re may
be an additional investment requirement. Warrants also have an exercise price. If the
exercise price of the warrant is higher than the striking price of the call, the covered
writer must also deposit the difference between the two as part of his investment.
The advantage of using warrants is that, if they are deeply in-the-money, they
may provide the cash covered writer with a higher return, since less of an investment
is involved.
Example: XYZ is at 50 and there are XYZ warrants to buy the common at 25. Since
the warrant is so deeply in-the-money, it will be selling for approximately $25 per
warrant. XYZ pays no dividend. Thus, if the writer were considering a covered write
of the XYZ July 50, he might choose to use the warrant instead of the common, since
his investment, per 100 shares of common, would only be $2,500 instead of the
$5,000 required to buy 100 XYZ. The potential profit would be the same in either
case because no dividend is involved.
Even if the stock does pay a dividend (warrants themselves have no dividend),
the writer may still be able to earn a higher return by writing against the warrant than
against the common because of the smaller investment involved. This would depend,
of course, on the exact size of the dividend and on how deeply the warrant is in-the
money.
Cbapter 2: Covered Call Writing 91
Covered writing against warrants is not a frequent practice because of the small
number of warrants on optionable stocks and the problems inherent in checking
available returns. However, in certain circumstances, the writer may actually gain a
decided advantage by writing against a deep in-the-money warrant. It is often not
advisable to write against a warrant that is at- or out-of-the-money, since it can
decline by a large percentage if the underlying stock drops in price, producing a high
risk position. Also, the writer's investment may increase in this case if he rolls down
to an option with a striking price lower than the warrant's exercise price.
WRITING AGAINST LEAPS
A form of covered call writing can be constructed by buying LEAPS call options and
selling shorter-term out-of-the-money calls against them. This strategy is much like
writing calls against warrants. This strategy is discussed in more detail in Chapter 25
on LEAPS, under the subject of diagonal spreads.
PERCS
The PERCS (Preferred Equity Redemption Cumulative Stock) is a form of covered
writing. It is discussed in Chapter 32.
THE INCREMENTAL RETURN CONCEPT OF COVERED WRITING
The incremental return concept of covered call writing is a way in which the covered
writer can earn the full value of stock appreciation between todays stock price and a
target sale price, which may be substantially higher. At the same time, the writer can
earn an incremental, positive return from writing options.
Many institutional investors are somewhat apprehensive about covered call
writing because of the upside limit that is placed on profit potential. If a call is writ
ten against a stock that subsequently declines in price, most institutional managers
would not view this as an unfavorable situation, since they would be outperforming
all managers who owned the stock and who did not write a call. However, if the stock
rises substantially after the call is written, many institutional managers do not like
having their profits limited by the written call. This strategy is not only for institu
tional money managers, although one should have a relatively substantial holding in
an underlying stock to attempt the strategy - at least 500 shares and preferably 1,000
shares or more. The incremental return concept can be used by anyone who is plan
ning to hold his stock, even if it should temporarily decline in price, until it reaches a
predetermined, higher price at which he is willing to sell the stock.
92 Part II: Call Option Strategies
The basic strategy involves, as an initial step, selecting the target price at which
the writer is willing to sell his stock.
Example: A customer owns 1,000 shares of XYZ, which is currently at 60, and is will
ing to sell the stock at 80. In the meantime, he would like to realize a positive cash
flow from writing options against his stock. This positive cash flow does not neces
sarily result in a realized option gain until the stock is called away. Most likely, with
the stock at 60, there would not be options available with a striking price of 80, so one
could not write 10 July 80's, for example. This would not be an optimum strategy
even if the July 80's existed, for the investor would be receiving so little in option pre
miums - perhaps 10 cents per call - that writing might not be worthwhile. The incre
mental return strategy allows this investor to achieve his objectives regardless of the
existence of options with a higher striking price.
The foundation of the incremental return strategy is to write against only a part
of the entire stock holding initially, and to write these calls at the striking price near
est the current stock price. Then, should the stock move up to the next higher strik
ing price, one rolls up for a credit by adding to the number of calls written. Rolling
for a credit is mandatory and is the key to the strategy. Eventually, the stock reaches
the target price and the stock is called away, the investor sells all his stock at the tar
get price, and in addition earns the total credits from all the option transactions.
Example: XYZ is 60, the investor owns 1,000 shares, and his target price is 80. One
might begin by selling three of the longest-term calls at 60 for 7 points apiece. Table
2-26 shows how a poor case - one in which the stock climbs directly to the target
price - might work. As Table 2-26 shows, if XYZ rose to 70 in one month, the three
original calls would be bought back and enough calls at 70 would be sold to produce
a credit - 5 XYZ October 70's. If the stock continued upward to 80 in another mont


three of the longest-term calls at 60 for 7 points apiece. Table
2-26 shows how a poor case - one in which the stock climbs directly to the target
price - might work. As Table 2-26 shows, if XYZ rose to 70 in one month, the three
original calls would be bought back and enough calls at 70 would be sold to produce
a credit - 5 XYZ October 70's. If the stock continued upward to 80 in another month,
the 5 calls would be bought back and the entire position - 10 calls - would be writ
ten against the target price.
If XYZ remains above 80, the stock will be called away and all 1,000 shares will
be sold at the target price of 80. In addition, the investor will earn all the option cred
its generated along the way. These amount to $2,800. Thus, the writer obtained the
full appreciation of his stock to the target price plus an incremental, positive return
from option writing.
In a flat market, the strategy is relatively easy to monitor. If a written call loses
its time value premium and therefore might be subject to assignment, the writer can
roll forward to a more distant expiration series, keeping the quantity of written calls
constant. This transaction would generate additional credits as well.
C1,,,pter 2: Covered Call Writing
TABLE 2-26.
Two months of incremental return strategy.
Day 1 : XYZ = 60
Sell 3 XYZ October 60's at 7
One month later: XYZ = 70
Buy back the 3 XYZ Oct 60's at 11 and
sell 5 XYZ Oct 70's at 7
Two months later: XYZ = 80
Buy back the 5 Oct 70's at 11 and
sell 10 XYZ Oct 80's at 6
COVERED CALL WRITING SUMMARY
93
+$2, 100 credit
-$3,300 debit
+$3,500 credit
-$5 ,500 debit
+$6.000 credit
+$2,800 credit
This concludes the chapter on covered call writing. The strategy will be referred to
later, when compared with other strategies. Here is a brief summary of the more
important points that were discussed.
Covered call writing is a viable strategy because it reduces the risk of stock own
ership and will make one's portfolio less volatile to short-term market movements. It
should be understood, however, that covered call writing may underperform stock
ownership in general because of the fact that stocks can rise great distances, while a
covered write has limited upside profit potential. The choice of which call to write
can make for a more aggressive or more conservative write. Writing in-the-money
calls is strategically more conservative than writing out-of-the-money calls, because
of the larger amount of downside protection received. The total return concept of
covered call writing attempts to achieve the maximum balance between income from
all sources - option premiums, stock ownership, and dividend income - and down
side protection. This balance is usually realized by writing calls when the stock is near
the striking price, either slightly in- or slightly out-of-the-money.
The writer should compute various returns before entering into the position:
the return if exercised, the return if the stock is unchanged at expiration, and the
break-even point. To truly compare various writes, returns should be annualized, and
all commissions and dividends should be included in the calculations. Returns will be
increased by taking larger positions in the underlying stock - 500 or 1,000 shares.
Also, by utilizing a brokerage firm's capability to produce "net" executions, buying the
stock and selling the call at a specified net price differential, one will receive better
executions and realize higher returns in the long run.
92 Part II: Call Option Strategies
The basic strategy involves, as an initial step, selecting the target price at which
the writer is willing to sell his stock
Example: A customer owns 1,000 shares ofXYZ, which is currently at 60, and is will
ing to sell the stock at 80. In the meantime, he would like to realize a positive cash
flow from writing options against his stock This positive cash flow does not neces
sarily result in a realized option gain until the stock is called away. Most likely, with
the stock at 60, there would not be options available with a striking price of 80, so one
could not write 10 July 80's, for example. This would not be an optimum strategy
even if the July 80's existed, for the investor would be receiving so little in option pre
miums - perhaps 10 cents per call - that writing might not be worthwhile. The incre
mental return strategy allows this investor to achieve his objectives regardless of the
existence of options with a higher striking price.
The foundation of the incremental return strategy is to write against only a part
of the entire stock holding initially, and to write these calls at the striking price near
est the current stock price. Then, should the stock move up to the next higher strik
ing price, one rolls up for a credit by adding to the number of calls written. Rolling
for a credit is mandatory and is the key to the strategy. Eventually, the stock reaches
the target price and the stock is called away, the investor sells all his stock at the tar
get price, and in addition earns the total credits from all the option transactions.
Example: XYZ is 60, the investor owns 1,000 shares, and his target price is 80. One
might begin by selling three of the longest-term calls at 60 for 7 points apiece. Table
2-26 shows how a poor case - one in which the stock climbs directly to the target
price - might work. As Table 2-26 shows, if XYZ rose to 70 in one month, the three
original calls would be bought back and enough calls at 70 would be sold to produce
a credit - 5 XYZ October 70's. If the stock continued upward to 80 in another month,
the 5 calls would be bought back and the entire position - 10 calls - would be writ
ten against the target price.
IfXYZ remains above 80, the stock will be called away and all 1,000 shares will
be sold at the target price of 80. In addition, the investor will earn all the option cred
its generated along the way. These amount to $2,800. Thu

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


. If the stock continued upward to 80 in another month,
the 5 calls would be bought back and the entire position - 10 calls - would be writ
ten against the target price.
IfXYZ remains above 80, the stock will be called away and all 1,000 shares will
be sold at the target price of 80. In addition, the investor will earn all the option cred
its generated along the way. These amount to $2,800. Thus, the writer obtained the
full appreciation of his stock to the target price plus an incremental, positive return
from option writing.
In a flat market, the strategy is relatively easy to monitor. If a written call loses
its time value premium and therefore might be subject to assignment, the writer can
roll f01ward to a more distant expiration series, keeping the quantity of written calls
constant. This transaction would generate additional credits as well.
O.,,er 2: Covered Call Writing
TABLE 2-26.
Two months of incremental return strategy.
Doy 1 : XYZ = 60
Sell 3 XYZ October 60's at 7
One month later: XYZ = 70
Buy back the 3 XYZ Oct 60's at 11 and
sell 5 XYZ Oct 70's at 7
Twa months later: XYZ = 80
Buy back the 5 Oct 70's at 11 and
sell 10 XYZ Oct 80's at 6
COVERED CALL WRITING SUMMARY
93
+$2, 100 credit
-$3 ,300 debit
+$3,500 credit
-$5 ,500 debit
+$6,000 credit
+$2,800 credit
This concludes the chapter on covered call writing. The strategy will be referred to
later, when compared with other strategies. Here is a brief summary of the more
important points that were discussed.
Covered call writing is a viable strategy because it reduces the risk of stock own
ership and will make one's portfolio less volatile to short-term market movements. It
should be understood, however, that covered call writing may underperform stock
ownership in general because of the fact that stocks can rise great distances, while a
covered write has limited upside profit potential. The choice of which call to write
can make for a more aggressive or more conservative write. Writing in-the-money
calls is strategically more conservative than writing out-of-the-money calls, because
of the larger amount of downside protection received. The total return concept of
covered call writing attempts to achieve the maximum balance between income from
all sources - option premiums, stock ownership, and dividend income - and down
side protection. This balance is usually realized by writing calls when the stock is near
the striking price, either slightly in- or slightly out-of-the-money.
The writer should compute various returns before entering into the position:
the return if exercised, the return if the stock is unchanged at expiration, and the
break-even point. To truly compare various writes, returns should be annualized, and
all commissions and dividends should be included in the calculations. Returns will be
increased by taking larger positions in the underlying stock - 500 or 1,000 shares.
Also, by utilizing a brokerage firm's capability to produce "net" executions, buying the
stock and selling the call at a specified net price differential, one will receive better
executions and realize higher returns in the long run.
94 Part II: Call Option Strategies
The selection of which call to write should be made on a comparison of avail
able returns and downside protection. One can sometimes write part of his position
out-of-the-money and the other part in-the-money to force a balance between return
and protection that might not otherwise exist. Finally, one should not write against an
underlying stock if he is bearish on the stock. The writer should be slightly bullish, or
at least neutral, on the underlying stock.
Follow-up action can be as important as the selection of the initial position
itself. By rolling down if the underlying stock drops, the investor can add downside
protection and current income. If one is unwilling to limit his upside potential too
severely, he may consider rolling down only part of his call writing position. As the
written call expires, the writer should roll forward into a more distant expiration
month if the stock is relatively close to the original striking price. Higher consistent
returns are achieved in this manner, because one is not spending additional stock
commissions by letting the stock be called away. An aggressive follow-up action can
also be taken when the underlying stock rises in price: The writer can roll up to a
higher striking price. This action increases the maximum profit potential but also
exposes the position to loss if the stock should subsequently decline. One would want
to take no follow-up action and let his stock be called if it is above the striking price
and if there are better returns available elsewhere in other securities.
Covered call writing can also be done against convertible securities - bonds or
preferred stocks. These convertibles sometimes offer higher dividend yields and
therefore increase the overall return from covered writing. Also, the use of warrants
or LEAPS in place of the underlying stock may be advantageous in certain circum
stances, because the net investment is lowered while the profit potential remains the
same. Therefore, the overall return could be higher.
Finally, the larger individual stockholder or institutional investor who wants to
achieve a certain price for his stock holdings should operate his covered writing strat
egy under the incremental return concept. This will allow him to realize the full prof
it potential of his underlying stock, up to the target sale price, and to earn additional
positive income from option writing.
Call Buying
The success of a call buying strategy depends primarily on one's ability to select
stocks that will go up and to time the selection reasonably well. Thus, call buying is
not a strategy in the same sense of the word as most of the other strategies discussed
in this text. Most other strategies are designed to remove some of the exactne


dditional
positive income from option writing.
Call Buying
The success of a call buying strategy depends primarily on one's ability to select
stocks that will go up and to time the selection reasonably well. Thus, call buying is
not a strategy in the same sense of the word as most of the other strategies discussed
in this text. Most other strategies are designed to remove some of the exactness of
stock picking, allowing one to be neutral or at least to have some room for error and
still make a profit. Techniques of call buying are important, though, because it is nec
essary to understand the long side of calls in order to understand more complex
strategies correctly.
Call buying is the simplest form of option investment, and therefore is the most
frequently used option "strategy" by the public investor. The following section out
lines the basic facts that one needs to know to implement an intelligent call buying
program.
WHY BUY?
The main attraction in buying calls is that they provide the speculator with a great
deal of leverage. One could potentially realize large percentage profits from only a
modest rise in price by the underlying stock. Moreover, even though they may be
large percentagewise, the risks cannot exceed a fixed dollar amount - the price orig
inally paid for the call. Calls must be paid for in full; they have no margin value and
do not constitute equity for margin purposes. Note: The preceding statements
regarding payment for an option in full do not necessarily apply to LEAPS options,
which were declared marginable in 1999. The following simple example illustrates
how a call purchase might work.
95
96 Part II: Call Option Strategies
Example: Assume that XYZ is at 48 and the 6-month call, the July 50, is selling for
3. Thus, with an investment of $300, the call buyer may participate, for 6 months, in
a move upward in the price ofXYZ common. IfXYZ should rise in price by 10 points
(just over 20%), the July 50 call will be worth at least $800 and the call buyer would
have a 167% profit on a move in the stock of just over 20%. This is the leverage that
attracts speculators to call buying. At expiration, if XYZ is below 50, the buyer's loss
is total, but is limited to his initial $300 investment, even if XYZ declines in price sub
stantially. Although this risk is equal to 100% of his initial investment, it is still small
dollarwise. One should nornwlly not invest more than 15% of his risk capital in call
buying, because of the relatively large percentage risks involved.
Some investors participate in call buying on a limited basis to add some upside
potential to their portfolios while keeping the risk to a fixed amount. For example, if
an investor normally only purchased low-volatility, conservative stocks because he
wanted to limit his downside risk, he might consider putting a small percentage of his
cash into calls on more volatile stocks. In this manner, he could "trade" higher-risk
stocks than he might normally do. If these volatile stocks increase in price, the
investor will profit handsomely. However, if they decline substantially - as well they
might, being volatile - the investor has limited his dollar risk by owning the calls
rather than the stock.
Another reason some investors buy calls is to be able to buy stock at a reason
able price without missing a market.
Example: With XYZ at 75, this investor might buy a call on XYZ at 80. He would like
to own XYZ at 80 if it can prove itself capable of rallying and be in-the-money at expi
ration. He would exercise the call in that case. On the other hand, if XYZ declines in
price instead, he has not tied up money in the stock and can lose only an amount
equal to the call premium that he paid, an amount that is generally much less than
the price of the stock itself.
Another approach to call buying is sometimes utilized, also by an investor who
does not want to "miss the market." Suppose an investor knows that, in the near
future, he will have an amount of money large enough to purchase a particular stock;
perhaps he is closing the sale of his house or a certificate of deposit is maturing.
However, he would like to buy the stock now, for he feels a rally is imminent. He
might buy calls at the present time if he had a small amount of cash available. The
call purchases would require an investment much smaller than the stock purchase.
Then, when he receives the cash that he knew was forthcoming, he could exercise the
calls and buy the stock. In this way, he might have participated in a rally by the stock
before he actually had the money available to pay for the stock in full.
Cl,opter 3: Call Buying 97
RISK AND REWARD FOR THE CALL BUYER
The most important fact for the call buyer to realize is that he will normally win only
if the stock rises in price. All the worthwhile analysis in the world spent in selecting
which call to buy will not produce profits if the underlying stock declines. However,
this fact should not dissuade one from making reasonable analyses in his call buying
selections. Too often, the call buyer feels that a stock will move up, and is correct in
that part of his projection, but still loses money on his call purchase because he failed
to analyze the risk and rewards involved with the various calls available for purchase
at the time. He bought the wrong call on the right stock.
Since the best ally that the call buyer has is upward movement in the underly
ing stock, the selection of the underlying stock is the most important choice the call
buyer has to make. Since timing is so important when buying calls, the technical fac
tors of stock selection probably outweigh the fundamentals; even if positive funda
mentals do exist, one does not know how long it will take in order for them to be
reflected in the price of the stock. One must be bullish on the underlying stock in
order to consider buying calls on that stock. Once the stock selection has b


make. Since timing is so important when buying calls, the technical fac
tors of stock selection probably outweigh the fundamentals; even if positive funda
mentals do exist, one does not know how long it will take in order for them to be
reflected in the price of the stock. One must be bullish on the underlying stock in
order to consider buying calls on that stock. Once the stock selection has been made,
only then can the call buyer begin to consider other factors, such as which striking
price to use and which expiration to buy. The call buyer may have another ally, but
not one that he can normally predict: If the stock on which he owns a call becomes
more volatile, the call's price will rise to reflect that change.
The purchase of an out-of-the-money call generally offers both larger potential
risk and larger potential reward than does the purchase of an in-the-money call.
Many call buyers tend to select the out-of-the-money call merely because it is cheap
er in price. Absolute dollar price should in no way be a deciding factor for the call
buyer. If one's funds are so limited that he can only afford to buy the cheapest calls,
he should not be speculating in this strategy. If the underlying stock increases in price
substantially, the out-of-the-money call will naturally provide the largest rewards.
However, if the stock advances only moderately in price, the in-the-money call may
actually perform better.
Example: XYZ is at 65 and the July 60 sells for 7 while the July 70 sells for 3. If the
stock moves up to 68 relatively slowly, the buyer of the July 70 - the out-of-the
money call - may actually experience a loss, even if the call has not yet expired.
However, the holder of the in-the-money July 60 will definitely have a profit because
the call will sell for at least 8 points, its intrinsic value. The point is that, percentage
wise, an in-the-rrwney call will offer better rewards for a rrwdest stock gain, and an
out-ofthe-rrwney call is better for larger stock gains.
98 Part II: Call Option Strategies
When risk is considered, the in-the-money call clearly has less probability of
risk. In the prior example, the in-the-money call buyer would not lose his entire
investment unless XYZ fell by at least 5 points. However, the buyer of the out-of-the
money July 70 would lose all of his investment unless the stock advanced by more
than 5 points by expiration. Obviously, the probability that the in-the-money call will
expire worthless is much smaller than that for the out-of-the-money call.
The time remaining to expiration is also relevant to the call buyer. If the stock
is fairly close to the striking price, the near-term call will most closely follow the price
movement of the underlying stock, so it has the greatest rewards and also the great
est risks. The far-term call, because it has a large amount of time remaining, offers
the least risk and least percentage reward. The intermediate-temi call offers a mod
erate amount of each, and is therefore often the most attractive one to buy. Many
times an investor will buy the longer-term call because it only costs a point or a point
and a half more than the intermediate-term call. He feels that the extra price is a bar
gain to pay for three extra months of time. This line of thought may prove somewhat
misleading, however, because most call buyers don't hold calls for more than 60 or 90
days. Thus, even though it looks attractive to pay the extra point for the long-term
call, it may prove to be an unnecessary expense if, as is usually the case, one will be
selling the call in two or three months.
CERTAINTY OF TIMING
The certainty with which one expects the underlying stock to advance may also help
to play a part in his selection of which call to buy. If one is fairly sure that the under
lying stock is about to rise immediately, he should strive for more reward and not be
as concerned about risk. This would mean buying short-term, slightly out-of-the
money calls. Of course, this is only a general rule; one would not normally buy an out
of-the-money call that has only one week remaining until expiration, in any case. At
the opposite end of the spectrum, if one is very uncertain about his timing, he should
buy the longest-term call, to moderate his risk in case his timing is wrong by a wide
margin. This situation could easily result, for example, if one feels that a positive fun
damental aspect concerning the company will assert itself and cause the stock to
increase in price at an unknown time in the future. Since the buyer does not know
whether this positive fundamental will come to light in the next month or six months
from now, he should buy the longer-term call to allow room for error in timing.
In many cases, one is not intending to hold the purchased call for any signifi
cant period of time; he is just looking to capitalize on a quick, short-term movement
by the underlying stock. In this case, he would want to buy a relatively short-term in
the-money call. Although such a call may be more ex-pensive than an out-of-the-
Cl,apter 3: Call Buying 99
money call on the same underlying stock, it will most surely move up on any increase
in price by the underlying stock. Thus, the short-term trader would profit.
THE DELTA
The reader should by now be familiar with basic facts concerning call options: The
time premium is highest when the stock is at the striking price of the call; it is lowest
deep in- or out-of-the-money; option prices do not decay at a linear rate -the time pre
mium disappears more rapidly as the option approaches expiration. As a further means
of review, the option pricing curve introduced in Chapter 1 is reprinted here. Notice
that all the facts listed above can be observed from Figure 3-1. The curves are much
nearer the "intrinsic value" line at the ends than they are in the middle, implying that
the time value premium is greatest when the stock is at the strike, and is least wh


the option approaches expiration. As a further means
of review, the option pricing curve introduced in Chapter 1 is reprinted here. Notice
that all the facts listed above can be observed from Figure 3-1. The curves are much
nearer the "intrinsic value" line at the ends than they are in the middle, implying that
the time value premium is greatest when the stock is at the strike, and is least when
the stock moves away from the strike either into- or out-of-the-money. Furthermore,
the fact that the curve for the 3-month option lies only about halfway between the
intrinsic value line and the curve of the 9-month option implies that the rate of decay
of an at- or near-the-money option is not linear. The reader may also want to refer back
to the graph of time value premium decay in Chapter 1 (Figure 1-4).
There is another property of call options that the buyer should be familiar with,
the delta of the option (also called the hedge ratio). Simply stated, the delta of an
option is the arrwunt by which the call will increase or decrease in price if the under
lying stock moves by 1 point.
FIGURE 3-1.
Option pricing curve; 3-, 6-, and 9-month calls.
Q)
0
~
C:
0
a
0
9-Month Curve
6-Month Curve
3-Month Curve
/
Intrinsic Value
Striking Price
Stock Price
As expiration date draws
closer, the lower curve
merges with the intrinsic
value line. The option
price then equals its
intrinsic value.
100 Part II: Call Option Strategies
Example: The delta of a call option is close to 1 when the underlying stock is well
above the striking price of the call. If XYZ were 60 and the XYZ July 50 call were
101/s, the call would change in price by nearly 1 point ifXYZ moved by 1 point, either
up or down. A deeply out-of-the-money call has a delta of nearly zero. If XYZ were
40, the July 50 call might be selling at¼ of a point. The call would change very little
in price if XYZ moved by one point, to either 41 or 39. When the stock is at the strik
ing price, the delta is usually between one-half of a point and five-eighths of a point.
Very long-term calls may have even larger at-the-money deltas. Thus, if XYZ were 50
and the XYZ July 50 call were 5, the call might increase to 5½ if XYZ rose to 51 or
decrease to 4½ if XYZ dropped to 49.
Actually, the delta changes each time the underlying stock changes even frac
tionally in price; it is an exact mathematical derivation that is presented in a later
chapter. This is most easily seen by the fact that a deep in-the-money option has a
delta of 1. However, if the stock should undergo a series of I-point drops down to the
striking price, the delta will be more like½, certainly not 1 any longer. In reality, the
delta changed instantaneously all during the price decline by the stock. For those
who are geometrically inclined, the preceding option price curve is useful in deter
mining a graphic representation of the delta. The delta is the slope of the tangent line
to the price curve. Notice that a deeply in-the-money option lies to the upper right
side of the curve, very nearly on the intrinsic value line, which has a slope of 1 above
the strike. Similarly, a deeply out-of-the-money call lies to the left on the price curve,
again near the intrinsic value line, which has a slope of zero below the strike.
Since it is more common to relate the option's price change to a full point
change in the underlying stock (rather than to deal in "instantaneous" price changes),
the concepts of up delta and down delta arise. That is, if the underlying stock moves
up by 1 full point, a call with a delta of .50 might increase by 5/s. However, should the
stock fall by one full point, the call might decrease by only 3/s. There is a different net
price change in the call when the stock moves up by 1 full point as opposed to when
it falls by a point. The up delta is observed to be 5/s while the down delta is 3/s. In the
true mathematical sense, there is only one delta and it measures "instantaneous"
price change. The concepts of up delta and down delta are practical, rather than the
oretical, concepts that merely illustrate the fact that the true delta changes whenev
er the stock price changes, even by as little as 1 point. In the following examples and
in later chapters, only one delta is referred to.
The delta is an important piece of information for the call buyer because it can
tell him how much of an increase or decrease he can expect for short-term moves by
the underlying stock. This piece of information may help the buyer decide which call
to buy.
Chapter 3: Call Buying 101
Example: If XYZ is 4 7½ and the call buyer expects a quick, but possibly limited, rise
in price in the underlying stock, should he buy the 45 call or the 50 call? The delta
may help him decide. He has the following information:
XYZ: 471/2 XYZ July 45 call: price = 31/2,
XYZ July 50 call: price = 1,
delta = 5/a
delta = 1/4
It will make matters easier to make a slightly incorrect, but simplifying, assumption
that the deltas remain constant over the short term. Which call is the better buy if
the buyer expects the stock to quickly rise to 49? This would represent a 1 ½-point
increase in XYZ, which would translate into a 15/16 increase in the July 45 (l½ times
5/s) or a 3/s increase in the July 50 (1 ½ times ¼). Consequently, the July 45, if it
increased in price by 15/16, would appreciate by 27%. The July 50, if it increased by
3/a, would appreciate by over 37%. Thus, the July 50 appears to be the better buy in
this simple example. Commissions should, of course, be included when making an
analysis for actual investment.
The investor does not have to bother with computing deltas for himself. Any
good call-buying data service will supply the information, and some brokerage hous
es provide this information free of charge.
More advanced applications of deltas are described in many of the succeeding
chapters, as they apply to a variety of strategies


urse, be included when making an
analysis for actual investment.
The investor does not have to bother with computing deltas for himself. Any
good call-buying data service will supply the information, and some brokerage hous
es provide this information free of charge.
More advanced applications of deltas are described in many of the succeeding
chapters, as they apply to a variety of strategies.
WHICH OPTION TO BUY?
There are various trading strategies, some short-term, some long-term (even buy and
hold). If one decides to use an option to implement a trading strategy, the time hori
zon of the strategy itself often dictates the general category of option that should be
bought - in-the-money versus out-of-the-money, near-term versus long-term, etc.
This statement is true whether one is referring to stock, index, or futures options.
The general rule is this: The shorter-term the strategy, the higher the delta should be
of the instrument being used to trade the strategy.
DAY TRADING
For example, day trading has become a popular endeavor. Statistics have been pro
duced that indicate that most day traders lose money. In fact, there are profitable day
traders; it simply requires more and harder work than many are willing to invest.
Many day traders have attempted to use options in their strategies. These day traders
102 Part II: Call Option Strategies
apparently are attracted by the leverage available from options, but they often lose
money via option trading as well.
What many of these option-oriented day traders fail to realize is that, for day
trading purposes, the instrument with the highest possible delta should be used. That
instrument is the underlying, for it has a delta of 1.0. Day trading is hard enough
without complicating it by trying to use options. So of you're day trading Microsoft
(MSFT), trade the stock, not an option.
What makes options difficult in such a short-term situation is their relatively
wide bid-asked spread, as compared to that of the underlying instrument itself. Also,
a day trader is looking to capture only a small part of the underlying's daily move; an
at-the-money or out-of-the-money option just won't respond well enough to those
movements. That is, if the delta is too low, there just isn't enough room for the option
day trader to make money.
If a day trader insists on using options, a short-term, in-the-money should be
bought, for it has the largest delta available - preferably something approaching .90
or higher. This option will respond quickly to small movements by the underlying.
SHORT-TERM TRADING
Suppose one employs a strategy whereby he expects to hold the underlying for
approximately a week or two. In this case, just as with day trading, a high delta is
desirable. However, now that the holding period is more than a day, it may be appro
priate to buy an option as opposed to merely trading the underlying, because the
option lessens the risk of a surprisingly large downside move. Still, it is the short
term, in-the-money option that should be bought, for it has the largest delta, and will
thus respond most closely to the movement in the underlying stock. Such an option
has a very high delta, usually in excess of .80. Part of the reason that the high-delta
options make sense in such situations is that one is fairly certain of the timing of day
trading or very short-term trading systems. When the system being used for selection
of which stock to trade has a high degree of timing accuracy, then the high-delta
option is called for.
INTERMEDIATE-TERM TRADING
As the time horizon of one's trading strategy lengthens, it is appropriate to use an
option with a lesser delta. This generally means that the timing of the selection
process is less exact. One might be using a trading system based, for ernmple, on sen
timent, which is generally not an exact timing indicator, but rather one that indicates
a general trend change at major turning points. The timing of the forthcoming move
Gapter 3: Call Buying 103
is not exact, because it often takes time for an extreme change in sentiment to reflect
itself in a change of direction by the underlying.
Hence, for a strategy such as this, one would want to use an option with a small
er delta. The investor would limit his risk by using such an option, knowing that large
moves are possible since the position is going to be held for several weeks or perhaps
even a couple of months or more. Therefore, an at-the-money option can be used in
such situations.
I.ONG-TERM TRADING
If one's strategy is even longer-term, an option with a lower delta can be considered.
Such strategies would generally have only vague timing qualities, such as selecting a
stock to buy based on the general fundamental outlook for the company. In the
extreme, it would even apply to "buy and hold" strategies.
Generally, buying out-of-the-money options is not recommended; but for very
long-term strategies, one might consider something slightly out-of-the-money, or at
least a fairly long-term at-the-money option. In either case, that option will have a
lower delta as compared to the options that have been recommended for the other
strategies mentioned above. Alternatively, LEAPS options might be appropriate for
stock strategies of this type.
ADVANCED SELECTION CRITERIA
The criteria presented previously represented elementary techniques for selecting
which call to buy. In actual practice, one is not usually bullish on just one stock at a
time. In fact, the investor would like to have a list of the "best" calls to buy at any
given time. Then, using some method of stock selection, either technical or funda
mental, he can select three or four calls that appear to offer the best rewards. This
list should be ranked in order of the best potential rewards available, but the con
struction of the list itself is important.
Call option rankings for buying purposes must be based on the volatilities of the


alls to buy at any
given time. Then, using some method of stock selection, either technical or funda
mental, he can select three or four calls that appear to offer the best rewards. This
list should be ranked in order of the best potential rewards available, but the con
struction of the list itself is important.
Call option rankings for buying purposes must be based on the volatilities of the
underlying stocks. This is not easy to do mathematically, and as a result many pub
lished rankings of calls are based strictly on percentage change in the underlying
stock. Such a list is quite misleading and can lead one to the wrong conclusions.
Example: There are two stocks with listed calls: NVS, which is not volatile, and VVS,
which is quite volatile. Since a call on the volatile stock will be higher-priced than a
call on the nonvolatile stock, the following prices might exist:
104 Part II: Call Option Strategies
NVS: 40 VVS: 40
NVS July 40 call: 2 VVS July 40 call: 4
If these two calls are ranked for buying purposes, based strictly on a percentage
change in the underlying stock, the NVS call will appear to be the better buy. For
example, one might see a list such as "best call buys if the underlying stock advances
by 10%." In this example, if each stock advanced 10% by expiration, both NVS and
WS would be at 44. Thus, the NVS July 40 would be worth 4, having doubled in
price, for a 100% potential profit. Meanwhile, the WS July 40 would be worth 4 also,
for a 0% profit to the call buyer. This analysis would lead one to believe that the NVS
July 40 is the better buy. Such a conclusion may be wrong, because an incorrect
assumption was made in the ranking of the potentials of the two stocks. It is not right
to assume that both stocks have the same probability of moving 10% by expiration.
Certainly, the volatile stock has a much better chance of advancing by 10% ( or more)
than the nonvolatile stock does. Any ranking based on equal percentage changes in
the underlying stock, without regard for their volatilities, is useless and should be
avoided.
The correct method of comparing these two July 40 calls is to utilize the actual
volatilities of the underlying stocks. Suppose that it is known that the volatile stock,
WS, could expect to move 15% in the time to July expiration. The nonvolatile stock,
NVS, however, could only expect a move of 5% in the same period. Using this infor
mation, the call buyer can arrive at the conclusion that WS July 40 is the better call
to buy:
Stock Price in July
VVS: 46 (up 15%)
NVS: 42 (up 5%)
Coll Price
VVS July 40: 6 (up 50%)
NVS July 40: 2 (unchanged)
By assuming that each stock can rise in accordance with its volatility, we can see that
the WS July 40 has the better reward potential, despite the fact that it was twice as
expensive to begin with. This method of analysis is much more realistic.
One more refinement needs to be made in this ranking process. Since most call
purchases are made for holding periods of from 30 to 90 days, it is not correct to
assume that the calls will be held to expiration. That is, even if one buys a 6-month
call, he will normally liquidate it, to take profits or cut losses, in 1 to 3 months. The
call buyer's list should thus be based on how the call will peiform if held for a realis
tic time period, such as 90 days.
Chapter 3: Call Buying 105
Suppose the volatile stock in our example, WS, has the potential to rise by 12%
in 90 days, while the less volatile stock, NVS, has the potential of rising only 4% in 90
days. In 90 days, the July 40 calls will not be at parity, because there will be some time
remaining until July expiration. Thus, it is necessary to attempt to predict what their
prices will be at the end of the 90-day holding period. Assume that the following
prices are accurate estimates of what the July 40 calls will be selling for in 90 days, if
the underlying stocks advance in relation to their volatilities:
Stock Price in 90 Days
VVS: 44.8 (up 12%)
NVS: 41 .6 (up 4%)
Coll Price
VVS July 40: 6 (up 50%)
NVS July 40: 21/2 (up 25%)
With some time remaining in the calls, they would both have time value premium at
the end of 90 days. The bigger time premium would be in the WS call, since the
underlying stock is more volatile. Under this method of analysis, the WS call is still
the better one to buy.
The correct method of ranking potential reward situations for call buyers is as
follows:
1. Assume each underlying stock can advance in accordance with its volatility over
a fixed period (30, 60, or 90 days).
2. Estimate the call prices after the advance.
3. Rank all potential call purchases by highest percentage reward opportunity for
aggressive purchases.
4. Assume each stock can decline in accordance with its volatility.
5. Estimate the call prices after the decline.
6. Rank all purchases by reward/risk ratio ( the percentage gain from item 2 divided
by the percentage loss from item 5).
The list from item 3 will generate more aggressive purchases because it incorporates
potential rewards only. The list from item 6 would be a less speculative one. This
method of analysis automatically incorporates the criteria set forth earlier, such as
buying short-term out-of-the-money calls for aggressive purchases and buying
longer-term in-the-money calls for a more conservative purchase. The delta is also a
function of the volatility and is essentially incorporated by steps 1 and 4.
It is virtually impossible to perform this sort of analysis without a computer. The
call buyer can generally obtain such a list from a brokerage firm or from a data serv
ice. For those individuals who have access to a computer and would like to generate
106 Part II: Call Option Strategies
such an analysis for themselves, the details of computing a stock's volatility and pre
dicting the call prices are provided in Chapter 28 on mathematical techniques.
OVERPRICED OR UNDERPRICED CALLS
Form


an generally obtain such a list from a brokerage firm or from a data serv
ice. For those individuals who have access to a computer and would like to generate
106 Part II: Call Option Strategies
such an analysis for themselves, the details of computing a stock's volatility and pre
dicting the call prices are provided in Chapter 28 on mathematical techniques.
OVERPRICED OR UNDERPRICED CALLS
Formulae exist that are capable of predicting what a call should be selling for, based
on the relationship of the stock price and the striking price, the time remaining to
expiration, and the volatility of the underlying stock. These are useful, for example,
in performing the second step in the foregoing analysis, estimating the call price after
an advance in the underlying stock. In reality, a call's actual price may deviate some
what from the price computed by the formula. If the call is actually selling for more
than the "fair" ( computed) price, the call is said to be overvalued. An undervalued
call is one that is actually trading at a price that is less than the "fair" price.
If the calls are truly overpriced, there may be a strategy that can help reduce
their cost while still preserving upside profit potential. This strategy, however,
requires the addition of a put spread to the call purchase, so it is beyond the scope
of the subject matter at the current time. It is described in Chapter 23 on spreads
combining calls and puts.
Generally, the amount by which a call is overvalued or undervalued may be only
a small fraction of a point, such as 10 or 20 cents. In theory, the call buyer who pur
chases an undervalued call has gained a slight advantage in that the call should return
to its "fair" value. However, in practice, this information is most useful only to mar
ket-makers or firm traders who pay little or no commissions for trading options. The
general public cannot benefit directly from the knowledge that such a small discrep
ancy exists, because of commission costs.
One should not base his call buying decisions merely on the fact that a call is
underpriced. It is small solace to the call buyer to find that he bought a "cheap" call
that subsequently declined in price. The method of ranking calls for purchase that
has been described does, in fact, give some slight benefit to underpriced calls.
However, under the recommended method of analysis, a call will not automatically
appear as an attractive purchase just because it is slightly undervalued.
TIME VALUE PREMIUM IS A MISNOMER
This is a topic that will be mentioned several times throughout the book, most
notably in conjunction with volatility trading. It is introduced here because even the
inexperienced option trader must understand that the portion of an option's price
that is not intrinsic value - the part that we routinely call "time value premium" - is
really composed of much more than just time value. Yes, time will eventually wear
Chpter 3: Call Buying 107
away that portion of the option's price as expiration approaches. However, when an
option has a considerable amount of time remaining until its expiration, the more
important component of the option value is really volatility. If traders expect the
underlying stock to be volatile, the option will be expensive; if they expect the oppo
site, the option will be cheap. This expensiveness and cheapness is reflected in the
portion of the option that is not intrinsic value. For example, a six-month option will
not decay much in one day's time, but a quick change in volatility expectations by
option traders can heavily affect the price of the option, especially one with a good
deal of time remaining. So an option buyer should carefully assess his purchases, not
just view them as something that will waste away. With careful analysis, option buy
ers can do very well, if they consider what can happen during the life of the option,
and not merely what will happen at expiration.
CALL BUYERS' FRUSTRATIONS
Despite one's best efforts, it may often seem that one does not make much money
when a fairly volatile stock makes a quick move of 3 or 4 points. The reasons for this
are somewhat more complex than can be addressed at this time, although they relate
strongly to delta, time decay, and the volatility of the underlying stock. They are dis
cussed in Chapter 36, 'The Basics of Volatility Trading." If one plans to conduct a
serious call buying strategy, he should read that chapter before embarking on a pro
gram of extensive call buying.
FOLLOW-UP ACTION
The simplest follow-up action that the call buyer can implement when the underly
ing stock drops is to sell his call and cut his losses. There is often a natural tendency
to hold out hope that the stock can rally back to or above the striking price. Most of
the time, the buyer does best by cutting his losses in situations in which the stock is
performing poorly. He might use a "mental" stop price or could actually place a sell
stop order, depending on the rules of the exchange where the call is traded. In gen
eral, stop orders for options result in poor executions, so using a "mental" stop is bet
ter. That is, one should base his exit point on the technical pattern of the underlying
stock itself. If it should break down below support, for example, then the option
holder should place a market (not held) order to sell his call option.
If the stock should rise, the buyer should be willing to take profits as well. Most
buyers will quite readily take a profit if, for example, a call that was bought for 5
points had advanced to be worth 10 points. However, the same investor is often
108 Part II: Call Option Strategies
reluctant to sell a call at 2 that he had previously bought for 1 point, because "I've
only made a point." The similarity is clear - both cases resulted in approximately a
100% profit - and the investor should be as willing to accept the one as he is the
other. This is not to imply that


ad advanced to be worth 10 points. However, the same investor is often
108 Part II: Call Option Strategies
reluctant to sell a call at 2 that he had previously bought for 1 point, because "I've
only made a point." The similarity is clear - both cases resulted in approximately a
100% profit - and the investor should be as willing to accept the one as he is the
other. This is not to imply that all calls that are bought at 1 should be sold when and
if they get to 2, but the same factors that induce one to sell the 10-point call after
doubling his money should apply to the 2-point call as well.
In fact, taking partial profits after a call holding has increased in value is often
a wise plan. For example, if someone bought a number of calls at a price of 3, and
they later were worth 5, it might behoove the call holder to sell one-third to one-half
of his position at 5, thereby taking a partial profit. Having done that, it is often easi
er to let the profits run on the balance, and letting profits run is generally one of the
keys to successful trading.
It is rarely to the call buyer's benefit to exercise the call if he has to pay com
missions. When one exercises a call, he pays a stock commission to buy the stock at
the striking price. Then when the stock is sold, a stock sale commission must also be
paid. Since option commissions are much smaller, dollarwise, than stock commis
sions, the call holder will usually realize more net dollars by selling the call in the
option market than by exercising it.
LOCKING IN PROFITS
When the call buyer is fortunate enough to see the underlying stock advance rela
tively quickly, he can implement a number of strategies to enhance his position.
These strategies are often useful to the call buyer who has an unrealized profit but is
torn between taking the profit or holding on in an attempt to generate more profits
if the underlying stock should continue to rise.
Example: A call buyer bought an XYZ October 50 call for 3 points when the stock
was at 48. Then the stock rises to 58. The buyer might consider selling his October
50 (which would probably be worth about 9 points) or possibly taking one of several
actions, some of which might involve the October 60 call, which may be selling for 3
points. Table 3-1 summarizes the situation. At this point, the call buyer might take
one of four basic actions:
1. Liquidate the position by selling the long call for a profit.
2. Sell the October 50 that he is currently long and use part of the proceeds to pur
chase October 60's.
3. Create a spread by selling the October 60 call against his long October 50.
4. Do nothing and remain long the October 50 call.
Gapter 3: Call Buying
TABLE 3-1.
Present situation on XYZ October calls.
Original Trade
XYZ common: 48
Bought XYZ October 50 at 3
109
Current Prices
XYZ Common: 58
XYZ October 50: 9
XYZ October 60: 3
Each of these actions would produce different levels of risk and reward from
this point forward. If the holder sells the October 50 call, he makes a 6-point profit,
less commissions, and terminates the position. He can realize no further appreciation
from the call, nor can he lose any of his current profits; he has realized a 6-point gain.
This is the least aggressive tactic of the four: If the underlying stock continues to
advance and rises above 63, any of the other three strategies will outperform the
complete liquidation of the call. However, if the underlying stock should instead
decline below 50 by expiration, this action would have provided the most profit of the
four strategies.
The other simple tactic, the fourth one listed, is to do nothing. If the call is then
held to expiration, this tactic would be the riskiest of the four: It is the only one that
could produce a loss at expiration if XYZ fell back below 50. However, if the under
lying stock continues to rise in price, more profits would accrue on the call. Every call
buyer realizes the ramifications of these two tactics - liquidating or doing nothing
and is generally looking for an alternative that might allow him to reduce some of his
risk without cutting off his profit potential completely. The remaining two tactics are
geared to this purpose: limiting the total risk while providing the opportunity for fur
ther profits of an amount greater than those that could be realized by liquidating.
The strategy in which the holder sells the call that he is currently holding, the
October 50, and uses part of the proceeds to buy the call at the next higher strike is
called rolling up. In this example, he could sell the October 50 at 9, pocket his initial
3-point investment, and use the remaining proceeds to buy two October 60 calls at 3
points each. Thus, it is sometimes possible for the speculator to recoup his entire
original investment and still increase the number of calls outstanding by rolling up.
Once this has been done, the October 60 calls will represent pure profits, whatever
their price. The buyer who "rolls up" in this rrwnner is essentially speculating with
someone else's money. He has put his own money back in his pocket and is using
accrued profits to attempt to realize further gains. At expiration, this tactic would
perform best if XYZ increased by a substantial amount. This tactic turns out to be the
110 Part II: Call Option Strategies
worst of the four at expiration if XYZ remains near its current price, staying above 53
but not rising above 63 in this example.
The other alternative, the third one listed, is to continue to hold the October 50
call but to sell the October 60 call against it. This would create what is known as a bull
spread, and the tactic can be used only by traders who have a margin account and can
meet their firm's minimum equity requirement for spreading (generally $2,000). This
spread position has no risk, for the long side of the spread - the October 50 cost 3
points, and the short side of the spread - the Oc


call but to sell the October 60 call against it. This would create what is known as a bull
spread, and the tactic can be used only by traders who have a margin account and can
meet their firm's minimum equity requirement for spreading (generally $2,000). This
spread position has no risk, for the long side of the spread - the October 50 cost 3
points, and the short side of the spread - the October 60 - brought in 3 points via its
sale. Even if the underlying stock drops below 50 by expiration and all the calls expire
worthless, the trader cannot lose anything except commissions. On the other hand, the
maximum potential of this spread is 10 points, the difference between the striking
prices of 50 and 60. This maximum potential would be realized if XYZ were anywhere
above 60 at expiration, for at that time the October 50 call would be worth 10 points
more than the October 60 call, regardless of how far above 60 the underlying stock
had risen. This strategy will be the best peiformer of the four if XYZ remains relative
ly unchanged, above the lower strike but not much above the higher strike by expira
tion. It is interesting to note that this tactic is never the worst peiforrner of the four
tactics, no matter where the stock is at expiration. For example, if XYZ drops below
50, this strategy has no risk and is therefore better than the "do nothing" strategy. If
XYZ rises substantially, this spread produces a profit of 10 points, which is better than
the 6 points of profit offered by the "liquidate" strategy.
There is no definite answer as to which of the four tactics is the best one to
apply in a given situation. However, if a call can be sold against the currently long call
to produce a bull spread that has little or no risk, it may often be an attractive thing
to do. It can never tum out to be the worst decision, and it would produce the largest
profits if XYZ does not rise substantially or fall substantially from its current levels.
Tables 3-2 and 3-3 summarize the four alternative tactics, when a call holder has an
unrealized profit. The four tactics, again, are:
1. "Do nothing" - continue to hold the currently long call.
2. "Liquidate" - sell the long call to take profits and do not reinvest.
3. "Roll up" - sell the long call, pocket the original investment, and use the remain
ing proceeds to purchase as many out-of-the-money calls as possible.
4. "Spread" - create a bull spread by selling the out-of-the-money call against the
currently profitable long call, preferably taking in at least the original cost of the
long call.
Cl,apter 3: Call Buying 111
TABLE 3-2.
Comparison of the four alternative strategies.
If the underlying stock then. . . The best tactic was. . . And the worst tactic was ...
continues to rise dramatic
ally ...
"roll up"
rises moderately above the do nothing
next strike ...
remains relatively unchanged . .. spread
falls back below the original liquidate
strike ...
TABLE 3-3.
Results at expiration.
XYZ Price at "Roll-up" "Do Nothing"
Expiration Profit Profit
50 or below $ 0 -$ 300(W)
53 0(W) 0(W)
56 0(W) + 300
60 0(W) + 700
63 + 600(W) + 1,000(B)
67 + 1,400(B) + 1,400(B)
70 + 2,000(B) + 1,700
liquidate
liquidate or "roll up"
"roll up"
do nothing
"Spread"
Profit
$ 0
+ 300
+ 600(B)
+ 1,000(B)
+ 1,000(B)
+ 1,000
+ 1,000
Liquidating
Profit
+$600(B)
+ 600(B)
+ 600(B)
+ 600
+ 600(W)
+ 600(W)
+ 600(W)
Note that each of the four tactics proves to be the best tactic in one case or another,
but that the spread tactic is never the worst one. Tables 3-2 and 3-3 represent the
results from holding until expiration. For those who prefer to see the actual numbers
involved in making these comparisons between the four tactics, Table 3-3 summa
rizes the potential profits and losses of each of the four tactics using the prices from
the example above. 'W" indicates that the tactic is the worst one at that price, and
"B" indicates that it is the best one.
There are, of course, modifications that an investor might make to any of these
tactics. For example, he might decide to sell out half of his long call position, recov
ering a major part of his original cost, and continue to hold the remainder of the long
calls. This still leaves room for further appreciation.
112 Part II: Call Option Strategies
DEFENSIVE ACTION
Two follow-up strategies are sometimes employed by the call buyer when the under
lying stock declines in price. Both involve spread strategies; that is, being long and
short two different calls on the same underlying stock simultaneously. Spreads are
discussed in detail in later chapters. This discussion of spreads applies only to their
use by the call buyer.
·"Rolling Down." If an option holder owns an option at a currently unreal
ized loss, it may be possible to greatly increase the chances of making a limited
profit on a relatively small rebound in the stock price. In certain cases, the
investor may be able to implement such a strategy at little or no increase in risk.
Many call buyers have encountered a situation such as this: An XYZ October 35
call was originally bought for 3 points in hopes of a quick rise in the stock price.
However, because of downward movements in the stock- to 32, say- the call is now
at 1 ½ with October expiration nearer. If the call buyer still expects a mild rally in the
stock before expiration, he might either hold the call or possibly "average down" (buy
more calls at I½). In either case he will need a rally to nearly 38 by expiration in
order to break even. Since this would necessitate at least a 15% upward move by the
stock before expiration, it cannot be considered very likely. Instead, the buyer should
consider implementing the following strategy, which will be explained through the
use of an example.
Example: The investor is long the October 35 call at this time:
XYZ, 32;
XYZ October 35 call, 1 ½; and
XYZ October 30 call, 3.
One could sell t


ce this would necessitate at least a 15% upward move by the
stock before expiration, it cannot be considered very likely. Instead, the buyer should
consider implementing the following strategy, which will be explained through the
use of an example.
Example: The investor is long the October 35 call at this time:
XYZ, 32;
XYZ October 35 call, 1 ½; and
XYZ October 30 call, 3.
One could sell two October 35's and, at the same time, buy one October 30 for no
additional investment before commissions. That is, the sale of 2 October 35's at $150
each would bring in $300, exactly the cost, before commissions, of buying the
October 30 call. This is the key to implementing the roll-down strategy: that one be
able to buy the lower strike call and sell two of the higher strike calls for nearly even
money.
Note that the investor is now short the call that he previously owned, the
October 35. Where he previously owned one October 35, he has now sold two of
them. He is also now long one October 30 call. Thus, his position is:
0.,,., 3: Call Buying
long 1 XYZ October 30 call,
1hort 1 XYZ October 35 call.
113
This is technically known as a bull spread, but the terminology is not important.
Table 3-4 summarizes the transactions that the buyer has made to acquire this
spread. The trader now "owns" the spread at a cost of $300, plus commissions. By
making this trade, he has lowered his break-even point significantly without increas
ing his risk. However, the maximum profit potential has also been limited; he can no
longer capitalize on a strong rebound by the underlying stock.
In order to see that the break-even point has been lowered, consider what the
results are~ is at 33 at October expiration. The October 30 call would be worth
3 points and the October 35 would expire worthless with XYZ at 33. Thus, the
October 30 call could be sold to bring in $300 at that time, and there would not be
any expense to buy back the October 35. Consequently, the spread could be liqui
dated for $300, exactly the amount for which it was "bought." The spread then breaks
even at 33 at expiration. If the call buyer had not rolled down, his break-even point
would be 38 at expiration, for he paid 3 points for the original October 35 call and he
would thus need XYZ to be at 38 in order to be able to liquidate the call for 3 points.
Clearly, the stock has a better chance of recovering to 33 than to 38. Thus, the call
buyer significantly lowers his break-even point by utilizing this strategy.
Lowering the break-even point is not the investor's only concern. He must also
be aware of what has happened to his profit and loss opportunities. The risk remains
essentially the same the $300 in debits, plus commissions, that has been paid out.
The risk has actually increased slightly, by the amount of the commissions spent in
"rolling down." However, the stock price at which this maximum loss would be real
ized has been lowered. With the original long call, the October 35, the buyer would
lose the entire $300 investment anywhere below 35 at October expiration. The
TABLE 3-4.
Transactions in bull spread.
Original trade
Later trade
Net position
Trade
Buy 1 October 35 call at 3
Sell 2 October 35 calls at 1 1/2
Buy 1 October 30 call at 3
Long 1 October 30 call
Short 1 October 35 call
Cost before Commissions
$300 debit
$300 credit
$300 debit
$300 debit
114 Part II: Call Option Strategies
spread strategy, however, would result in a total loss of $300 only if XYZ were below
30 at October expiration. With XYZ above 30 in October, the long side of the spread
could be liquidated for some value, thereby avoiding a total loss. The investor has
reduced the chance of realizing the maximum loss, since the stock price at which that
loss would occur has been lowered by 5 points.
As with most investments, the improvement of risk exposure - lowering the
break-even point and lowering the maximum loss price - necessitates that some
potential reward be sacrificed. In the original long call position (the October 35), the
maximum profit potential was unlimited. In the new position, the potential profit is
limited to 2 points if XYZ should rally back to, or anywhere above, 35 by October
expiration. To see this, assume XYZ is 35 at expiration. Then the long October 30 call
would be worth 5 points, while the October 35 would expire worthless. Thus, the
spread could be liquidated for 5 points, a 2-point profit over the 3 points paid for the
spread. This is the limit of profit for the spread, however, since if XYZ is above 35 at
expiration, any further profits in the long October 30 call would be offset by a corre
sponding loss on the short October 35 call. Thus, if XYZ were to rally heavily by expi
ration, the "rolled down" position would not realize as large a profit as the original
long call position would have realized.
Table 3-5 and Figure 3-2 summarize the original and new positions. Note that
the new position is better for stock prices between 30 and 40. Below 30, the two posi
tions are equal, except for the additional commissions spent. If the stock should rally
back above 40, the original position would have worked out better. The new position
is an improvement, provided that XYZ does not rally back above 40 by expiration.
The chances that XYZ could rally 8 points, or 25%, from 32 to 40 would have to be
considered relatively remote. Rolling the long call down into the spread would thus
appear to be the correct thing to do in this case.
This example is particularly attractive, because no additional money was
required to establish the spread. In many cases, however, one may find that the long
call cannot be rolled into the spread at even money. Some debit may be required.
This fact should not necessarily preclude making the change, since a small addition
al investment may still significantly increase the chance of breaking even or making
a profit on a rebound.
Example: The follow


itional money was
required to establish the spread. In many cases, however, one may find that the long
call cannot be rolled into the spread at even money. Some debit may be required.
This fact should not necessarily preclude making the change, since a small addition
al investment may still significantly increase the chance of breaking even or making
a profit on a rebound.
Example: The following prices now exist, rather than the ones used earlier. Only the
October 30 call price has been altered:
XYZ, 32;
XYZ October 35 call, 1 ½; and
XYZ October 30 call, 4.
O.,ter 3: Call Buying
TABLE 3-5.
Original and spread positions compared.
Stock Price Long Call
at Expiration Result
25 -$300
30 - 300
33 - 300
35 - 300
38 0
40 + 200
45 + 700
FIGURE 3-2.
Companion: original call purchase vs. spread.
§
~ +$200
·5..
~
al
tJ)
.3
0
:1:
e
c.. -$300
Stock Price at Expiration
Spread
Result
-$300
- 300
0
+ 200
+ 200
+ 200
+ 200
115
With these prices, a 1-point debit would be required to roll down. That is, selling 2
October 35 calls would bring in $300 ($150 each), but the cost of buying the October
30 call is $400. Thus, the transaction would have to be done at a cost of $100, plus
commissions. With these prices, the break-even point after rolling down would be 34,
still well below the original break-even price of 38. The risk has now been increased
by the additional 1 point spent to roll down. If XYZ should drop below 30 at October
expiration, the investor would have a total loss of 4 points plus commissions. The
maximum loss with the original long October 35 call was limited to 3 points plus a
smaller amount of commissions. Finally, the maximum amount of money that the
116 Part II: Call Option Strategies
spread could make is now $100, less commissions. The alternative in this example is
not nearly as attractive as the previous one, but it might still be worthwhile for the
call buyer to invoke such a spread if he feels that XYZ has limited rally potential up
to October expiration.
One should not automatically discard the use of this strategy merely because a
debit is required to convert the long call to a spread. Note that to "average down" by
buying an additional October 35 call at 1 ½ would require an additional investment
of $150. This is more than the $100 required to convert into the spread position in
the immediately preceding example. The break-even point on the position that was
"averaged down" would be over 37 at expiration, whereas the break-even point on the
spread is 34. Admittedly, the averaged-down position has much more profit potential
than the spread does, but the conversion to the spread is less expensive than "aver
aging down" and also provides a lower break-even price.
In summary, then, if the call buyer finds himself with an unrealized loss because
the stock has declined, and yet is unwilling to sell, he may be able to improve his
chances of breaking even by "rolling down" into a spread. That is, he would sell 2 of
the calls that he is currently long - the one that he owns plus another one - and
simultaneously buy one call at the next lower striking price. If this transaction of sell
ing 2 calls and buying 1 call can be done for approximately even money, it could def
initely be to the buyer's benefit to implement this strategy, because the break-even
point would be lowered considerably and the buyer would have a much better
chance of getting out even or making a small profit should the underlying stock have
a small rebound.
Creating a Calendar Spread. A different type of defensive spread strategy
is sometimes used by the call buyer who finds that the underlying stock has declined.
In this strategy, the holder of an intermediate- or long-term call sells a near-term call,
with the same striking price as the call he already owns. This creates what is known
as a calendar spread. The idea behind doing this is that if the short-term call expires
worthless, the overall cost of the long call will be reduced to the buyer. Then, if the
stock should rally, the call buyer has a better chance of making a profit.
Example: Suppose that an investor bought an XYZ October 35 call for 3 points some
time in April. By June the stock has fallen to 32, and it appears that the stock might
remain depressed for a while longer. The holder of the October 35 call might con
sider selling a July 35 call, perhaps for a price of 1 point. Should XYZ remain below
35 until July expiration, the short call would expire worthless, earning a small, 1-point
profit. The investor would still own the October 35 call and would then hope for a
rally by XYZ before October in order to make profits on that call. Even if XYZ does
Chpter 3: Call Buying 117
not rally by October, he has decreased his overall loss by the amount received for the
sale of the July 35 call.
This strategy is not as attractive to use as the previous one. If XYZ should rally
before July expiration, the investor might find himself with two losing positions. For
example, suppose that XYZ rallied back to 36 in the next week. His short call that he
sold for 1 point would be selling for something more than that, so he would have an
unrealized loss on the short July 35. In addition, the October 35 would probably not
have appreciated back to its original price of 3, and he would therefore have an unre
alized loss on that side of the spread as well.
Consequently, this strategy should be used with great caution, for if the under
lying stock rallies quickly before the near-term expiration, the spread could be at a
loss on both sides. Note that in the former spread strategy, this could not happen.
Even if XYZ rallied quickly, some profit would be made on the rebound.
A FURTHER COMMENT ON SPREADS
Anyone not familiar with the margin requirements for spreads, under both the
exchange margin rules and the rules of the brokerage firm he is dealing with, should
not attempt to uti


ion, the spread could be at a
loss on both sides. Note that in the former spread strategy, this could not happen.
Even if XYZ rallied quickly, some profit would be made on the rebound.
A FURTHER COMMENT ON SPREADS
Anyone not familiar with the margin requirements for spreads, under both the
exchange margin rules and the rules of the brokerage firm he is dealing with, should
not attempt to utilize a spread transaction. Later chapters on spreads outline the
more common requirements for spread transactions. In general, one must have a
margin account to establish a spread and must have a minimum amount of equity in
the account. Thus, the call buyer who operates in a cash account cannot necessarily
use these spread strategies. To do so might incur a margin call and possible restric
tion of one's trading account. Therefore, check on specific requirements before uti
lizing a spread strategy. Do not assume that a long call can automatically be "rolled"
into any sort of spread.
Other Call Buying Strategies
In this chapter, two additional strategies that utilize the purchase of call options are
described. Both of these strategies involve buying calls against the short sale of the
underlying stock. When listed puts are traded on the underlying stock, these strate
gies are often less effective than when they are implemented with the use of put
options. However, the concept is important, and sometimes these strategies are more
viable in markets where calls are ve:iy liquid but puts are not. These strategies are
generally known as "synthetic" strategies.
THE PROTECTED SHORT SALE (OR SYNTHETIC PUT)
Purchasing a call at the same time that one is short the underlying stock is a means
of limiting the risk of the short sale to a fixed amount. Since the risk is theoretically
unlimited in a short sale, many investors are reluctant to use the strategy. Even for
those investors who do sell stock short, it can be rather upsetting if the stock rises in
price. One may be forced into an emotional - and perhaps incorrect - decision to
cover the short sale in order to relieve the psychological pressure. By owning a call
at the same time he is short, the investor limits the risk to a fixed and generally small
amount.
Example: An investor sells XYZ short at 40 and simultaneously purchases an XYZ
July 40 call for 3 points. If XYZ falls in price, the short seller will make his profit on
the short sale, less the 3 points paid for the call, which will expire worthless. Thus, by
buying the call for protection, a small amount of profit potential is sacrificed.
However, the advantage of owning the call is demonstrated when the results are
examined for a stock rise. IfXYZ should rise to any price above 40 by July expiration,
118
Cl,apter 4: Other Call Buying Strategies 119
the short seller can cover his short by exercising the long call and buying stock at 40.
Thus, the maximum risk that the short seller can incur in this example is the 3 points
paid for the call. Table 4-1 and Figure 4-1 depict the results at expiration from uti
lizing this strategy. Commissions are not included. Note that the break-even point is
37 in this example. That is, if the stock drops 3 points, the protected short sale posi
tion will break even because of the 3-point loss on the call. The short seller who did
not spend the extra money for the long call would, of course, have a 3-point profit at
37. To the upside, however, the protected short sale outperforms a regular short sale
if the stock climbs anywhere above 43. At 43, both types of short sales have $300 loss
es. But above that level, the loss would continue to grow for a regular short sale, while
it is fixed for the short seller who also bought a call. In either case, the short seller's
risk is increased slightly by the fact that he is obligated to pay out the dividends on
the underlying stock, if any are declared.
A simple formula is available for determining the maximum amount of risk
when one protects a short sale by buying a call option:
Risk = Striking price of purchased call + Call price - Stock price
Depending on how much risk the short seller is willing to absorb, he might want to
buy an out-of-the-money call as protection rather than an at-the-money call, as was
shown in the example above. A smaller dollar amount is spent for the protection
when one buys an out-of-the-money call, so that the short seller does not give away
as much of his profit potential. However, his risk is larger because the call does not
start its protective qualities until the stock goes above the striking price.
Example: With XYZ at 40, the short seller of XYZ buys the July 45 call at ½ for pro
tection. His maximum possible loss, if XYZ is above 45 at July expiration, would be
TABLE 4-1.
Results at expiration-protected short sale.
XYZ Price at Profit Call Price at Profit Total
Expiration on XYZ Expiration on Call Profit
20 +$2,000 0 -$ 300 +$1,700
30 + 1,000 0 - 300 + 700
37 + 300 0 - 300 0
40 0 0 - 300 300
50 - 1,000 10 + 700 300
60 - 2,000 20 + 1,700 300
120
FIGURE 4-1.
Protected short sale.
C:
0 .:;
~
'a.. X
UJ
1o +$0 en en
0
...J
0
-e
0.-$300
40'
',
Stock Price at Expiration
'
Part II: Call Option Strategies
43
', ', ' ', ' ',
Short ',
' Sale 'll
5½ points - the five points between the current stock price of 40 and the striking
price of 45, plus the amount paid for the call. On the other hand, if XYZ declines, the
protected short seller will make nearly as much as the short seller who did not pro
tect, since he only spent ½ point for the long call.
If one buys an in-the-nwney call as protection for the short sale, his risk will be
quite minimal. However, his profit potential will be severely limited. As an example,
with XYZ at 40, if one had purchased a July 35 call at 5½, his risk would be limited
to½ point anywhere above 35 at July expiration. Unfortunately, he would not realize
any profit on the position until t


nt for the long call.
If one buys an in-the-nwney call as protection for the short sale, his risk will be
quite minimal. However, his profit potential will be severely limited. As an example,
with XYZ at 40, if one had purchased a July 35 call at 5½, his risk would be limited
to½ point anywhere above 35 at July expiration. Unfortunately, he would not realize
any profit on the position until the stock went below 34½, a drop of 5½ points. This
is too much protection, for it limits the profit so severely that there is only a small
hope of making a profit.
Generally, it is best to buy a call that is at-the-nwney or only slightly out-of the
money as the protection for the short sale. It is not of much use to buy a deeply out
of-the-money call as protection, since it does very little to moderate risk unless the
stock climbs quite dramatically. Normally, one would cover a short sale before it went
heavily against him. Thus, the money spent for such a deeply out-of-the-money call
is wasted. However, if one wants to give a short sale plenty of room to "work" and
Cl,opter 4: Other Call Buying Strategies 121
feels ve:ry certain that his bearish view of the stock is the correct view, he might then
buy a fairly deep out-of-the-money call just as disaster protection, in case the stock
suddenly bolted upward in price (if it received a takeover bid, for example).
MARGIN REQUIREMENTS
The newest margin rules now allow one to receive favorable margin treatment when
a short sale of stock is protected by a long call option. The margin required is the
lower of (1) 10% of the call's striking price plus any out-of-the-money amount, or (2)
30% of the current short stock's market value. The position will be marked to market
daily, and most brokers will require that the short sale be margined at "normal" rates
if the stock is below the strike price.
Example: Suppose the following prices exist:
XYZ Common stock: 47
Oct 40 call: 8
Oct 50 call: 3
Oct 60 call: 1
Suppose that one is considering a short sale of 100 shares of XYZ at 47 and the
purchase of one of the calls as protection. Here are the margin requirements for the
various strike prices. (Note that the option price, per se, is not part of the margin
requirement, but all options must be paid for in full, initially).
Position
Short XYZ, long Oct 40 call
Short XYZ, long Oct 50 call
Short XYZ, long Oct 60 call
l 0% strike + out-of-the-money
400 + 0 = 400*
500 + 300 = 800*
600 + 1,300 = 1,900
30% stock price
1,410
1,410
1,41 0*
*Since the margin requirement is the lower of the two figures, the items marked with an asterisk in
this table are the margin requirements.
Again, remember that the long call would have to be paid for in full, and that most
brokers impose a maintenance requirement of at least the value of the short sale itself
as long as the stock is below the strike price of the long call, in addition to the above
requirements.
122 Part II: Call Option Strategies
FOLLOW-UP ACTION
There is little that the protected short seller needs to perform in the way of follow
up action in this strategy, other than closing out the position. If the underlying stock
moves down quickly and it appears that it might rebound, the short sale could be cov
ered without selling the long call. In this manner, one could potentially profit on the
call side as well if the stock came back above the original striking price. If the under
lying stock rises in price, a similar strategy of taking off only the profitable call side
of the transaction is not recommended. That is, if XYZ climbed from 40 to 50 and the
July 40 call also rose from 3 to 10, it is not advisable to take the 7-point profit in the
call, hoping for a drop in the stock price. The reason for this is that one is entering
into a highly risk-oriented situation by removing his protection when the call is in
the-money. Thus, when the stock drops, it is all right - perhaps even desirable - to
take the profit, because there is little or no additional risk if the stock continues to
drop. However, when the stock rises, it is not an equivalent situation. In that case, if
the short seller sells his call for a profit and the stock subsequently rises even further,
large losses could result.
It may often be advisable to close the position if the call is at or near parity,
in-the-money, by exercising the call. In most strategies, the option holder has no
advantage in exercising the call because of the large dollar difference between
stock commissions and option commissions. However, in the protected short sale
strategy, the short seller is eventually going to have to cover the short stock in any
case and incur the stock commission by so doing. It may be to his advantage to
exercise the call and buy his stock at the striking price, thereby buying stock at a
lower price and perhaps paying a slightly lower commission amount.
Example: XYZ rises to 50 from the original short sale price of 40, and the XYZ July
40 call is selling at 10 somewhere close to expiration. The position could be liquidat
ed by either (1) buying the stock back at 50 and selling the call at 10, or (2) exercis
ing the call to buy stock at 40. In the first case, one would pay a stock commission at
a price of $50 per share plus an option commission on a $10 option. In the second
case, the only commission would be a stock commission at the price of $40 per share.
Since both actions accomplish the same end result - closing the position entirely for
40 points plus commissions - clearly the second choice is less costly and therefore
more desirable. Of course, if the call has time value premium in it of an amount
greater than the commission savings, the first alternative should be used.
Orapter 4: Other Call Buying Strategies 123
THE REVERSE HEDGE (SIMULATED STRADDLE)
There is another strategy involving the purchase of long calls against the short sale of
stock. In this strategy, one purchases c


less costly and therefore
more desirable. Of course, if the call has time value premium in it of an amount
greater than the commission savings, the first alternative should be used.
Orapter 4: Other Call Buying Strategies 123
THE REVERSE HEDGE (SIMULATED STRADDLE)
There is another strategy involving the purchase of long calls against the short sale of
stock. In this strategy, one purchases calls on more shares than he has sold short. The
strategist can profit if the underlying stock rises far enough or falls far enough dur
ing the life of the calls. This strategy is generally referred to as a reverse hedge or sim
ulated straddle. On stocks for which listed puts are traded, this strategy is outmoded;
the same results can be better achieved by buying a straddle (a call and a put).
Hence, the name "simulated straddle" is applied to the reverse hedge strategy.
This strategy has limited loss potential, usually amounting to a moderate per
centage of the initial investment, and theoretically unlimited profit potential. When
properly selected (selection criteria are described in great detail in Chapter 36,
which deals with volatility trading), the percentage of success can be quite high in
straddle or synthetic straddle buying. These features make this an attractive strategy,
especially when call premiums are low in comparison to the volatility of underlying
stock.
Example: XYZ is at 40 and an investor believes that the stock has the potential to
move by a relatively large distance, but he is not sure of the direction the stock will
take. This investor could short XYZ at 40 and buy 2 XYZ July 40 calls at 3 each to set
up a reverse hedge. If XYZ moves up by a large distance, he will incur a loss on his
short stock, but the fact that he owns two calls means that the call profits will outdis
tance the stock loss. If, on the other hand, XYZ drops far enough, the short sale prof
it will be larger than the loss on the calls, which is limited to 6 points. Table 4-2 and
Figure 4-2 show the possible outcomes for various stock prices at July expiration. If
XYZ falls, the stock profits on the short sale will accumulate, but the loss on the two
calls is limited to $600 (3 points each) so that, below 34, the reverse hedge can make
ever-increasing profits. To the upside, even though the short sale is incurring losses,
the call profits grow faster because there are two long calls. For example, at 60 at
expiration, there will be a 20-point ($2,000) loss on the short stock, but each XYZ July
40 call will be worth 20 points with the stock at 60. Thus, the two calls are worth
$4,000, representing a profit of $3,400 over the initial cost of $600 for the calls.
Table 4-2 and Figure 4-2 illustrate another important point: The maximum loss
would occur if the stock were exactly at the striking price at expiration of the calls. This
maximum loss would occur if XYZ were at 40 at expiration and would amount to $600.
In actual practice, since the short seller must pay out any dividends paid by the under
lying stock, the risk in this strategy is increased by the amount of such dividends.
124
TABLE 4-2.
Reverse hedge at July expiration.
XYZ Price at Stock
Expiration Profit
20 +$2,000
25 + 1,500
30 + 1,000
34 + 600
40 0
46 600
50 - 1,000
55 - 1,500
60 - 2,000
FIGURE 4-2.
Reverse hedge {simulated straddle).
C:
0
~
!
co
(/)
(/)
.3
~-$600
e a.
Profit on
2 Calls
-$ 600
600
600
600
600
+ 600
+ 1,400
+ 2,400
+ 3,400
Stock Price at Expiration
Part II: Call Option Strategies
Total
Profit
+$ l ,400
+ 900
+ 400
0
600
0
+ 400
+ 900
+ 1,400
The net margin required for this strategy is 50% of the underlying stock plus
the full purchase price of the calls. In the example above, this would be an initial
investment of $2,000 (50% of the stock price) plus $600 for the calls, or $2,600 total
plus commissions. The short sale is marked to market, so the collateral requirement
would grow if the stock rose. Since the maximum risk, before commissions, is $600,
this means that the net percentage risk in this transaction is $600/$2,600, about 23%.
Cl,opter 4: Other Call Buying Strategies 125
This is a relatively small percentage risk in a position that could have very large prof
its. There is also very little chance that the entire maximum loss would ever be real
ized since it occurs only at one specific stock price. One should not be deluded into
thinking that this strategy is a sure money-maker. In general, stocks do not move very
far in a 3- or 6-month period. With careful selection, though, one can often find sit
uations in which the stock will be able to move far enough to reach the break-even
points. Even when losses are taken, they are counterbalanced by the fact that signif
icant gains can be realized when the stock moves by a great distance.
It is obvious from the information above that profits are made if the stock moves
far enough in either direction. In fact, one can determine exactly the prices beyond
which the stock would have to move by expiration in order for profits to result. These
prices are 34 and 46 in the foregoing example. The downside break-even point is 34
and the upside break-:even point is 46. These break-even points can easily be com
puted. First, the maximum risk is computed. Then the break-even points are deter
mined.
Maximum risk = Striking price + 2 x Call price - Stock price
Upside break-even point = Striking price + Maximum risk
Downside break-even point = Striking price - Maximum risk
In the preceding example, the striking price was 40, the stock price was also 40,
and the call price was 3. Thus, the maximum risk = 40 + 2 x 3 - 40 = 6. This con
firms that the maximum risk in the position is 6 points, or $600. The upside break
even point is then 40 + 6, or 46, and the downside break-even point is 40 - 6, or 34.
These also agree with Table 4-2 and Figure 4-2.
Before expiration, profits can be made even closer to th