ents. If the assigned writer purchases stock to fulfill a
contract, reduced margin requirements generally apply to the transaction, so
that he would not have to fully margin the purchased stock merely for the pur
pose of delivery. Generally, the customer only has to pay a day-trade margin of
Oapter 1: Definitions 17
the difference between the current price of XYZ and the delivery price of $45
per share. If he goes short to honor the assignment, then he has to fully margin
the short sale at the current rate for stock sold short on a margin basis.
AFTER EXERCISING THE OPTION
The OCC and the customer exercising the option are not concerned with the actual
method in which the delivery is handled by the assigned customer. They want only to
ensure that the 100 shares of XYZ at 45 are, in fact, delivered. The holder who exer
cised the call can keep the stock in his account if he wants to, but he has to margin it
fully or pay cash in a cash account. On the other hand, he may want to sell the stock
immediately in the open market, presumably at a higher price than 45. If he has an
established margin account, he may sell right away without putting out any money. If
he exercises in a cash account, however, the stock must be paid for in full - even if it
is subsequently sold on the same day. Alternatively, he may use the delivered stock to
cover a short sale in his own account if he happens to be short XYZ stock.
COMMISSIONS
Both the buyer of the stock via the exercise and the seller of the stock via the assign
ment are charged a full stock commission on 100 shares, unless a special agreement
exists between the customer and the brokerage firm. Generally, option holders incur
higher commission costs through assignment than they do selling the option in the
secondary market. So the public customer who holds an option is better off selling the
option in the secondary market than exercising the call.
Example: XYZ is $55 per share. A public customer owns the XYZ January 45 call
option. He realizes that exercising the call, buying XYZ at 45, and then immediately
selling it at 55 in the stock market would net a profit of 10 points - or $1,000.
However, the combined stock commissions on both the purchase at 45 and the sale
at 55 might easily exceed $100. The net gain would actually be only $900.
On the other hand, the XYZ January 45 call is worth (and it would normally sell
for) at least 10 points in the listed options market. The commission for selling one call
at a price of 10 is roughly $30. The customer therefore decides to sell his XYZ
January 45 call in the option market. He receives $1,000 (10 points) for the call and
pays only $30 in commissions - for a net of $970. The benefit of his decision is obvi
ous.
Of course, sometimes a customer wants to own XYZ stock at $45 per share,
despite the stock commissions. Perhaps the stock is an attractive addition that will
18 Part I: Basic Properties of Stock Options
bring greater potential to a portfolio. Or if the customer is already short the XYZ
stock, he is going to have to buy 100 shares and pay the commissions sooner or later
in any case; so exercising the call at the lower stock price of 45 may be more desir
able than buying at the current price of 55.
ANTICIPATING ASSIGNMENT
The writer of a call often prefers to buy the option back in the secondary market,
rather than fulfill the obligation via a stock transaction. It should be strJssed again that
once the writer receives an assignment notice, it is too late to attempt to buy back
(cover) the call. The writer must buy before assignment, or live up to the terms upon
assignment. The writer who is aware of the circumstances that generally cause the
holders to exercise can anticipate assignment with a fair amount of certainty. In antic
ipation of the assignment, the writer can then close the contract in the secondary mar
ket. As long as the writer covers the position at any time during a trading day, he can
not be assigned on that option. Assignment notices are determined on open positions
as of the close of trading each day. The crucial question then becomes, "How can the
writer anticipate assignment?" Several circumstances signal assignments:
1. a call that is in-the-money at expiration,
2. an option trading at a discount prior to expiration, or
3. the underlying stock paying a large dividend and about to go ex-dividend.
Automatic Exercise. Assignment is all but certain if the option is in-the
money at expiration. Should the stock close even a half-point above the striking
price on the last day of trading, the holder will exercise to take advantage of the
half-point rather than let the option expire. Assignment is nearly inevitable even
if a call is only a few cents in-the-money at expiration. In fact, even if the call
trades in-the-money at any time during the last trading day, assignment may be
forthcoming. Even if a holder forgets that he owns an option and fails to exer
cise, the OCC automatically exercises any call that is ¾-point in-the-money at
expiration, unless the individual brokerage firm whose customer is long the call
gives specific instructions not to exercise. This automatic exercise mechanism
ensures that no investor throws away money through carelessness.
Example: XYZ closes at 51 on the third Friday of January (the last day of trading for
the January option series). Since options don't expire until Saturday, the next day, the
OCC and all brokerage firms have the opportunity to review their records to issue
assignments and exercises and to see if any options could have been profitably exer-
Gapter 1: Definitions 19
cised but were not. If XYZ closed at 51 and a customer who owned a January 45 call
option failed to either sell or exercise it, it is automatically exercised. Since it is worth
$600, this customer stands to receive a substantial amount of money back, even after
stock commissions.
In the case of an XYZ January 5


nd to see if any options could have been profitably exer-
Gapter 1: Definitions 19
cised but were not. If XYZ closed at 51 and a customer who owned a January 45 call
option failed to either sell or exercise it, it is automatically exercised. Since it is worth
$600, this customer stands to receive a substantial amount of money back, even after
stock commissions.
In the case of an XYZ January 50 call option, the automatic exercise procedure
is not as clear-cut with the stock at 51. Though the OCC wants to exercise the call
automatically, it cannot identify a specific owner. It knows only that one or more XYZ
January calls are still open on the long side. When the OCC checks with the broker
age firm, it may find that the firm does not wish to have the XYZ January 50 call exer
cised automatically, because the customer would lose money on the exercise after
incurring stock commissions. Yet the OCC must attempt to automatically exercise
any in-the-money calls, because the holder may have overlooked a long position.
When the public customer sells a call in the secondary market on the last day of
trading, the buyer on the other side of the trade is very likely a market-maker. Thus,
when trading stops, much of the open interest in in-the-money calls held long
belongs to market-makers. Since they can profitably exercise even for an eighth of a
point, they do so. Hence, the writer may receive an assignment notice even if the
stock has been only slightly above the strike price on the last trading day before expi
ration.
Any writer who wishes to avoid an assignment notice should always buy back ( or
cover) the option if it appears the stock will be above the strike at expiration. The
probabilities of assignment are extremely high if the option expires in-the-money.
Early Exercise Due to Discount. When options are exercised prior to
expiration, this is called early, or premature, exercise. The writer can usually
expect an early exercise when the call is trading at or below parity. A parity or
discount situation in advance of expiration may mean that an early exercise is
forthcoming, even if the discount is slight. A writer who does not want to deliv
er stock should buy back the option prior to expiration if the option is apparently
going to trade at a discount to parity. The reason is that arbitrageurs (floor
traders or member firm traders who pay only minimal commissions) can take
advantage of discount situations. (Arbitrage is discussed in more detail later in
the text; it is mentioned here to show why early exercise often occurs in a dis
count situation.)
Example: XYZ is bid at $50 per share, and an XYZ January 40 call option is offered
at a discount price of 9.80. The call is actually "worth" 10 points. The arbitrageur can
take advantage of this situation through the following actions, all on the same day:
20 Part I: Basic Properties ol Stoclc Options
1. Buy the January 40 call at 9.80.
2. Sell short XYZ common stock at 50.
3. Exercise the call to buy XYZ at 40.
The arbitrageur makes 10 points from the short sale of XYZ (steps 2 and 3), from
which he deducts the 9.80 points he paid for the call. Thus, his total gain is 20 cents
- the amount of the discount. Since he pays only a minimal commission, this trans-
action results in a net profit. '
Also, if the writer can expect assignment when the option has no time value pre
mium left in it, then conversely the option will usually not be called if time premium
is left in it.
Example: Prior to the expiration date, XYZ is trading at 50½, and the January 50 call
is trading at 1. The call is not necessarily in imminent danger of being called, since it
still has half a point of time premium left.
Time value Call Striking Stock
= + premium price price price
= 1 + 50 50½
= ½
Early Exercise Due to Dividends on the Underlying Stock. Some
times the market conditions create a discount situation, and sometimes a large
dividend gives rise to a discount. Since the stock price is almost invariably
reduced by the amount of the dividend, the option price is also most likely
reduced after the ex-dividend. Since the holder of a listed option does not receive
the dividend, he may decide to sell the option in the secondary market before the
ex-date in anticipation of the drop in price. If enough calls are sold because of
the impending ex-dividend reduction, the option may come to parity or even to a
discount. Once again, the arbitrageurs may move in to take advantage of the sit
uation by buying these calls and exercising them.
If assigned prior to the ex-date, the writer does not receive the dividend for he
no longer owns the stock on the ex-date. Furthermore, if he receives an assignment
notice on the ex-date, he must deliver the stock with the dividend. It is therefore very
important for the writer to watch for discount situations on the day prior to the ex
date.
0.,,,,, I: Definitions 21
A word of caution: Do not conclude from this discussion that a call will be exer
cised for the dividend if the dividend is larger than the remaining time premium. It
won't. An example will show why.
Emmple: XYZ stock, at 50, is going to pay a $1 dividend with the ex-date set for the
next day. An XYZ January 40 call is selling at 10¼; it has a quarter-point of time pre
mium. (TVP = 10¼ + 40 - 50 = ¼). The same type of arbitrage will not work
Suppose that the arbitrageur buys the call at 10¼ and exercises it: He now owns the
stock for the ex-date, and he plans to sell the stock immediately at the opening on the
ex-date, the next day. On the ex-date, XYZ opens at 49, because it goes ex-dividend
by $1. The arbitrageur's transactions thus consist of:
1. Buy the XYZ January 40 call at 10¼.
2. Exercise the call the same day to buy XYZ at 40.
3. On the ex-date, sell XYZ at 49 and collect the $1 dividend.
He makes 9 points on the stock (steps 2 and 3), and he receives a 1-point dividend,
for a total cash inflow of 10 point

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


day. On the ex-date, XYZ opens at 49, because it goes ex-dividend
by $1. The arbitrageur's transactions thus consist of:
1. Buy the XYZ January 40 call at 10¼.
2. Exercise the call the same day to buy XYZ at 40.
3. On the ex-date, sell XYZ at 49 and collect the $1 dividend.
He makes 9 points on the stock (steps 2 and 3), and he receives a 1-point dividend,
for a total cash inflow of 10 points. However, he loses 10¼ points paying for the call.
The overall transaction is a loser and the arbitrageur would thus not attempt it.
A dividend payment that exceeds the time premium in the call, therefore, does
not imply that the writer will be assigned.
More of a possibility, but a much less certain one, is that the arbitrageur may
attempt a "risk arbitrage" in such a situation. Risk arbitrage is arbitrage in which the
arbitrageur runs the risk of a loss in order to try for a profit. The arbitrageur may sus
pect that the stock will not be discounted the full ex-dividend amount or that the
call's time premium will increase after the ex-date. In either case (or both), he might
make a profit: If the stock opens down only 60 cents or if the option premium
expands by 40 cents, the arbitrageur could profit on the opening. In general, howev
er, arbitrageurs do not like to take risks and therefore avoid this type of situation. So
the probability of assignment as the result of a dividend payment on the underlying
stock is small, unless the call trades at parity or at a discount.
Of course, the anticipation of an early exercise assumes rational behavior on the
part of the call holder. If time premium is left in the call, the holder is always better
off financially to sell that call in the secondary market rather than to exercise it.
However, the terms of the call contract give a call holder the right to go ahead and
exercise it anyway - even if exercise is not the profitable thing to do. In such a case,
a writer would receive an assignment notice quite unexpectedly. Financially unsound
early exercises do happen, though not often, and an option writer must realize that,
22 Part I: Basic Properties of Stock Options
in a very small percentage of cases, he could be assigned under very illogical cir
cumstances.
THE OPTION MARKETS
The trader of stocks does not have to become very familiar with the details of the way
the stock market works in order to make money. Stocks don't expire, nor Cal} an
investor be pulled out of his investment unexpectedly. However, the option trader is
required to do more homework regarding the operation of the option markets. In
fact, the option strategist who does not know the details of the working of the option
markets will likely find that he or she eventually loses some money due to ignorance.
MARKET-MAKERS
In at least one respect, stock and listed option markets are similar. Stock markets use
specialists to do two things: First, they are required to make a market in a stock by
buying and selling from their own inventory, when public orders to buy or sell the
stock are absent. Second, they keep the public book of orders, consisting of limit
orders to buy and sell, as well as stop orders placed by the public. When listed option
trading began, the Chicago Board Options Exchange (CBOE) introduced a similar
method of trading, the market-maker and the board broker system. The CBOE
assigns several market-makers to each optionable stock to provide bids and offers to
buy and sell options in the absence of public orders. Market-makers cannot handle
public orders; they buy and sell for their own accounts only. A separate person, the
board broker, keeps the book of limit orders. The board broker, who cannot do any
trading, opens the book for traders to see how many orders to buy and sell are placed
nearest to the current market (consisting of the highest bid and lowest offer). (The
specialist on the stock exchange keeps a more closed book; he is not required to for
mally disclose the sizes and prices of the public orders.)
In theory, the CBOE system is more efficient than the stock exchange system.
With several market-makers competing to create the market in a particular security,
the market should be a more efficient one than a single specialist can provide. Also,
the somewhat open book of public orders should provide a more orderly market. In
practice, whether the CBOE has a more efficient market is usually a subject for heat
ed discussion. The strategist need not be concerned with the question.
The American Stock Exchange uses specialists for its option trading, but it also
has floor traders who function similarly to market-makers. The regional option
exchanges use combinations of the two systems; some use market-makers, while oth
ers use specialists.
Cl,apter 1: Definitions 23
OPTION SYMBOLOGY
It is probably a good idea for an option trader to understand how option symbols are
created and used, for it may prove to be useful information. If one has a sophisticat
ed option quoting and pricing system, the quote vendor will usually provide the
translation between option symbols and their meanings. The free option quote sec
tion on the CBOE's Web site, www.cboe.com, can be useful for that purpose as well.
Even with those aids, it is important that an option trader understand the concepts
surrounding option symbology.
THE OPTION BASE SYMBOL
The basic option symbol consists of three parts:
Option symbol = Base symbol + Expiration month code + Striking price code
The base symbol is never more than three characters in length. In its simplest form,
the base symbol is the same as the stock symbol. That works well for stocks with three
or fewer letters in their symbol, such as General Electric (GE) or IBM (IBM), but
what about NASDAQ stocks? For NASDAQ stocks, the OCC makes up a three-let
ter symbol that is used to denote options on the stock. A few examples are:
Stock
Cisco
Microsoft
Qualcomm
Stock Symbol
csco
MSFT
QCOM
Op


t form,
the base symbol is the same as the stock symbol. That works well for stocks with three
or fewer letters in their symbol, such as General Electric (GE) or IBM (IBM), but
what about NASDAQ stocks? For NASDAQ stocks, the OCC makes up a three-let
ter symbol that is used to denote options on the stock. A few examples are:
Stock
Cisco
Microsoft
Qualcomm
Stock Symbol
csco
MSFT
QCOM
Option Base Symbol
CYQ
MSQ
QAQ
In the three examples, there is a letter "Q" in each of the option base symbols.
However, that is not always the case. The option base symbol assigned by the OCC
for a NASDAQ stock may contain any three letters (or, rarely, only two letters).
THE EXPIRATION MONTH CODE
The next part of an option symbol is the expiration month code, which is a one-char
acter symbol. The symbology that has been created actually uses the expiration
month code for two purposes: (1) to identify the expiration month of the option, and
(2) to designate whether the option is a call or a put.
The concept is generally rather simple. For call options, the letter A stands for
January, B for February, and so forth, up through L for December. For put options,
the letter M stands for January, N for February, and so forth, up through X for
December. The letters Y and Z are not used for expiration month codes.
24 Part I: Basic Properties ol Stock Options
THE STRIKING PRICE CODE
This is also a one-character symbol, designed to identify the striking price of the
option. Things can get ve:iy complicated where striking price codes are concerned,
but simplistically the designations are that the letter A stands for 5, B stands for 10,
on up to S for 95 and T for 100. If the stock being quoted is more expensive - say,
trading at $150 per share - then it is possible that A will stand for 105, B for 110, S
for 195 and T for 200 (although, as will be shown later, a more complicated approach
might have to be used in cases such as these). It should be noted that the exchanges
- who designate the striking price codes and their numerical meaning - do not have •
to adhere to any of the generalized conventions described here. They usually adhere
to as many of them as they can, in order to keep things somewhat standardized, but
they can use the letters in any way they want. Typically, they would only use any strik
ing price code letter outside of its conventional designation after a stock has split or
perhaps paid a special dividend of some sort.
Before getting into the more complicated option symbol constructions, let's
look at a few simple, straightforward examples:
Stock Stock Symbol Description Option Symbol
IBM IBM IBM July 125 call IBMGE
Cisco csco Cisco April 75 put CYQPO
Ford Motor F Ford March 40 call FCH
General Motors GM GM December 65 put GMXM
In each option symbol, the last two characters are the expiration month code and the
striking price code. Preceding them is the option base symbol. For the IBM July 125,
the option symbol is quite straightforward. IBM is the option base symbol (as well as
the stock symbol), G stands for July, and E for 125, in this case.
For the Cisco April 75 put, the option base symbol is CYQ (this was given in the
previous table, but if one didn't know what the base symbol was, you would have to
look it up on the Internet or call a broker). The expiration month code in this case is
P, because P stands for an April put option. Finally, the striking price code is 0, which
stands for 75.
The Ford March 40 call and the GM December 65 put are similar to the oth
ers, except that the stock symbols only require one and two characters, respectively,
so the option symbol is thus a shorter symbol as well - first using the stock symbol,
then the standard character for the expiration month, followed by the standard char
acter for the striking price.
Chapter 1: Definitions 25
MORE STRIKING PRICE CODES
The letters A through T cannot handle all of the possible striking price codes. Recall
that many stocks, especially lower-priced ones, have striking prices that are spaced
2½ points apart. In those cases, a special letter designation is usually used for the
striking price codes:
Striking Price Code
u
V
w
X
y
z
Possible Meanings
7.5 or 37.5 or 67.5 or 97.5 or even 127.5!
12.5 or 42.5 or 72.5 or 102.5 or 132.5
17.5 or 47.5 or 77.5 or 107.5 or 137.5
22.5 or 52.5 or 82.5 or 112.5 or 142.5
27.5 or 57.5 or 87.5 or 117.5 or 147.5
32.5 or 62.5 or 92.5 or 122.5 or 152.5
Typically, only the first or second meaning is used for these letters. The higher-priced
ones only occur after a very expensive stock splits 2-for-l (say, a stock that had a strike
price of 155 and split 2-for-l, creating a strike. price of 155 divided by 2, or 77.50).
WRAPS
Note that any striking price code can have only one meaning. Thus, if the letter A is
being used to designate a strike price of 5, and the underlying stock has a tremen
dous rally to over $100 per share, then the letter A cannot also be used to designate
the strike price of 105. Something else must be done. In the early years of option
trading, there was no need for wrap symbols, but in recent - more volatile - times,
stocks have risen 100 points during the life of an option.
For example, if XYZ was originally trading at 10, there might be a 9-month, XYZ
December 10 call. Its symbol would be XYZLB. If, in the course of the next few
months, XYZ traded up to nearly 110 while the December 10 call was still in exis
tence, the exchange would want to trade an XYZ December 110 call. But a new let
ter would have to be designated for any new strikes (A already stands for 5, so it can
not stand for 105; B already stands for 10, so it cannot stand for 110, etc.). There
aren't enough letters in the alphabet to handle this, so the exchange creates an addi
tional option base symbol, called a wrap symbol.
In this case, the exchange might say that the option base symbol XYA is now
going to be used to desi


have to be designated for any new strikes (A already stands for 5, so it can
not stand for 105; B already stands for 10, so it cannot stand for 110, etc.). There
aren't enough letters in the alphabet to handle this, so the exchange creates an addi
tional option base symbol, called a wrap symbol.
In this case, the exchange might say that the option base symbol XYA is now
going to be used to designate strike prices of 105 and higher ( up to 200) for the com
mon stock whose symbol is XYZ. Having done that, the letter A can be used for 105,
B for 110, etc.
26
Option
XYZ December 10 call
XYZ December 110 call
Part I: Basic Properties ol Stock Options
Symbol
XYZLB
XYALB (wrap symbol is XYA)
Note that the wrap symbol now allows the usage of Bin its standard interpretati<,n
once again.
This process can be extended. Suppose that, by some miracle, this stock rose to
205 prior to the December expiration. Things like this happened to Yahoo (YHOO),
Amazon (AMZN), Qualcomm (QCOM), and others during the 1990s. If that hap
pened, the exchange would now create another wrap symbol and use it to designate
strike prices from 205 to 300. Suppose XYZ traded up to 210, and the exchange then
said that YYA would now be the wrap symbol for the higher strikes. In that case, these
symbols would exist:
Option
XYZ December 10 call
XYZ December 110 call
XYZ December 210 call
Symbol
XYZLB
XYALB (wrap symbol is XYA)
YYALB (wrap symbol is YYA)
Note that there doesn't have to be any particular relationship between the wrap sym
bols and the stock itself; any three-character designation could be used.
LEAPS SYMBOLS
A LEAPS option is one that is very long-term, expiring one or more years hence.
Consequently, the expiration month codes encounter a problem with LEAPS similar
to the one seen for striking price codes where wraps are concerned. The letter A
stands for January as an expiration month code. However, if there is a LEAPS option
on this same stock, and that LEAPS option expires in January of the next year, the
letter A cannot be used to designate the expiration month of the LEAPS option, since
it is already being used for the "standard" option. Consequently, LEAPS options have
a different base option symbol than the "standard" base option symbol.
Example: The current year is 2001. The OCC might have designated that, for IBM,
LEAPS options expiring in the year 2002 will have the option base symbol VBM, and
those expiring in the year 2003 will have the option base symbol WBM. Thus, the fol
lowing symbols would be used to describe the designated options:
Chapter 1: Definitions
Option Description
IBM January 125 call (expiring in 2001)
IBM January 125 call (expiring in 2002)
IBM January 125 call (expiring in 2003)
IBM January 125 put (expiring in 2003)
27
Option Symbol
IBMAE
VBMAE
WBMAE
WBMME
Note that the last line shows a LEAPS put option symbol. The letter M stands for a
January put option - the standard usage for the expiration month code.
STOCK SPLITS
Stock splits often wreak havoc on option symbols, as the exchanges are forced to use
the standard characters in nonstandard ways in order to accommodate all the addi
tional strikes that are created when a stock splits. The actual discussion of stock splits
and the resultant option symbology is deferred to the next section.
SYMBOLOGY SUMMARY
The exchanges do a good job of making symbol information available. Each exchange
has a Web site where memos detailing the changes required by LEAPS, wraps, and
splits are available for viewing.
The OCC and the exchanges have been forced to create multiple option base
symbols for a single stock in order to accommodate the various strike price and expi
ration month situations - to avoid duplication of the standardized character used for
the strike or expiration month. This is unwieldy and confusing for option traders and
for data vendors as well. In some rare cases, mistakes are made, and there can briefly
be two designations for the same option symbol. The only way to eliminate this con
fusion would be to use a longer, more descriptive option symbol that included the
expiration year and the striking price as numerical values, much as is done with
futures options. It is the member firms themselves and some of the quote vendors
who object to the transformation to this less confusing system, because they would
have to recode their software and alter their databases.
DETAILS OF OPTION TRADING
The facts that the strategist should be concerned with are included in this section.
They are not presented in any particular order of importance, and this list is not nec
essarily complete. Many more details are given in the discussion of specific strategies
throughout this text.
28 Part I: Basic Properties of Stock Options
1. Options expire on the Saturday following the third Friday of the expiration
rrwnth, although the third Friday is the last day of trading. In general, however,
waiting past 3:30 P.M. on the last day to place orders to buy or sell the expiring
options is not advisable. In the "crush" of orders during the final minutes of trad- •
ing, even a market order may not have enough time to be executed.
2. Option trades have a one-day settlement cycle. The trade settles on the next busi
ness day after the trade. Purchases must be paid for in full, and the credits from
sales "hit" the account on the settlement day. Some brokerage firms require set
tlement on the same day as the trade, when the trade occurs on the last trading
day of an expiration series.
3. Options are opened for trading in rotation. When the underlying stock opens for
trading on any exchange, regional or national, the options on that stock then go
into opening rotation on the corresponding option exchange. The rotation system
also applies if the underlying stock halts trading and then reopens during a trad
ing day; options on that stock .reopen via a rotation.
In the rotation itself,


ns are opened for trading in rotation. When the underlying stock opens for
trading on any exchange, regional or national, the options on that stock then go
into opening rotation on the corresponding option exchange. The rotation system
also applies if the underlying stock halts trading and then reopens during a trad
ing day; options on that stock .reopen via a rotation.
In the rotation itself, interested parties make bids and offers for each particular
option series one at a time - the XYZ January 45 call, the XYZ January 50 call,
and so on - until all the puts and calls at various expiration dates and striking
prices have been opened. Trades do not necessarily have to take place in each
series, just bids and offers. Orders such as spreads, which involve more than one
option, are not executed during a rotation.
While the rotation is taking place, it is possible that the underlying stock could
make a substantial move. This can result in option prices that seem unrealistic
when viewed from the perspective of each option's opening. Consequently, the
opening price of an option can be a somewhat suspicious statistic, since none of
them open at exactly the same time.
Also, it should be noted that most option traders do not trade during rotation, so
a market order may receive a very poor price. Hence, if one is considering trad
ing during rotation, a limit order should be used. ( Order entry is discussed in
more detail in a later section of this chapter.)
4. When the underlying stock splits or pays a stock dividend, the terms of its options
are adjusted. Such an adjustment may result in fractional striking prices and in
options for other than 100 shares per contract. No adjustments in terms are made
for cash dividends. The actual details of splits, stock dividends, and rights offer
ings, along with their effects on the option terms, are always published by the
option exchange that trades those options. Notices are sent to all member firms,
who then make that information available to their brokers for distribution to
clients. In actual practice, the option strategist should ascertain from the broker
28 Part I: Bask Properties of Stock Options
l. Options expire on the Saturday following the third Friday of the expiration
rrwnth, although the third Friday is the last day of trading. In general, however,
waiting past 3:30 P.M. on the last day to place orders to buy or sell the expiring
options is not advisable. In the "crush" of orders during the final minutes of trad- ,
ing, even a market order may not have enough time to be executed.
2. Option trades have a one-day settlement cycle. The trade settles on the next busi
ness day after the trade. Purchases must be paid for in full, and the credits from
sales "hit" the account on the settlement day. Some brokerage firms require set
tlement on the same day as the trade, when the trade occurs on the last trading
day of an expiration series.
3. Options are opened for trading in rotation. When the underlying stock opens for
trading on any exchange, regional or national, the options on that stock then go
into opening rotation on the corresponding option exchange. The rotation system
also applies if the underlying stock halts trading and then reopens during a trad
ing day; options on that stock reopen via a rotation.
In the rotation itself, interested parties make bids and offers for each particular
option series one at a time - the XYZ January 45 call, the XYZ January 50 call,
and so on - until all the puts and calls at various expiration dates and striking
prices have been opened. Trades do not necessarily have to take place in each
series, just bids and offers. Orders such as spreads, which involve more than one
option, are not executed during a rotation.
While the rotation is taking place, it is possible that the underlying stock could
make a substantial move. This can result in option prices that seem unrealistic
when viewed from the perspective of each option's opening. Consequently, the
opening price of an option can be a somewhat suspicious statistic, since none of
them open at exactly the same time.
Also, it should be noted that most option traders do not trade during rotation, so
a market order may receive a very poor price. Hence, if one is considering trad
ing during rotation, a limit order should be used. ( Order entry is discussed in
more detail in a later section of this chapter.)
4. When the underlying stock splits or pays a stock dividend, the terms of its options
are adjusted. Such an adjustment may result in fractional striking prices and in
options for other than 100 shares per contract. No adjustments in terms are made
for cash dividends. The actual details of splits, stock dividends, and rights offer
ings, along with their effects on the option terms, are always published by the
option exchange that trades those options. Notices are sent to all member firms,
who then make that information available to their brokers for distribution to
clients. In actual practice, the option strategist should ascertain from the broker
28 Part I: Basic Properties ol Stock Options
1. Options expire on the Saturday following the third Friday of the expiration
month, although the third Friday is the last day of trading. In general, however,
waiting past 3:30 P.M. on the last day to place orders to buy or sell the expiring
options is not advisable. In the "crush" of orders during the final minutes of trad- ,
ing, even a market order may not have enough time to be executed.
2. Option trades have a one-day settlement cycle. The trade settles on the next busi
ness day after the trade. Purchases must be paid for in full, and the credits from
sales "hit" the account on the settlement day. Some brokerage firms require set
tlement on the same day as the trade, when the trade occurs on the last trading
day of an expiration series.
3. Options are opened for trading in rotation. When the underlying st


ay settlement cycle. The trade settles on the next busi
ness day after the trade. Purchases must be paid for in full, and the credits from
sales "hit" the account on the settlement day. Some brokerage firms require set
tlement on the same day as the trade, when the trade occurs on the last trading
day of an expiration series.
3. Options are opened for trading in rotation. When the underlying stock opens for
trading on any exchange, regional or national, the options on that stock then go
into opening rotation on the corresponding option exchange. The rotation system
also applies if the underlying stock halts trading and then reopens during a trad
ing day; options on that stock reopen via a rotation.
In the rotation itself, interested parties make bids and offers for each particular
option series one at a time - the XYZ January 45 call, the XYZ January 50 call,
and so on - until all the puts and calls at various expiration dates and striking
prices have been opened. Trades do not necessarily have to take place in each
series, just bids and offers. Orders such as spreads, which involve more than one
option, are not executed during a rotation.
While the rotation is taking place, it is possible that the underlying stock could
make a substantial move. This can result in option prices that seem unrealistic
when viewed from the perspective of each option's opening. Consequently, the
opening price of an option can be a somewhat suspicious statistic, since none of
them open at exactly the same time.
Also, it should be noted that most option traders do not trade during rotation, so
a market order may receive a very poor price. Hence, if one is considering trad
ing during rotation, a limit order should be used. ( Order entry is discussed in
more detail in a later section of this chapter.)
4. When the underlying stock splits or pays a stock dividend, the terms of its options
are adjusted. Such an adjustment may result in fractional striking prices and in
options for other than 100 shares per contract. No adjustments in terms are made
for cash dividends. The actual details of splits, stock dividends, and rights offer
ings, along with their effects on the option terms, are always published by the
option exchange that trades those options. Notices are sent to all member firms,
who then make that information available to their brokers for distribution to
clients. In actual practice, the option strategist should ascertain from the broker
a.,,., 1: Definitions 29
the specific terms of the new option series, in case the broker has overlooked the
information sent.
E«ample 1: XYZ is a $50 stock with option striking prices of 45, 50, and 60 for the
January, April, and July series. It declares a 2-for-l stock split. Usually, in a 2-for-l
split situation, the number of outstanding option contracts is doubled and the strik
ing prices are halved. The owner of 5 XYZ January 60 calls becomes the owner of 10
XYZ January 30 calls. Each call is still for 100 shares of the underlying stock.
If fractional striking prices arise, the exchange also publishes the quote symbol
that is to be used to find the price of the new option. The XYZ July 45 call has a sym
bol ofXYZGI: G stands for July and I is for 45. After the 2-for-l split, one July 45 call
becomes 2 July 22½ calls. The strike of 22½ is assigned a letter. The exchanges usu
ally attempt to stay with the standard symbols as much as possible, meaning that X
would be designated for 22½. Hence, the symbol for the XYZ July 22½ call would be
XYZGX.
After the split, XYZ has options with strikes of 22½, 25, and 30. In some cases,
the option exchange officials may introduce another strike if they feel such a strike is
necessary; in this example, they might introduce a striking price of 20.
E«ample 2: UVW Corp. is now trading at 40 with strikes of 35, 40, and 45 for the
January, April, and July series. UVW declares a 2½ percent stock dividend. The con
tractually standardized 100 shares is adjusted up to 102, and the striking prices are
reduced by 2 percent (rounded to the nearest eighth). Thus, the "old" 35 strike
becomes a "new" strike of 343/s: 1.02 divided into 35 equals 34.314, which is 343/s
when rounded to the nearest eighth. The "old" 40 strike becomes a "new" strike of
39¼, and the "old" 45 strike becomes 441/s. Since these new strikes are all fraction
al, they are given special symbols - probably U, V, and W. Thus, the "old" symbol
UVWDH (UVW April 40) becomes the "new" symbol UVWDV (UVW April 39¼).
After the split, the exchange usually opens for trading new strikes of 35, 40, and
45 - each for 100 shares of the underlying stock. For a while, there are six striking
prices for UVW options. As time passes, the fractional strikes are eliminated as they
expire. Since they are not reintroduced, they eventually disappear as long as UVW
does not issue further stock dividends.
Example 3: WWW Corp. (symbol WWW) is trading at $120 per share, with strike
prices of ll0, ll5, 120, 125, and 130. WWW declares a 3-for-l split. In this case, the
strike prices would be divided by 3 (and rounded to the nearest eighth); the number
of contracts in every account would be tripled; and each option would still be an
option on 100 shares of WWW stock. The general rule of thumb is that when a split
results in round lots (2-for-l, 3-for-l, 4-for-l, etc.), the number of option contracts is
30 Part I: Basic Properties ol Stock Options
increased and the strike price is decreased, and each option still represents 100
shares of the underlying stock.
In this case, the strikes listed above (110 through 130) would be adjusted to•
become new strikes: 36.625, 38.375, 40, 41.625, and 43.375. The 40 strike would be
assigned the standard strike price symbol of the letter H. However, the others would
need to be designated by the exchange, so U might stand for 38.375, V for 41.625,
and so forth.
Example 4: When a split does not result in a ro


ck.
In this case, the strikes listed above (110 through 130) would be adjusted to•
become new strikes: 36.625, 38.375, 40, 41.625, and 43.375. The 40 strike would be
assigned the standard strike price symbol of the letter H. However, the others would
need to be designated by the exchange, so U might stand for 38.375, V for 41.625,
and so forth.
Example 4: When a split does not result in a round lot, a different adjustment must
be used for the options. Suppose that AAA Corp. (symbol: AAA) is trading at $60 per
share and declares a 3-for-2 split. In this case, each option's strike will be multiplied
by two-thirds (to reflect the 3-for-2 split), but the number of contracts held in an
account will remain the same and each option will be an option on 150 shares of AAA
stock.
Suppose that there were strikes of 55, 60, and 65 preceding this split. After the
split, AAA common itself would be trading at $40 per share, reflecting the post-split
3-for-2 adjustment from its previous price of 60. There would be new options with
strikes of 36.625, 40, and 43.375 (these had been the pre-split strikes of 55, 60, and
65).
Since each of these options would be for 150 shares of the underlying stock, the
exchange creates a new option base symbol for these options, because they no longer
represent 100 shares of AAA common. Suppose the exchange says that the post-split,
150-share option contracts will henceforth use the option symbol AAX.
After the split, the exchange will then list "normal" 100-share options on AAA,
perhaps with strike prices of 35, 40, and 45. This creates a situation that can some
times be confusing for traders and can lead to problems. There will actually be two
options with striking prices of 40 - one for 100 shares and the other for 150 shares.
Suppose the July contract is being considered. The option with symbol AAAGH is a
July 40 option on 100 shares of AAA Corp., while the option with symbol AAXGH is
a July 40 option on 150 shares of AAA Corp. Since option prices are quoted on a per
share basis, they will have nearly identical price quotes on any quote system (see item
5). If one is not careful, you might trade the wrong one, thereby incurring a risk that
you did not intend to take.
For example, suppose that you sell, as an opening transaction, the AAXGH July
40 call at a price of 3. Furthermore, suppose that you did not realize that you were
selling the 150-share option; this was a mistake, but you don't yet realize it. A couple
of days later, you see that this option is now selling at 13 - a loss of 10 points. You
might think that you had just lost $1,000, but upon examining your brokerage state
ment (or confirms, or day trading sheet), you suddenly see that the loss is $1,500 on
0.,,,, 1: Definitions 31
that contract! Quite a difference, especially if multiple contracts are involved. This
could come as a shock if you thought you were hedged (perhaps you bought 100
shares of AAA common when you sold this call), only to find out later that you didn't
have a correctly hedged position in place after all.
Even more severe problems can arise if this stock splits again during the life
of this option. Sometimes the options will be adjusted so that they represent a non
standard number of shares, such as the 150-share options involved here; and after
multiple splits, the exchange may even apply a multiplier to the option, rather than
adjusting its strike price repeatedly. This type of thing wouldn't happen on the first
stock split, but it might occur on subsequent stock splits, spaced closely together
over the life of an option. In such a case, the dollar value of the option moves much
faster than one would expect from looking at a quote of the contract.
So you must be sure that you are trading the exact contract you intend to, and
not relying on the fact that the striking price is correct and the option price quote
seems to be in line. One must verify that the option being bought or sold is exactly
the one intended. In general, it is a good idea, after a split or similar adjustment, to
establish opening positions solely with the standard contracts and to leave the split
adjusted contracts alone.
5. All options are quoted on a per-share basis, regardless of how many shares of
stock the option involves. Normally the quote assumes 100 shares of the under
lying stock. However, in a case like the UVW options just described, a quote of 3
for the UVW April 39¼ means a dollar price of $306 ($3 x 102).
6. Changes in the price of the underlying stock can also bring about new striking
prices. XYZ is a $47 stock with striking prices of 45 and 50. If the price of XYZ
stock falls to $40, the striking prices of 45 and 50 do not give option traders
enough opportunities in XYZ. So the exchange might introduce a new striking
price of 40. In practice, a new series is generally opened when the stock trades
at the lowest (or highest) existing strike in any series. For example, if XYZ is
falling, as soon as it traded at or below 45, the striking price of 40 may be intro
duced. The officials of the option exchange that trades XYZ options make the
decision as to the exact day when the strike begins trading.
POSITION LIMIT AND EXERCISE LIMIT
1. An investor or a group of investors cannot be long or short more than a set limit
of contracts in one stock on the same side of the market. The actual limit varies
according to the trading activity in the underlying stock. The most heavily trad
ed stocks with a large number of shares outstanding have position limits of 75,000
32 Part I: Basic Properties ol Stock Options
contracts. Smaller stocks have position limits of 60,000, 31,000, 22,500, or 13,500
contracts. These limits can be expected to increase over time, if stocks' capital
izations continue to increase. The exchange on which the option is listed makes
available a list of the position limits on each of its optionable stocks. So, if one
were long


f 75,000
32 Part I: Basic Properties ol Stock Options
contracts. Smaller stocks have position limits of 60,000, 31,000, 22,500, or 13,500
contracts. These limits can be expected to increase over time, if stocks' capital
izations continue to increase. The exchange on which the option is listed makes
available a list of the position limits on each of its optionable stocks. So, if one
were long the limit of XYZ call options, he cannot at the same time be short any
XYZ put options. Long calls and short puts are on the same side of the market;
that is, both are bullish positions. Similarly, long puts and short calls are both on
the bearish side of the market. While these position limits generally exceed by far
any position that an individual investor normally attains, the limits apply to "relat
ed" accounts. For instance, a money manager or investment advisor who is man
aging many accounts cannot exceed the limit when all the accounts' positions are
combined.
8. The numher of contracts that can be exercised in a particular period of time ( usu
ally 5 business days) is also limited to the same arrwunt as the position limit. This
exercise limit prevents an investor or group from "cornering" a stock by repeat
edly buying calls one day and exercising them the next, day after day. Option
exchanges set exact limits, which are subject to change.
ORDER ENTRY
Order Information
Of the various types of orders, each specifies:
1. whether the transaction is a buy or sell,
2. the option to be bought or sold,
3. whether the trade is opening or closing a position,
4. whether the transaction is a spread (discussed later), and
5. the desired price.
TYPES OF ORDERS
Many types of orders are acceptable for trading options, but not all are acceptable on
all exchanges that trade options. Since regulations change, information regarding
which order is valid for a given exchange is best supplied by the broker to the cus
tomer. The following orders are acceptable on all option exchanges:
Market Order. This is a simple order to buy or sell the option at the best pos
sible price as soon as the order gets to the exchange floor.
Cl,apter 1: Definitions 33
Market Not Held Order. The customer who uses this type of order is giv
ing the floor broker discretion in executing the order. The floor broker is not
held responsible for the final outcome. For example, if a floor broker has a "mar
ket not held" order to buy, and he feels that the stock will "downtick" (decline
in price) or that there is a surplus of sellers in the crowd, he may often hold off
on the execution of the buy order, figuring that the price will decline shortly and
that the order can then be executed at a more favorable price. In essence, the
customer is giving the floor broker the right to use some judgment regarding the
execution of the order. If the floor broker has an opinion and that opinion is cor
rect, the customer will probably receive a better price than if he had used a reg
ular market order. If the broker's opinion is wrong, however, the price of the
execution may be worse than a regular market order.
Limit Order. The limit order is an order to buy or to sell at a specified price
- the limit. It may be executed at a better price than the limit - a lower one for
buyers and a higher one for sellers. However, if the limit is never reached, the
order may never be executed.
Sometimes a limit order may specify a discretionary margin for the floor broker.
In other words, the order may read "Buy at 5 with dime discretion." This instruction
enables the floor broker to execute the order at 5.10 if he feels that the market will
never reach 5. Under no circumstances, however, can the order be executed at a
price higher than 5.10. Other orders may or may not be accepted·on some option
exchanges.
Stop Order. This order is not always valid on all option exchanges. A stop
order becomes a market order when the security trades at or through the price
specified on the order. Buy stop orders are placed above the current market
price, and sell stop orders are entered below the current market price. Such
orders are used to either limit loss or protect a profit. For example, if a holder's
option is selling for 3, a sell stop order for 2 is activated if the market drops
down below the 2 level, whereupon the floor broker would execute the order as
soon as possible. The customer, however, is not guaranteed that the trade will be
exactly at 2.
Stop-Limit Order. This order becomes a limit order when the specified price
is reached. Whereas the stop order has to be executed as soon as the stop price
is reached, the stop-limit may or may not be filled, depending on market behav
ior. For instance, if the option is trading at 3 while a stop-limit order is placed
at a price of 2, the floor broker may not be able to get a trade exactly at 2. If the
34 Part I: Basic Properties of Stock Options
option continues to decline through 2 - 1.90, 1.80, 1.70, and so on - without ~
ever regaining the 2 level, then the broker's hands are tied. He may not execute
what is now a limit order unless the call trades at 2.
Good-Until-Canceled Order. A limit, stop, or stop-limit order may be des
ignated "good until canceled." If the conditions for the order execution do not
occur, the order remains valid for 6 months without renewal by the customer.
Customers using an on-line broker will not be able to enter "market not held"
orders, and may not be able to use stop orders or good-until-canceled orders either,
depending on the brokerage firm.
PROFITS AND PROFIT GRAPHS
A visual presentation of the profit potential of any position is important to the over
all understanding and evaluation of it. In option trading, the many multi-security
positions especially warrant strict analysis: stock versus options (as in covered or ratio
writing) or options versus options (as in spreads). Some strategists prefer a table list
ing the outcomes of a p


OFITS AND PROFIT GRAPHS
A visual presentation of the profit potential of any position is important to the over
all understanding and evaluation of it. In option trading, the many multi-security
positions especially warrant strict analysis: stock versus options (as in covered or ratio
writing) or options versus options (as in spreads). Some strategists prefer a table list
ing the outcomes of a particular strategy for the stock at various prices; others think
the strategy is more clearly demonstrated by a graph. In the rest of the text, both a
table and a graph will be presented for each new strategy discussed.
Example: A customer wishes to evaluate the purchase of a call option. The potential
profits or losses of a purchase of an XYZ July 50 call at 4 can be arrayed in either a
table or a graph of outcomes at expiration. Both Table 1-5 and Figure 1-5 depict the
same information; the graph is merely the line representing the column marked
"Profit or Loss" in the table. The vertical axis represents dollars of profit or loss, and
the horizontal axis shows the stock price at expiration. In this case, the dollars of prof
it and the stock price are at the expiration date. Often, the strategist wants to deter
mine what the potential profits and losses will be before expiration, rather than at the
expiration date itself. Tables and graphs lend themselves well to the necessary analy
sis, as will be seen in detail in various places later on.
In practice, such an example is too simple to require a table or a graph - cer
tainly not both - to evaluate the potential profits and losses of a simple call purchase
held to expiration. However, as more complex strategies are discussed, these tools
become ever more useful for quickly determining such things as when a position
makes money and when it loses, or how fast one's risk increases at certain stock
prices.
Cl,opter 1: Definitions
TABLE 1-5.
Potential profits and losses for an XYZ call purchase.
XYZ Price at Call Price at Profit or
Expiration Expiration Loss
40 $ 0 -$ 400
45 0 - 400
50 0 - 400
55 5 + 100
60 10 + 600
70 20 + 1,600
FIGURE 1-5.
Graph of potential profits for an XYZ call purchase.
C
.Q
~ ·a
X
w
1il
(J)
(J)
$0 0 ..J
5
-e a.
-$400
Stock Price at Expiration
35

fli\R'E II
Call Option ·
.. Strategies
INTRODUCTION
The average person dealing in option trading utilizes primarily one of two option
strategies - call buying or covered call writing. These strategies are, at face value,
simple, and they are therefore the ones most often tried. There are many more
strategies involving the use of call options, many of which will be described later in
this Part. However, Chapters 2 and 3 deal with the fundamental call option strate
gies.
Both covered call writing and call buying are relatively simple strategies, but,
like any investment, they can be employed with differing levels of skill and complex
ity. The discussions to follow begin by describing the basics of each strategy and then
discuss each in depth.
38
CHAPl'ER 2
Covered Call Writing
Covered call writing is the name given to the strategy by which one sells a call option
while simultaneously owning the obligated number of shares of underlying stock.
The writer should be mildly bullish, or at least neutral, toward the underlying stock.
By writing a call option against stock, one always decreases the risk of owning the
stock. It may even be possible to profit from a covered write if the stock declines
somewhat. However, the covered call writer does limit his profit potential and there
fore may not fully participate in a strong upward move in the price of the underlying
stock. Use of this strategy is becoming so common that the strategist must under
stand it thoroughly. It is therefore discussed at length.
THE IMPORTANCE OF COVERED CALL WRITING
COVERED CALL WRITING FOR DOWNSIDE PROTECTION
Example: An investor owns 100 shares of XYZ common stock, which is currently sell
ing at $48 per share. If this investor sells an XYZ July 50 call option while still hold
ing his stock, he establishes a covered write. Suppose the investor receives $300 from
the sale of the July 50 call. If XYZ is below 50 at July expiration, the call option that
was sold expires worthless and the investor earns the $300 that he originally received
for writing the call. Thus, he receives $300, or 3 points, of downside protection. That
is, he can afford to have the XYZ stock drop by 3 points and still break even on the
total transaction. At that time he can write another call option if he so desires.
Note that if the underlying stock should fall by more than 3 points, there will be
a loss on the overall position. Thus, the risk in the covered writing strategy material
izes if the stock falls by a distance greater than the call option premium that was orig
inally taken in.
39
40 Part II: Call Option Strategies
THE BENEFITS OF AN INCREASE IN STOCK PRICE
If XYZ increases in price moderately, the trader may be able to have the best of both
worlds.
Example: If XYZ is at or just below 50 at July expiration, the call still expires worth
less, and the investor makes the $300 from the option in addition to having a small
profit from his stock purchase. Again, he still owns the stock.
Should XYZ increase in price by expiration to levels above 50, the covered
writer has a choice of alternatives. As one alternative, he could do nothing, in which
case the option would be assigned and his stock would be called away at the striking
price of 50. In that case, his profits would be equal to the $300 received from selling
the call plus the profit on the increase of his stock from the purchase price of 48 to
the sale price of 50. In this case, however, he would no longer own the stock. If as
another alternative he desires to retain his stock ownership, he can elect to buy back
( or cover) the written call in the open market. This decision might involve taking a
l


would be equal to the $300 received from selling
the call plus the profit on the increase of his stock from the purchase price of 48 to
the sale price of 50. In this case, however, he would no longer own the stock. If as
another alternative he desires to retain his stock ownership, he can elect to buy back
( or cover) the written call in the open market. This decision might involve taking a
loss on the option part of the covered writing transaction, but he would have a cor
respondingly larger profit, albeit unrealized, from his stock purchase. Using some
specific numbers, one can see how this second alternative works out.
Example: XYZ rises to a price of 60 by July expiration. The call option then sells near
its intrinsic value of 10. If the investor covers the call at 10, he loses $700 on the
option portion of his covered write. (Recall that he originally received $300 from the
sale of the option, and now he is buying it back for $1,000.) However, he relieves the
obligation to sell his stock at 50 ( the striking price) by buying back the call, so he has
an unrealized gain of 12 points in the stock, which was purchased at 48. His total
profit, including both realized and unrealized gains, is $500.
This profit is exactly the same as he would have made if he had let his stock be
called from him. If called, he would keep the $300 from the sale of the call, and he
would make 2 points ( $200) from buying the stock at 48 and selling it, via exercise, at
50. This profit, again, is a total of $500. The major difference between the two cases
is that the investor no longer owns his stock after letting it be called away, whereas
he retains stock ownership if he buys back the written call. Which of the two alter
natives is the better one in a given situation is not always clear.
No matter how high the stock climbs in price, the profit from a covered write is
limited because the writer has obligated himself to sell stock at the striking price. The
covered writer still profits when the stock climbs, but possibly not by as much as he
might have had he not written the call. On the other hand, he is receiving $300 of
immediate cash inflow, because the writer may take the premium immediately and
Gapter 2: Covered Call Writing 41
do with it as he pleases. That income can represent a substantial increase in the
income currently provided by the dividends on the underlying stock, or it can act to
offset part of the loss in case the stock declines.
For readers who prefer formulae, the profit potential and break-even point of a
covered write can be summarized as follows:
Maximum profit potential = Strike price Stock price + Call price
Downside break-even point = Stock price - Call price
QUANTIFICATION OF THE COVERED WRITE
Table 2-1 and Figure 2-1 depict the profit graph for the example involving the XYZ
covered write of the July 50 call. The table makes the assumption that the call is
bought back at parity. If the stock is called away, the same total profit of $500 results;
but the price involved on the stock sale is always 50, and the option profit is always
$300.
Several conclusions can be drawn. The break-even point is 45 (zero total prof
it) with risk below 45; the maximum profit attainable is $500 if the position is held
until expiration; and the profit if the stock price is unchanged is $300, that is, the cov
ered writer makes $300 even if his stock goes absolutely nowhere.
The profit graph for a covered write always has the shape shown in Figure 2-1.
Note that the maximum profit always occurs at all stock prices equal to or greater
than the striking price, if the position is held until expiration. However, there is
downside risk. If the stock declines in price by too great an amount, the option pre
mium cannot possibly compensate for the entire loss. Downside protective strategies,
which are discussed later, attempt to deal with the limitation of this downside risk.
TABLE 2-1.
The XYZ July 50 call.
XYZ Price Stock July 50 Call Call Total
at Expiration Profit at Expiration Profit Profit
40 -$ 800 0 +$300 -$500
45 - 300 0 + 300 0
48 0 0 + 300 + 300
50 + 200 0 + 300 + 500
55 + 700 5 - 200 + 500
60 + 1,200 10 - 700 + 500
42
FIGURE 2-1.
XYZ covered write.
C +$500
0
e ·a.
i.ti
cii en $0 en 0
...J
0
~ a.
Part II: Call Option Strategies
Maximum Profit Range
50 55 60
"-. Downside Risk
Stock Price at Expiration
COVERED WRITING PHILOSOPHY
The primary objective of covered writing, for most investors, is increased income
through stock ownership. An ever-increasing number of private and institutional
investors are writing call options against the stocks that they own. The facts that the
option premium acts as a partial compensation for a decline in price by the underly
ing stock, and that the premium represents an increase in income to the stockhold
er, are evident. The strategy of owning the stock and writing the call will outperform
outright stock ownership if the stock falls, remains the same, or even rises slightly. In
fact, the only time that the outright owner of the stock will outperform a covered
writer is if the stock increases in price by a relatively substantial amount during the
life of the call. Moreover, if one consistently writes call options against his stock, his
portfolio will show less variability of results from quarter to quarter. The total posi
tion - long stock and short option - has less volatility than the stock alone, so on a
quarter-by-quarter basis, results will be closer to average than they would be with
normal stock ownership. This is an attractive feature, especially for portfolio man
agers.
However, one should not assume that covered writing will outperform stock
ownership. Stocks sometimes tend to make most of their gains in large spurts. A cov
ered writer will not participate in moves such as that. The long-term gains that are
quoted for holding stocks include periods of large gains and sometimes pe


ck ownership. This is an attractive feature, especially for portfolio man
agers.
However, one should not assume that covered writing will outperform stock
ownership. Stocks sometimes tend to make most of their gains in large spurts. A cov
ered writer will not participate in moves such as that. The long-term gains that are
quoted for holding stocks include periods of large gains and sometimes periods of
large losses as well. The covered writer will not participate in the largest of those
gains, since his profit potential is limited.
Chapter 2: Covered Call Writing 43
PHYSICAL LOCATION Of THE STOCK
Before getting more involved in the details of covered writing strategy, it may be use
ful to review exactly what stock holdings may be written against. Recall that this dis
cussion applies to listed options. If one has deposited stock with his broker in either
a cash or a margin account, he may write an option for each 100 shares that he owns
without any additional requirement. However, it is possible to write covered options
without actually depositing stock with a brokerage firm. There are several ways in
which to do this, all involving the deposit of stock with a bank.
Once the stock is deposited with the bank, the investor may have the bank issue
an escrow receipt or letter of guarantee to the brokerage firm at which the investor
does his option business. The bank must be an "approved" bank in order for the bro
kerage firm to accept a letter of guarantee, and not all firms accept letters of guaran
tee. These items cost money, and as a new receipt or letter is required for each new
option written, the costs may become prohibitive to the customer if only 100 or 200
shares of stock are involved. The cost of an escrow receipt can range from as low as
$15 to upward of $40, depending on the bank involved.
There is another alternative open to the customer who wishes to write options
without depositing his stock at the brokerage firin. He may deposit his stock with a
bank that is a member of the Depository Trust Corporation (DTC). The DTC guar
antees the Options Clearing Corporation that it will, in fact, deliver stock should an
assignment notice be given to the call writer. This is the most convenient method for
the investor to use, and is the one used by most of the institutional covered writing
investors. There is usually no additional charge for this service by the bank to insti
tutional accounts. However, since only a limited number of banks are members of
DTC, and these banks are generally the larger banks located in metropolitan centers,
it may be somewhat difficult for many individual investors to take advantage of the
DTC opportunity.
TYPES Of COVERED WRITES
While all covered writes involve selling a call against stock that is owned, different
terms are used to describe various categories of covered writing. The two broadest
terms, under which all covered writes can be classified, are the out-of the-rrwney cov
ered write and the in-the-rrwney covered write. These refer, obviously, to whether the
option itself was in-the-money or out-of-the-money when the write was first estab
lished. Sometimes one may see covered writes classified by the nature of the stock
involved (low-priced covered write, high-yield covered write, etc;), but these are only
subcases of the two broad categories.
44 Part II: Call Option Strategies.
In general, out-of-the-money covered writes offer higher potential rewards but
have less risk protection than do in-the-money covered writes. One can establish an
aggressive or defensive covered writing position, depending on how far the call
option is in- or out-of-the-money when the write is established. In-the-money writes
are more defensive covered writing positions.
Some examples may help to illustrate how one covered write can be consider
ably more conservative, from a strategy viewpoint, than another.
Example: XYZ common stock is selling at 45 and two options are being considered
for writing: an XYZ July 40 selling for 8, and an XYZ July 50 selling for 1. Table 2-2
depicts the profitability of utilizing the July 40 or the July 50 for the covered writing.
The in-the-money covered write of the July 40 affords 8 points, or nearly 18% pro
tection down to a price of 37 (the break-even point) at expiration. The out-of-the
money covered write of the July 50 offers only 1 point of downside protection at expi
ration. Hence, the in-the-rrwney covered write offers greater downside protection
than does the out-of-the-rrwney covered write. This statement is true in general - not
merely for this example.
In the balance of the financial world, it is normally true that investment posi
tions offering less risk also have lower reward potential. The covered writing exam
ple just given is no exception. The in-the-money covered write of the July 40 has a
maximum potential profit of $300 at any point above 40 at the time of expiration.
However, the out-of-the-money covered write of the July 50 has a maximum poten
tial profit of $600 at any point above 50 at expiration. The maximum potential profit
of an out-of-the-rrwney covered write is generally greater than that of an in-the
rrwney write.
TABLE 2-2.
Profit or loss of the July 40 and July 50 calls.
In-the-Money Write Out-of-the-Money Write
of July 40 of July SO
Stock of Total Stock at Total
Expiration Profit Expiration Profit
35 -$200 35 -$900
37 0 40 - 400
40 + 300 44 0
45 + 300 45 + 100
50 + 300 50 + 600
60 + 300 60 + 600
Cl,apter 2: Covered Call Writing 45
To make a true comparison between the two covered writes, one must look at
what happens with the stock between 40 and 50 at expiration. The in-the-money
write attains its maximum profit anywhere within that range. Even a 5-point decline
by the underlying stock at expiration would still leave the in-the-money writer with
his maximum profit. However, realizing the maximum profit potential with an out-of
the-money cover


between the two covered writes, one must look at
what happens with the stock between 40 and 50 at expiration. The in-the-money
write attains its maximum profit anywhere within that range. Even a 5-point decline
by the underlying stock at expiration would still leave the in-the-money writer with
his maximum profit. However, realizing the maximum profit potential with an out-of
the-money covered write always requires a rise in price by the underlying stock. This
further illustrates the more conservative nature of the in-the-money write. It should
be noted that in-the-money writes, although having a smaller profit potential, can still
be attractive on a percentage return basis, especially if the write is done in a margin
account.
One can construct a more aggressive position by writing an out-of-the-money
call. One's outlook for the underlying stock should be bullish in that case. If one is
neutral or moderately bearish on the stock, an in-the-money covered write is more
appropriate. If one is truly bearish on a stock he owns, he should sell the stock instead
of establishing a covered write.
THE TOTAL RETURN CONCEPT
OF COVERED WRITING
When one writes an out-of-the-money option, the overall position tends to reflect
more of the result of the stock price movement and less of the benefits of writing the
call. Since the premium on an out-of-the-money call is relatively small, the total posi
tion will be quite susceptible to loss if the stock declines. If the stock rises, the posi
tion will make money regardless of the result in the option at expiration. On the other
hand, an in-the-money write is more of a "total" position - taking advantage of the
benefit of the relatively large option premium. If the stock declines, the position can
still make a profit; in fact, it can even make the maximum profit. Of course, an in
the-money write will also make money if the stock rises in price, but the profit is not
generally as great in percentage terms as is that of an out-of-the-money write.
Those who believe in the total return concept of covered writing consider both
downside protection and maximum potential return as important factors and are
willing to have the stock called away, if necessary, to meet their objectives. When
premiums are moderate or small, only in-the-money writes satisfy the total return
philosophy.
Some covered writers prefer never to lose their stock through exercise, and as
a result will often write options quite far out-of-the-money to minimize the chances
of being called by expiration. These writers receive little downside protection and, to
make money, must depend almost entirely on the results of the stock itself. Such a
46 Part II: Call Option Strategies
philosophy is more like being a stockholder and trading options against one's stock
position than actually operating a covered writing strategy. In fact, some covered
writers will attempt to buy back written options for quick profits if such profits mate
rialize during the life of the covered write. This, too, is a stock ownership philosophy,
not a covered writing strategy. The total return concept represents the true strategy
in covered writing, whereby one views the entire position as a single entity and is not
predominantly concerned with the results of his stock ownership.
THE CONSERVATIVE COVERED WRITE
Covered writing is generally accepted to be a conservative strategy. This is because
the covered writer always has less risk than a stockholder, provided that he holds the
covered write until expiration of the written call. If the underlying stock declines, the
covered writer will always offset part of his loss by the amount of the option premi
um received, no matter how small.
As was demonstrated in previous sections, however, some covered writes are
clearly more conservative than others. Not all option writers agree on what is meant
by a conservative covered write. Some believe that it involves writing an option
(probably out-of-the-money) on a conservative stock, generally one with high yield
and low volatility. It is true that the stock itself in such a position is conservative, but
the position is more aptly termed a covered write on a conservative stock. This is dis
tinctly different from a conservative covered write.
A true conservative covered write is one in which the total position is conserva
tive - offering reduced risk and a good probability of making a profit. An in-the-money
wiite, even on a stock that itself is not conservative, can become a conservative total
position when the option itself is properly chosen. Clearly, an investor cannot write
calls that are too deeply in-the-money. If he did, he would get large amounts of down
side protection, but his returns would be severely limited. If all that one desired was
maximum protection of his money at a nominal rate of profit, he could leave the
money in a bank. Instead, the conservative covered writer strives to make a potential
ly acceptable return while still receiving an above-average amount of protection.
Example: Again assume XYZ common stock is selling at 45 and an XYZ July 40 call
is selling at 8. A covered write of the XYZ July 40 would require, in a cash account,
an investment of $3,700 - $4,500 to purchase 100 shares of XYZ, less the $800
received in option premiums. The write has a maximum profit potential of $300. The
potential return from this position is therefore $300/$3, 700, just over 8% for the peri
od during which the write must be held. Since it is most likely that the option has 9
months of life or less, this return would be well in excess of 10% on a per annum
Chapter 2: Covered Call Writing 47
basis. If the write were done in a margin account, the return would be considerably
higher.
Note that we have ignored dividends paid by the underlying stock and commis
sion charges, factors that are discussed in detail in the next section. Also, one should
be aware that if he is l


ths of life or less, this return would be well in excess of 10% on a per annum
Chapter 2: Covered Call Writing 47
basis. If the write were done in a margin account, the return would be considerably
higher.
Note that we have ignored dividends paid by the underlying stock and commis
sion charges, factors that are discussed in detail in the next section. Also, one should
be aware that if he is looking at an annualized return from a covered write, there is
no guarantee that such a return could actually be obtained. All that is certain is that
the writer could make 8% in 9 months. There is no guarantee that 9 months from
now, when the call expires, there will be an equivalent position to establish that will
extend the same return for the remainder of the annualization period. Annual returns
should be used only for comparative purposes between covered writes.
The writer has a position that has an annualized return (for comparative pur
poses) of over 10% and 8 points of downside protection. Thus, the total position is an
investment that will not lose money unless XYZ common stock falls by more than 8
points, or about 18%; and is an investment that could return the equivalent of 10%
annually should XYZ common stock rise, remain the same, or fall by 5 points (to 40).
This is a conservative position. Even if XYZ itself is not a conservative stock, the
action of writing this option has made the total position a conservative one. The only
factor that might detract from the conservative nature of the total position would be
if XYZ were so volatile that it could easily fall more than 8 points in 9 months.
In a strategic sense, the total position described above is better and more con
servative than one in which a writer buys a conservative stock -yielding perhaps 6 or
7% - and writes an out-of-the-money call for a minimal premium. If this conserva
tive stock were to fall in price, the writer would be in danger of being in a loss situa
tion, because here the option is not providing anything more than the most minimal
downside protection. As was described earlier, a high-yielding, low-volatility stock
will not have much time premium in its in-the-money options, so that one cannot
effectively establish an in-the-money write on such a "conservative" stock.
COMPUTING RETURN ON INVESTMENT
Now that the reader has some general feeling for covered call writing, it is time to
discuss the specifics of computing return on investment. One should always know
exactly what his potential returns are, including all costs, when he establishes a cov
ered writing position. Once the procedure for computing returns is clear, one can
more logically decide which covered writes are the most attractive.
There are three basic elements of a covered write that should be computed
before entering into the position. The first is the return if exercised. This is the return
on investment that one would achieve if the stock were called away. For an out-of-the-
48 Part II: Call Option Strategies
money covered write, it is necessary for the stock to rise in price in order for the return
if exercised to be achieved. However, for an in-the-money covered write, the return if
exercised would be attained even if the stock were unchanged in price at option expi
ration. Thus, it is often advantageous to compute the return if unchanged - that is, the
return that would be realized if the underlying stock were unchanged when the option
expired. One can more fairly compare out-of-the-money and in-the-money covered
writes by using the return if unchanged, since no assumption is made concerning stock
price movement. The third important statistic that the covered writer should consid
er is the exact downside break-even point after all costs are included. Once this down
side break-even point is known, one can readily compute the percentage of downside
protection that he would receive from selling the call.
Example 1: An investor is considering the following covered write of a 6-month call:
Buy 500 XYZ common at 43, sell 5 XYZ July 45 calls at 3. One must first compute the
net investment required (Table 2-3). In a cash account, this investment consists of
paying for the stock in full, less the net proceeds from the sale of the options. Note
that this net investment figure includes all commissions necessary to establish the
position. (The commissions used here are approximations, as they vary from firm to
firm.) Of course, if the investor withdraws the option premium, as he is free to do,
his net investment will consist of the stock cost plus commissions. Once the neces
sary investment is known, the writer can compute the return if exercised. Table 2-4
illustrates the computation. One first computes the profit if exercised and then
divides that quantity by the net investment to obtain the return if exercised. Note
that dividends are included in this computation; it is assumed that XYZ stock will pay
$500 in dividends on the 500 shares during the life of the call. Moreover, all com
missions are included as well - the net investment includes the original stock pur
chase and option sale commissions, and the stock sale commission is explicitly listed.
For the return computed here to be realized, XYZ stock would have to rise in
price from its current price of 43 to any price above 45 by expiration. As noted ear
lier, it may be more useful to know what return could be made by the writer if the
stock did not move anywhere at all. Table 2-5 illustrates the method of computing the
TABLE 2-3.
Net investment required-cash account.
Stock cost (500 shares at 43)
Plus stock purchase commissions
Less option premiums received
Plus option sale commissions
Net cash investment
+
$21,500
320
1,500
+ 60
$20,380
Oapter 2: Covered Call Writing
TABLE 2-4.
Return if exercised-cash account.
Stock sale proceeds (500 shares at 45)
Less stock sale commissions
Plus dividends earned until expiration
Less net inve


ash account.
Stock cost (500 shares at 43)
Plus stock purchase commissions
Less option premiums received
Plus option sale commissions
Net cash investment
+
$21,500
320
1,500
+ 60
$20,380
Oapter 2: Covered Call Writing
TABLE 2-4.
Return if exercised-cash account.
Stock sale proceeds (500 shares at 45)
Less stock sale commissions
Plus dividends earned until expiration
Less net investment
Net profit if exercised
Return if exercised $2,290 = 11 2o/c
$20,380 .
0
TABLE 2-5.
Return if unchanged-cash account.
Unchanged stock value (500 shares at 43)
Plus dividends
Less net investment
Profit if unchanged
Return if unchanged $1,620 = 7.9'¼
$20,380 °
+
$22,500
330
500
- 20,380
$ 2,290
$21,500
+ 500
- 20,380
$ 1,620
49
return if unchanged - also called the static return and sometimes incorrectly referred
to as the "expected return." Again, one first calculates the profit and then calculates
the return by dividing the profit by the net investment. An important point should be
made here: There is no stock sale commission included in Table 2-5. This is the most
common way of calculating the return if unchanged; it is done this way because in a
majority of cases, one would continue to hold the stock if it were unchanged and
would write another call option against the same stock. Recall again, though, that if
the written call is in-the-rrwney, the return if unchanged is the same as the return if
exercised. Stock sale commissions must therefore be included in that case.
Once the necessary returns have been computed and the writer has a feeling for
how much money he could make in the covered write, he next computes the exact
downside break-even point to determine what kind of downside protection the writ
ten call provides (Table 2-6). The total return concept of covered writing necessitates
viewing both potential income and downside protection as important criteria for
selecting a writing position. If the stock were held to expiration and the $500 in div
idends received, the writer would break even at a price of 39.8. Again, a stock sale
commission is not generally included in the break-even point computation, because
50 Part II: Call Option Strategies
the written call would expire totally worthless and the writer might then write anoth
er call on the same stock. Later, we discuss the subject of continuing to write against
stocks already owned. It will be seen that in many cases, it is advantageous to con
tinue to hold a stock and write against it again, rather than to sell it and establish a
covered write in a new stock.
TABLE 2-6.
Downside break-even point-cash account.
Net investment
Less dividends
Total stock cost to expiration
Divide by shares held
Break-even price
$20,380
500
$19,880
+ 500
39.8
Next, we translate the break-even price into percent downside protection
(Table 2-7), which is a convenient way of comparing the levels of downside protec
tion among variously priced stocks. We will see later that it is actually better to com
pare the downside protection with the volatility of the underlying stock. However,
since percent downside protection is a common and widely accepted method that is
more readily calculated, it is necessary to be familiar with it as well.
Before moving on to discuss what kinds of returns one should attempt to strive
for in which situati_ons, the same example will be worked through again for a covered
write in a margin account. The use of margin will provide higher potential returns,
since the net investment will be smaller. However, the margin interest charge
incurred on the debit balance (the amount of money borrowed from the brokerage
firm) will cause the break-even point to be higher, thus slightly reducing the amount
of downside protection available from writing the call. Again, all commissions to
establish the position are included in the net investment computation.
TABLE 2-7.
Percent downside protection-cash account.
Initial stock price
Less break-even price
Points of protection
Divide by original stock price
Equals percent downside protection
43
-39.8
3.2
+43
7.4%
Clrapter 2: Covered Call Writing 51
Example 2: Recall that the net investment for the cash write was $20,380. A
margin covered write requires less than half of the investment of a cash write when
the margin rate (set by the Federal Reserve) is 50%. In a margin account, if one
desires to remove the premium from the account, he may do so immediately provid
ed that he has enough reserve equity in the account to cover the purchase of the
stock. If he does so, his net investment would be equal to the debit balance calcula
tion shown on the right in Table 2-8.
TABLE 2-8.
Net investment required-margin account.
Stock cost $21,500
Plus stock commissions + 320 Debit balance calculation:
Net stock cost $21,820 Net stock cost $21,820
Times margin rate X 50% Less equity - 10,910
Equity required $10,910 Debit balance $10,910
Less premiums received 1,500 (at 50% margin)
Plus option commissions + 60
Net margin investment $ 9,470
Tables 2-9 to 2-12 illustrate the computation of returns from writing on margin.
If one has already computed the cash returns, he can use method 2 most easily.
Method 1 involves no prior profit calculations.
TABLE 2-9.
Return if exercised-margin account.
Method 1 Method 2
Stock sale proceeds
Less stock commission
Plus dividends
$22,500 Net profit if exercised-cash $2,290
+
Less margin interest charges
330
500
(10% on $10,910 for 6 months) - 545
Less debit balance
Less net margin investment
Net profit-margin
- 10,910
- 9 470
$ 1,745
Less margin interest charges -
Net profit if exercised
margin
$1,745 Return if exercised = $9 ,470 = 18.4%
545
$1,745
52
TABLE 2-10.
Return if unchanged-margin account.
Method 1
Unchanged stock value (500
shares at 43)
Plus dividends
Less margin interest charges
(10% on $10,910 debit for
6 months)
Less debit balance
Less ne


investment
Net profit-margin
- 10,910
- 9 470
$ 1,745
Less margin interest charges -
Net profit if exercised
margin
$1,745 Return if exercised = $9 ,470 = 18.4%
545
$1,745
52
TABLE 2-10.
Return if unchanged-margin account.
Method 1
Unchanged stock value (500
shares at 43)
Plus dividends
Less margin interest charges
(10% on $10,910 debit for
6 months)
Less debit balance
Less net investment (margin)
Net profit if unchanged
margin
$21,500
+ 500
545
10,910
- 9 470
$ 1,075
Part II: Call Option Strategies
Method 2
Profit if unchanged-cash
Less margin interest charges -
Net profit if unchanged
margin
$1,620
545
$1,075
Return if unchanged = $ l ,075 = 11 .4%
$9,470
TABLE 2-11.
Break-even point-margin write.
Net margin investment
Plus debit balance
Less dividends
Plus margin interest charges
Total stock cost to expiration
Divide by shares held
Break-even point-margin
TABLE 2-12.
Percent downside protection-margin write.
Initial stock price
Less break-even price-margin
Points of protection
Divide by original stock price
Equals percent downside protection-margin
$ 9,470
+ 10,910
500
+ 545
$20,425
+ 500
40.9
43
-40.9
2.1
+43
4.9%
The return if exercised is 18.4% for the covered write using margin. In Example
1 the return if exercised for a cash write was computed as 11.2%. Thus, the return if
exercised from a margin write is considerably higher. In fact, unless a fairly deep in
the-money write is being considered, the return on margin will always be higher than
Cl,apter 2: Covered Call Writing 53
the return from cash. The farther out-of-the-money that the written call is, the big
ger the discrepancy between cash and margin returns will be when the return if exer
cised is computed.
As with the computation for return if exercised for a write on margin, the return
if unchanged calculation is similar for cash and margin also. The only difference is the
subtraction of the margin interest charges from the profit. The return if unchanged is
also higher for a margin write, provided that there is enough option premium to com
pensate for the margin interest charges. The return if unchanged in the cash example
was 7.9% versus 11.4% for the margin write. In general, the farther from the strike in
either direction - out-of-the-money or in-the-money - the less the return if
unchanged on margin will exceed the cash return if unchanged. In fact, for deeply out
of-the-money or deeply in-the-money calls, the return if unchanged will be higher on
cash than on margin. Table 2-11 shows that the break-even point on margin, 40.9, is
higher than the break-even point from a cash write, 39.8, because of the margin inter
est charges. Again, the percent downside protection can be computed as shown in
Table 2-12. Obviously, since the break-even point on margin is higher than that on
cash, there is less percent downside protection in a margin covered write.
One other point should be made regarding a covered write on margin: The bro
kerage firm will loan you only half of the strike price amount as a maximum. Thus, it
is not possible, for example, to buy a stock at 20, sell a deeply in-the-money call struck
at 10 points, and trade for free. In that case, the brokerage firm would loan you only
5 - half the amount of the strike.
Even so, it is still possible to create a covered call write on margin that has little or
even zero margin .requirement. For example, suppose a stock is selling at 38 and that a
long-term LEAPS option struck at 40 is selling for 19. Then the margin requirement is
zero! This does not mean you're getting something for free, however. True, your invest
ment is zero, but your risk is still 19 points. Also, your broker would ask for some sort of
minimum margin to begin with and would of course ask for maintenance margin if the
underlying stock should fall in price. Moreover, you would be paying margin interest all
during the life of this long-term LEAPS option position. Leverage can be a good thing or
a bad thing, and this strategy has a great deal of leverage. So be careful if you utilize it.
COMPOUND INTEREST
The astute reader will have noticed that our computations of margin interest have
been overly simplistic; the compounding effect of interest rates has been ignored.
That is, since interest charges are normally applied to an account monthly, the
investor will be paying interest in the later stages of a covered writing position not
only on the original debit, but on all previous monthly interest charges. This effect is
described in detail in a later chapter on arbitrage techniques. Briefly stated, rather
54 Part II: Call Option Strategies
than computing the interest charge as the debit times the interest rate multiplied by
the time to expiration, one should technically use:
Margin interest charges = Debit [(l + r/ -1]
where r is the interest rate per month and t the number of months to expiration. (It
would be incorrect to use days to expiration, since brokerage firms compute interest
monthly, not daily.)
In Example 2 of the preceding section, the debit was $10,910, the time was 6
months, and the annual interest rate was 10%. Using this more complex formula, the
margin interest charges would be $557, as opposed to the $545 charge computed
with the simpler formula. Thus, the difference is usually small, in terms of percent
age, and it is therefore comrrwn practice to use the simpler method.
SIZE OF THE POSITION
So far it has been assumed that the writer was purchasing 500 shares of XYZ and sell
ing 5 calls. This requires a relatively considerable investment for one position for the
individual investor. However, one should be aware that buying too few shares for cov
ered writing purposes can lower returns considerably.
Example: If an investor were to buy 100 shares of XYZ at 43 and sell l July 45 call
for 3, his return if exercised would drop from the 11.2% return (cash) that was com
puted earlier