing as a strategy unto itself, as was the case in
previous discussion, some investors who actually want to acquire stock will often
te naked puts as well.
bmple: XYZ is a $60 stock and an investor feels it would be a good buy at 55. He
places an open buy order with a limit of 55. Three months later, XYZ has drifted
down to 57 but no lower. It then turns and rises heavily, but the buy limit was never
reached, and the investor misses out on the advance.
This hypothetical investor could have used a naked put to his advantage.
Suppose that when XYZ was originally at 60, this investor wrote a naked three-month
put for 5 points instead of placing an open buy limit order. Then, if XYZ is anywhere
below 60 at expiration, he will have stock put to him at 60. That is, he will have to buy
stock at 60. However, since he received 5 points for the put sale, his net cost for the
stock is 55. Thus, even ifXYZ is at 57 at expiration and has never been any lower, the
investor can still buy XYZ for a net cost of 55.
Of course, if XYZ rose right away and was above 60 at expiration, the put would
not be assigned and the investor would not own XYZ. However, he would still have
made $500 from selling the put, which is now worthless. The put writer thus assumes
a more active role in his investments by acting rather than waiting. He receives at
least some compensation for his efforts, even though he did not get to buy the stock.
If, instead of rising, XYZ fell considerably, say to 40 by expiration, the investor
would be forced to purchase stock at a net cost of 55, thereby giving himself an
immediate paper loss. He was, however, going to buy stock at 55 in any case, so the
put writer and the investor using a buy limit have the same result in this case. Critics
may point out that any buy order for common stock may be canceled if one's opinion
changes about purchasing the stock. The put writer, of course, may do the same thing
by closing out his obligation through a closing purchase of the put.
This technique is useful to many types of investors who are oriented toward
eventually owning the stock. Large portfolio managers as well as individual investors
may find the sale of puts useful for this purpose. It is a method of attempting to accu
mulate a stock position at prices lower than today's market price. If the stock rises
and the stock is not bought, the investor will at least have received the put premium
as compensation for his efforts.
SOME CAUTION IS REQUIRED
Despite the seemingly benign nature of naked put writing, it can be a highly dan
gerous strategy for two reasons: (1) Large losses are possible if the underlying stock
300 Part Ill: Put Option Strategies
takes a nasty fall, and (2) collateral requirements are small, so it is possible to utilize
a great deal of leverage. It may seem like a good idea to write out-of-the-money puts
on "quality" stocks that you "wouldn't mind owning." However, any stock is subject
to a crushing decline. In almost any year there are serious declines in one or more of
the largest stocks in America (IBM in 1991, Procter and Gamble in 1999, and Xerox
in 1999, just to name a few). If one happens to be short puts on such stocks - and
worse yet, ifhe happens to have overextended himself because he had the initial mar
gin required to sell a great deal of puts - then he could actually be wiped out on such
a decline. Therefore, do not leverage your account heavily in the naked put strategy,
regardless of the "quality" of the underlying stock.
THE COVERED PUT SALE
By definition, a put sale is covered only if the investor also owns a corresponding put
with striking price equal to or greater than the strike of the written put. This is a
spread. However,formargin purposes, one is covered ifhe sells a put and is also short
the underlying stock. The margin required is strictly that for the short sale of the
stock; there is none required for the short put. This creates a position with limited
profit potential that


also owns a corresponding put
with striking price equal to or greater than the strike of the written put. This is a
spread. However,formargin purposes, one is covered ifhe sells a put and is also short
the underlying stock. The margin required is strictly that for the short sale of the
stock; there is none required for the short put. This creates a position with limited
profit potential that is obtained if the underlying stock is anywhere below the strik
ing price of the put at expiration. There is unlimited upside risk, since if the under
lying stock rises, the short sale of stock will accrue losses, while the profit from the
put sale is limited. This is really a position equivalent to a naked call write, except that
the covered put writer must pay out the dividend on the underlying stock, if one
exists. The naked sale of a call also has an advantage over this strategy in that com
mission costs are considerably smaller. In addition, the time value premium of a call
is generally higher than that of a put, so that the naked call writer is taking in more
time premium. The covered put sale is a little-used strategy that appears to be infe
rior to naked call writing. As a result, the strategy is not described more fully.
RATIO PUT WRITING
A ratio put write involves the short sale of the underlying stock plus the sale of 2 puts
for each 100 shares sold short. This strategy has a profit graph exactly like that of a
ratio call write, achieving its maximum profit at the striking price of the written
options, and having large potential losses if the underlying stock should move too far
in either direction. The ratio call write is a highly superior strategy, however, for the
reasons just outlined. The ratio call writer receives dividends while the ratio put
Qapter 19: The Sale ol a Put 301
writer would have to pay them out. In addition, the ratio call writer will generally be
taking in larger amounts of time value premium, because calls have more time pre
mium than puts do. Therefore, the ratio put writing strategy is not a viable one.
CHAPTER 20
The Sale of a Straddle
Selling a straddle involves selling both a put and a call with the same terms. As with
any type of option sale, the straddle sale may be either covered or uncovered. Both
uses are fairly common. The covered sale of a straddle is very similar to the covered
call writing strategy and would generally appeal to the same type of investor. The
uncovered straddle write is more similar to ratio call writing, and is attractive to the
more aggressive strategist who is interested in selling large amounts of time premi
um in hopes of collecting larger profits if the underlying stock remains fairly stable.
THE COVERED STRADDLE WRITE
In this strategy, one owns the underlying stock and simultaneously writes a straddle
on that stock. This may be particularly appealing to investors who are already
involved in covered call writing. In reality, this position is not totally covered - only
the sale of the call is covered by the ownership of the stock. The sale of the put is
uncovered. However, the name "covered straddle" is generally used for this type of
position in order to distinguish it from the uncovered straddle write.
Example: XYZ is at 51 and an XYZ January 50 call is selling for 5 points while an XYZ
January 50 put is selling for 4 points. A covered straddle write would be established
by buying 100 shares of the underlying stock and simultaneously selling one put and
one call. The similarity between this position and a covered call writer's position
should be obvious. The covered straddle write is actually a covered write - long 100
shares of XYZ plus short one call - coupled with a naked put write. Since the naked
put write has already been shown to be equivalent to a covered call write, this posi
tion is quite similar to a 200-share covered call write. In fact, all the profit and loss
302
er 20: The Sale of a Straddle 303
aracteristics of a covered call write are the same for the covered straddle write.
There is limited upside profit potential and potentially large downside risk.
Readers will remember that the sale of a naked put is equivalent to a covered
call write. Hence, a covered straddle write can be thought of either as the equivalent
of a 200-share covered call write, or as the sale of two uncovered puts. In fact, there
•• some merit to the strategy of selling two puts instead of establishing a covered
straddle write. Commission costs would be smaller in that case, and so would the ini
tial investment required (although the introduction of leverage is not always a good
tlting).
The maximum profit is attained if XYZ is anywhere above the striking price of
50 at expiration. The amount of maximum profit in this example is $800: the premi
um received from selling the straddle, less the 1-point loss on the stock if it is called
11way at 50. In fact, the maximum profit potential of a covered straddle write is quick
ly computed using the following formula:
Maximum profit = Straddle premium + Striking price - Initial stock price
The break-even point in this example is 46. Note that the covered writing por
tion of this example buying stock at 51 and selling a call for 5 points - has a break
even point of 46. The naked put portion of the position has a break-even point of 46
as well, since the January 50 put was sold for 4 points. Therefore, the combined posi
tion - the covered straddle write - must have a break-even point of 46. Again, this
observation is easily defined by an equation:
B ak . Stock price + Strike price - Straddle premium re -even pnce =
2
Table 20-1 and Figure 20-1 compare the covered straddle write to a 100-share cov
ered call write of the XYZ January 50 at expiration.
The attraction for the covered call writer to become a covered straddle writer is
that he may be able to increase his return without substantially altering the parame
ters of his covered call writ


. Stock price + Strike price - Straddle premium re -even pnce =
2
Table 20-1 and Figure 20-1 compare the covered straddle write to a 100-share cov
ered call write of the XYZ January 50 at expiration.
The attraction for the covered call writer to become a covered straddle writer is
that he may be able to increase his return without substantially altering the parame
ters of his covered call writing position. Using the prices in Table 20-1, if one had
decided to establish a covered write by buying XYZ at 51 and selling the January 50
call at 5 points, he would have a position with its maximum potential return anywhere
above 50 and with a break-even point of 46. By adding the naked put to his covered
call position, he does not change the price parameters of his position; he still makes
his maximum profit anywhere above 50 and he still has a break-even point of 46.
Therefore, he does not have to change his outlook on the underlying stock in order
to become a covered straddle writer.
The investment is increased by the addition of the naked put, as are the poten
tial dollars of profit if the stock is above 50 and the potential dollars of loss if the stock
304 Part Ill: Put Option Strategies
TABLE 20-1.
Results at expiration of covered straddle write.
Stock (A) 100-Shore (8) Put
Price Covered Write Write
35
40
46
50
60
FIGURE 20-1.
-$1, 100
600
0
+ 400
+ 400
Covered straddle write.
+$800
§ +$400
e ·5.
~
al
en $0 en 0 ...J
c5
e a. ~,
,,' ,, ,,
,, ,,
,, ,,
,,
-$1, 100
600
0
+ 400
+ 400
100-Share Covered
Call Write
~-----------------►
, 46 50
Stock Price at Expiration
Covered Straddle
Write (A+ 8)
-$2,200
- 1,200
0
+ 800
+ 800
is below 46 at expiration. The covered straddle writer loses money twice as fast on
the downside, since his position is similar to a 200-share covered write. Because the
commissions are smaller for the naked put write than for the covered call write, the
covered call writer who adds a naked put to his position will generally increase his
return somewhat.
Follow-up action can be implemented in much the same way it would be for a
covered call write. Whenever one would normally roll his call in a covered situation,
t,r 20: The Sale ol a Straddle 305
now rolls the entire straddle - rolling down for protection, rolling up for an
ease in profit potential, and rolling forward when the time value premium of the
die dissipates. Rolling up or down would probably involve debits, unless one
led to a longer maturity.
Some writers might prefer to make a slight adjustment to the covered straddle
ting strategy. Instead of selling the put and call at the same price, they prefer to
ell an out-of-the-money put against the covered call write. That is, if one is buying
XYZ at 50 and selling the call, he might then also sell a put at 45. This would increase
his upside profit potential and would allow for the possibility of both options expir
ing worthless if XYZ were anywhere between 45 and 50 at expiration. Such action
would, of course, increase the potential dollars of risk if XYZ fell below 45 by expira
tion, but the writer could always roll the call down to obtain additional downside pro
tection.
One final point should be made with regard to this strategy. The covered call
writer who is writing on margin and is fully utilizing his borrowing power for call writ
ing will have to add additional collateral in order to write covered straddles. This is
because the put write is uncovered. However, the covered call writer who is operat
ing on a cash basis can switch to the covered straddle writing strategy without put
ting up additional funds. He merely needs to move his stock to a margin account and
use the collateral value of the stock he already owns in order to sell the puts neces
sary to implement the covered straddle writes.
THE UNCOVERED STRADDLE WRITE
In an uncovered straddle write, one sells the straddle without owning the underlying
stock. In broad terms, this is a neutral strategy with limited profit potential and large
risk potential. However, the probability of making a profit is generally quite large,
and methods can be implemented to reduce the risks of the strategy.
Since one is selling both a put and a call in this strategy, he is initially taking in
large amounts of time value premium. If the underlying stock is relatively unchanged
at expiration, the straddle writer will be able to buy the straddle back for its intrinsic
value, which would normally leave him with a profit.
Example: The following prices exist:
XYZ common, 45;
XYZ January 45 call, 4; and
XYZ January 45 put, 3.
306 Part Ill: Put Option Strategies
A straddle could be sold for 7 points. If the stock were above 38 and below 52 at expi
ration, the straddle writer would profit, since the in-the-money option could ht·
bought back for less than 7 points in that case, while the out-of-the-money option
expires worthless (Table 20-2).
TABLE 20-2.
The naked straddle write.
XYZ Price at Call Put Total
Expiration Profit Profit Profit
30 +$ 400 -$1,200 -$800
35 + 400 700 - 300
38 + 400 400 0
40 + 400 200 + 200
45 + 400 + 300 + 700
50 100 + 300 + 200
52 300 + 300 0
55 600 + 300 - 300
60 - 1,100 + 300 - 800
Notice that Figure 20-2 has a shape like a roof. The maximum potential profit
point is at the striking price at expiration, and large potential losses exist in either
direction if the underlying stock should move too far. The reader may recall that the
ratio call writing strategy - buying 100 shares of the underlying stock and selling two
calls - has the same profit graph. These two strategies, the naked straddle write and
the ratio call write, are equivalent. The two strategies do have some differences, of
course, as do all equivalent strategies; but they are similar in that both are highly
probabilistic strategies that can be somewhat complex. In addition, both have large
potential risks under adverse market cond


selling two
calls - has the same profit graph. These two strategies, the naked straddle write and
the ratio call write, are equivalent. The two strategies do have some differences, of
course, as do all equivalent strategies; but they are similar in that both are highly
probabilistic strategies that can be somewhat complex. In addition, both have large
potential risks under adverse market conditions or if follow-up strategies are not
applied.
The investment required for a naked straddle is the greater of the requirement
on the call or the put. In general, this means that the margin requirement is equal to
the requirement for the in-the-money option in a simple naked write. This require
ment is 20% of the stock price plus the in-the-money option premium. The straddle
writer should allow enough collateral so that he can take whatever follow-up actions
he deems necessary without having to incur a margin call. If he is intending to close
out the straddle if the stock should reach the upside break-even point - 52 in the
example above - then he should allow enough collateral to finance the position with
ler 20: The Sale of a Straddle
GURE 20-2.
ked straddle sale.
307
Stock Price at Expiration
the stock at 52. If, however, he is planning to take other action that might involve
staying with the position if the stock goes to 55 or 56, he should allow enough collat
eral to be able to finance that action. If the stock never gets that high, he will have
excess collateral while the position is in place.
SELECTING A STRADDLE WRITE
Ideally, one would like to receive a premium for the straddle write that produces a
profit range that is wide in relation to the volatility of the underlying stock. In the
example above, the profit range is 38 to 52. This may or may not be extraordinarily
wide, depending on the volatility of XYZ. This is a somewhat subjective measure
ment, although one could construct a simple straddle writer's index that ranked strad
dles based on the following simple formula:
I d Straddle time value premium n ex= _______ ..._ ___ _
Stock price x Volatility
Refinements would have to be made to such a ranking, such as eliminating cases in
which either the put or the call sells for less than ¼ point ( or even 1 point, if a more
restrictive requirement is desired) or cases in which the in-the-money time premium
is small. Furthermore, the index would have to be annualized to be able to compare
straddles for different expiration months. More advanced selection criteria, in the
308 Part Ill: Put Option Strategies
form of an expected return analysis, will be presented in Chapter 28 on mathemati
cal applications.
More screens can be added to produce a more conservative list of straddl<'
writes. For example, one might want to ignore any straddles that are not worth at
least a fixed percentage, say 10%, of the underlying stock price. Also, straddles that
are too short-term, such as ones with less than 30 days of life remaining, might b<'
thrown out as well. The remaining list of straddle writing candidates should be ones
that will provide reasonable returns under favorable conditions, and also should be
readily adaptable to some of the follow-up strategies discussed later. Finally, one
would generally like to have some amount of technical support at or above the lower
break-even price and some technical resistance at or below the upper break-even
point. Thus, once the computer has generated a list of straddles ranked by an index
such as the one listed above, the straddle writer can further pare down the list by
looking at the technical pictures of the underlying stocks.
FOLLOW-UP ACTION
The risks involved in straddle writing can be quite large. When market conditions are
favorable, one can make considerable profits, even with restrictive selection require
ments, and even by allowing considerable extra collateral for adverse stock move
ments. However, in an extremely volatile market, especially a bullish one, losses can
occur rapidly and follow-up action must be taken. Since the time premium of a put
tends to shrink when it goes into-the-money, there is actually slightly less risk to the
downside than there is to the upside. In an extremely bullish market, the time value
premiums of call options will not shrink much at all and might even expand. This may
force the straddle writer to pay excessive amounts of time value premium to buy back
the written straddle, especially if the movement occurs well in advance of expiration.
The simplest form of follow-up action is to buy the straddle back when and if the
underlying stock reaches a break-even point. The idea behind doing so is to limit the
losses to a small amount, because the straddle should be selling for only slightly more
than its original value when the stock has reached a break-even point. In practice,
there are several flaws in this theory. If the underlying stock arrives at a break-even
point well in advance of expiration, the amount of time value premium remaining in
the straddle may be extremely large and the writer will be losing a fairly large amount
by repurchasing the straddle. Thus, a break-even point at expiration is probably a loss
point prior to expiration.
Example: After the straddle is established with the stock at 45, there is a sudden rally
in the stock and it climbs quickly to 52. The call might be selling for 9 points, even
20: The Sale of a Straddle 309
gh it is 7 points in-the-money. This is not unusual in a bullish situation.
ver, the put might be worth 1 ½points.This is also not unusual, as out-of-the
y puts with a large amount of time remaining tend to hold time value premium
well. Thus, the straddle writer would have to pay 10½ points to buy back this
dle, even though it is at the break-even point, 7 points in-the-money on the call
This example is included merely to demonstrate that it is a misconception to
ieve that one can always buy the straddle bac


s is also not unusual, as out-of-the
y puts with a large amount of time remaining tend to hold time value premium
well. Thus, the straddle writer would have to pay 10½ points to buy back this
dle, even though it is at the break-even point, 7 points in-the-money on the call
This example is included merely to demonstrate that it is a misconception to
ieve that one can always buy the straddle back at the break-even point and hold
losses to mere fractions of a point by doing so. This type of buy-back strategy
ks best when there is little time remaining in the straddle. In that case, the
options will indeed be close to parity and the straddle will be able to be bought back
for close to its initial value when the stock reaches the break-even point.
Another follow-up strategy that can be employed, similar to the previous one
but with certain improvements, is to buy back only the in-the-money option when it
reaches a price equal to that of the initial straddle price.
~mple: Again using the same situation, suppose that when XYZ began to climb
heavily, the call was worth 7 points when the stock reached 50. The in-the-money
option the call - is now worth an amount equal to the initial straddle value. It could
then be bought back, leaving the out-of-the-money put naked. As long as the stock
then remained above 45, the put would expire worthless. In practice, the put could
be bought back for a small fraction after enough time had passed or if the underly
Ing stock continued to climb in price.
This type of follow-up action does not depend on taking action at a fixed stock
price, but rather is triggered by the option price itself. It is therefore a dynamic sort
of follow-up action, one in which the same action could be applied at various stock
prices, depending on the amount of time remaining until expiration. One of the prob
lems with closing the straddle at the break-even points is that the break-even point is
C)nly a valid break-even point at expiration. A long time before expiration, this stock
price will not represent much of a break-even point, as was pointed out in the last
example. Thus, buying back only the in-the-money option at a fixed price may often
be a superior strategy. The drawback is that one does not release much collateral by
buying back the in-the-money option, and he is therefore stuck in a position with
little potential profit for what could amount to a considerable length of time. The
collateral released amounts to the in-the-money amount; the writer still needs to
C.'Ollateralize 20% of the stock price.
One could adjust this follow-up method to attempt to retain some profit. For
example, he might decide to buy the in-the-money option when it has reached a
310 Part Ill: Put Option Strategies
value that is 1 point less than the total straddle value initially taken in. This would
then allow him the chance to make a I-point profit overall, if the other option expired
worthless. In any case, there is always the risk that the stock would suddenly revers('
direction and cause a loss on the remaining option as well. This method of follow-up
action is akin to the ratio writing follow-up strategy of using buy and sell stops on th<'
underlying stock.
Before describing other types of follow-up action that are designed to combat
the problems described above, it might be worthwhile to address the method used in
ratio writing - rolling up or rolling down. In straddle writing, there is often little to
be gained from rolling up or rolling down. This is a much more viable strategy in ratio
writing; one does not want to be constantly moving in and out of stock positions,
because of the commissions involved. Howeve1~ with straddle writing, once one posi
tion is closed, there is no need to pursue a similar straddle in that same stock. It may
be more desirable to look elsewhere for a new straddle position.
There are two other very simple forms of follow-up action that one might con
sider using, although neither one is for most strategists. First, one might consider
doing nothing at all, even if the underlying stock moves by a great deal, figuring that
the advantage lies in the probability that the stock will be back near the striking price
by the time the options expire. This action should be used only by the most diversi
fied and well-heeled investors, for in extreme market periods, almost all stocks may
move in unison, generating tremendous losses for anyone who does not take some
sort of action. A more aggressive type off allow-up action would be to attempt to "leg
out" of the straddle, by buying in the profitable side and then hoping for a stock price
reversal in order to buy back the remaining side. In the example above, when XYZ
ran up to 52, an aggressive trader would buy in the put at 1 ½, taking his profit, and
then hope for the stock to fall back in order to buy the call in cheaper. This is a very
aggressive type of follow-up action, because the stock could easily continue to rise in
price, thereby generating larger losses. This is a trader's sort of action, not that of a
disciplined strategist, and it should be avoided.
In essence, follow-up action should be designed to do two things: First, to limit
the risk in the position, and second, to still allow room for a potential profit to be
made. None of the above types of follow-up action accomplish both of these purpos
es. There is, however, a follow-up strategy that does allow the straddle writer to limit
his losses while still allowing for a potential profit.
Example: After the straddle was originally sold for 7 points when the stock was at 45,
the stock experiences a rally and the following prices exist:
XYZ common, 50;
XYZ January 45 call, 7;
Cl,opter 20: The Sale of a Straddle
XYZ January 45 put, l; and
XYZ January 50 call, 3.
311
The January 50 call price is included because it will be part of the follow-up strategy.
Notice that this straddle has a considerable amo