n intelligent valuation range. In this example,
a 36 percent margin of safety is sufficient for me to commit a small
proportion of my portfolio to an unlevered investment, but not to go “all
in. ” For a concentrated, levered position in this investment, I would need a
margin of safety approaching 76 percent (= ($25 − $6)/$25) and at least over
60 percent (= ($25 - $10)/$25).
When might such a large margin of safety present itself? Just when
the market has lost all hope and is pricing in disaster for the company.
This is where the contrarianism comes into play. The best time to make
a levered investment in a company with high levels of operational lever -
age is when the rest of the market is mainly concerned about the possible
negative effects of that operational leverage. For example, during a reces-
sion, consumer demand drops and idle time at factories increases. This
has a quick and often very negative effect on profitability for companies
that own the idle factories, and if conditions are bad enough or look to
have no near-term (i.e., within about six months) resolution, the price of
those companies’ stocks can plummet. Market prices often fall so low as to
imply, from a valuation perspective, that the factories are likely to remain
idled forever. In these cases, I believe that not using investment leverage in
this case may carry with it more real risk than using investment leverage
Gaining Exposure • 199
(see my discussion of risk in Chapter 12 after reading the paragraphs below
about financial leverage).
In boom times, just the opposite is true. Factories are nearing full
capacity and demand is strong. Most of the market is thinking only of the
extra percentage points of profit that can be squeezed out of the opera-
tions when continuing strong demand pushes factory capacity even higher.
As every contrarian knows, this is precisely the wrong time to fall in love
with the stock of an operationally levered company; it is also precisely the
wrong time to use investment leverage to gain exposure to the stock of an
operationally levered company.
Financial leverage is more dangerous and requires a much more care-
ful consideration of valuation scenarios, especially if the economy is in or is
going into recession. In recessions, consumer demand for products slows,
but banks’ and bondholders’ demand for interest and principal payments
continues unabated. If demand is so low that a company is not generating
enough cash flow to pay interest on its debt, or if it can pay interest on its
debt but does not have enough cash on hand to pay an entire principal pay-
ment (and banks refuse to finance that payment), the equity of the com-
pany will be worth nothing. As Buffett has so eloquently wrote in the 2010
annual letter to Berkshire Hathaway shareholders, “[A]ny series of positive
numbers, however impressive the numbers may be, evaporates when mul-
tiplied by a single zero. ” It doesn’t matter how great a given business may
be during boom times; if its equity value falls to zero during bad times, the
owner of the company’s stock will lose his or her entire investment.
One sad fact of life is that in many cases, companies with great op-
erational leverage (e.g., those that own factories) have funded this leverage
through the issuance of debt—hereby layering financial leverage onto oper-
ational leverage. Because financial leverage represents such a severe risk to
equity investors during bust times, and because it is devilishly hard to know
when the next bust time might come, I personally think that using less in-
vestment leverage on companies fitting this profile is generally prudent.
Let us assume that you have decided on the composition of an investment
meal and dug in using your chosen allocation size and leverage level. How do
you know when to stop “eating” and close all or part of your position? Or con-
versely, what should you do when you realize that the meal is more delicious
than you had originally imagined? These are natural questions to ask.
200  •   The Intelligent Option Investor
After you enter a position and some time passes, it becomes clearer
what valuation scenario the company is tending toward. In some cases,
a bit of information will come out that is critical to your valuation of the
company on which other market participants may not be focused. Obvi-
ously, if a bit of information comes out that has a big, positive or negative
impact on your assessment of the company’s value, you should adjust your
position size accordingly. If you believe the impact is positive, it makes
sense to build to a position by increasing your shares owned and/or by
adding “spice” to that meal by adjusting your target leverage level. If the
impact is negative, it makes sense to start by reducing leverage (or you
can think of it as increasing the proportion of cash supporting a particular
position), even if this reduction means realizing a loss. If the impact of the
news is so negative that the investment is no longer attractive from a risk-
reward perspective, I believe that it should be closed and the lumps taken
sooner rather than later. Considering what we know about prospect theory,
this is psychologically a difficult thing to do, but in my experience, waiting
to close a position in which you no longer have confidence seldom does
you any good.
Obviously, the risk/reward equation of an investment is also influ-
enced by a stock’s market price. If the market price starts scraping against
the upper edge of your valuation range, again, it is time to reduce leverage
and/or close the position.
If your options are in danger of expiring before a stock has reached
your fair value estimate, you may roll your position by selling your option
position and using the proceeds to buy another option position at a more
distant tenor. At this time, you must again think about your target leverage
and adjust the strikes of your options accordingly. If th


reduce leverage
and/or close the position.
If your options are in danger of expiring before a stock has reached
your fair value estimate, you may roll your position by selling your option
position and using the proceeds to buy another option position at a more
distant tenor. At this time, you must again think about your target leverage
and adjust the strikes of your options accordingly. If the price of the stock
has decreased over the life of the option contract, this will mean that you
realize a loss, which is not an easy thing to do psychologically, but consid-
ering the limitations imposed by time for all option investments, this is an
unavoidable situation in this case.
One of the reasons I dislike investing in non-LEAPS call options is
that rolling means that not only do we have to pay another set of bro-
ker and exchange fees, but we also must pay both sides of the bid-ask
spread. Keeping in mind how wide the bid-ask spread can be with options
and what an enormous drag this can be on returns, you should carefully
Gaining Exposure • 201
consider whether the prospective returns justify entering a long call posi-
tion that will likely have to be rolled multiple times before the stock hits
your fair value estimate.
By the way, it goes without saying that to the extent that an option
you want to roll has a significant amount of time value on it, it is better
to roll before time decay starts to become extreme. This usually occurs at
around three months before expiration. It turns out that option liquidity
increases in the last three months before expiration, and rolling is made
easier with the greater liquidity.
Having discussed gaining bullish exposure with this section about
long calls, let’s now turn to gaining bearish exposure in the following sec-
tion on long puts.
Long Put
GREEN
Downside: Undervalued
Upside: Fairly priced
Execute: Buy a put option
Risk: Amount of premium paid
Reward: Amount equal to strike price—premium
The Gist
An investor uses this strategy when he or she believes that it is very likely
that the value of a company is much lower than the present market price.
The investor must pay a premium to initiate the position, and the propor-
tion of the premium that represents time value should be recognized as a
202  •   The Intelligent Option Investor
realized loss because it cannot be recovered. If the stock fails to move into
the area of exposure before option expiration, there will be no profit to
offset this realized loss.
In economic terms, this transaction allows an investor to sell short
an overvalued company without accepting an uncertain risk of loss if the
stock rises. Instead of the uncertain risk of loss, the investor must pay the
fixed premium. This strategy obeys the same rules of leverage as discussed
earlier in this book, with ITM put options offering less leverage but a great-
er cushion before realizing a loss than do ATM or OTM put options.
T enor Selection
Shorting stocks, which is what you are doing when you buy put op-
tions, is hard work, not for the faint of heart. There are a couple of
reasons for this:
1. Markets generally go up, and for better or worse, a rising tide usu-
ally does lift all boats.
2. Even when a company is overvalued, it is hard to know what cata-
lyst will make that fact obvious to the rest of the market and when.
In the words of Jim Chanos, head of the largest short-selling hedge fund
in the world, the market is a “giant positive reinforcement machine. ”
1
It is psychologically difficult to hold a bearish position when it seems
like the whole world disagrees with you. All these difficulties in taking
bearish positions are amplified by options because options are levered
instruments, and losses feel all the more acute when they occur on a
levered position.
My rule for gaining bullish exposure is to pick the longest-tenor op-
tion possible. I made the point that by buying LEAPS, you can enjoy a
likely upward drift that exceeds the drift assumed by option pricing. When
buying puts, you are on the opposite side of this drift factor (i.e., the “ris-
ing tide lifts all boats” factor), and every day that the stock does not fall is
another day of time value that has decayed without you enjoying a profit.
On the other hand, if you decide not to spend as much on time value and
buy a shorter-tenor put option, unless the market realizes that the stock is
Gaining Exposure • 203
overvalued and it drops before the shorter option expires, you must pay the
entire bid-ask spread and the broker and exchange fees again when you roll
your put option.
The moral of the story is that when selecting tenors for puts, you need
to balance the existence of upward market drift (which lends weight to the
argument for choosing shorter tenors) with bid-ask spreads and other fees
(which lends weight to the argument for longer tenors). If you can iden-
tify a catalyst, you can plan the tenor of the option investment based on
the expected catalyst. However, it’s unfortunate but mysteriously true that
bearish catalysts have a tendency to be ignored by the market’s “happy ma-
chine” until the instant when suddenly they are not and the shares collapse.
The key for a short seller is to be in the game when the market realizes the
stock’s overvaluation.
Strike Price Selection
When it comes to strike prices, short sellers find themselves fighting drift
in much the same way as they did when selecting tenors. A short seller with
a position in stocks can be successful if the shares he or she is short go up
less than other stocks in the market. The short exposure acts as a hedge to
the portfolio as a whole, and if it loses less money than the rest of the port-
folio gains, it can be thought of as a successful investment.
However, the definition for success is different for buyers of a put
option, who must not only see their bearish bets not go up by much but
rather must see their bearish bets fall if they are to enjo

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


ks in the market. The short exposure acts as a hedge to
the portfolio as a whole, and if it loses less money than the rest of the port-
folio gains, it can be thought of as a successful investment.
However, the definition for success is different for buyers of a put
option, who must not only see their bearish bets not go up by much but
rather must see their bearish bets fall if they are to enjoy a profit. If the
investor wanting bearish exposure decides to gain it by buying OTM puts,
he or she must—as we learned in the section about leverage—accept a
realized loss as soon as the put is purchased. If, on the other hand, the
investor wants to minimize the realized loss accepted up front, he or she
must accept that he or she is in a levered bearish position so that every
1 percent move to the upside for the stock generates a loss larger than 1
percent for the position.
There is another bearish strategy that you can use by accepting
exposure that I will discuss in the next section, but for investors who are
gaining bearish exposure, there is no way to work around the dilemma of
the option-based short seller just mentioned.
204  •   The Intelligent Option Investor
Portfolio Management
There is certainly no way around the tradeoff between OTM and ITM
risk—the rules of leverage are immutable whether in a bullish or a bear -
ish investment—but there are some ways of framing the investment that
will allow intelligent investors to feel more comfortable with making
these types of bearish bets. First, I believe that losses associated with a
bearish position are treated differently within our own minds than those
associated with bullish positions. The reason for this might be the fact
that if you decide to proactively invest in the market, you must buy se-
curities, but you need not sell shares short. The fact that you are losing
when you are engaged in an act that you perceive as unnecessary just
adds to a sense of regret and self-doubt that is necessarily part of the
investing process.
In addition, investors seem to be able to accept underperform-
ing bullish investments in a portfolio context (e.g., “XYZ is losing, but
it’s only 5 percent of my holdings, and the rest of my portfolio is up, so
it’s okay”) but look at underperforming bearish investments as if they
were the only investments they held (e.g., “I’m losing 5 percent on that
damned short. Why did I ever short that stock in the first place?”). In gen-
eral, people have a hard time looking at investments in a portfolio con-
text (I will discuss this more when I talk about hedging in Chapter 11),
but this problem seems to be orders of magnitude worse in the case of a
bearish position.
My solution to this dilemma—perhaps not the best or most rational
from a performance standpoint but most manageable to me from a psy-
chological one—is to buy OTM puts with much smaller position sizes than
I might for bullish bets with the same conviction level. This means that I
have smaller, more highly levered positions. The reason this works for me
is that once I spend the premium on the put option, I consider the money
gone—a sunk cost—and do not even bother to look at the mark-to-market
value of the option after that unless there is a large drop in the stock price.
Somehow this acknowledgment of a realized loss up front is easier to han-
dle psychologically than watching my ITM put position suffer unrealized
losses of 1.5 times the rise of the stock every day.
This strategy may well be proof that I simply am not a natural-born
short seller, and you are encouraged, now that you understand the issues
Gaining Exposure • 205
involved, to devise a method for gaining bearish exposure that fits your own
risk profile.
Strangle
GREEN
GREEN
Downside: Undervalued
Upside: Undervalued
Execute: Buy an OTM call option simultaneously with buying an
OTM put option
Risk: Amount of premium paid
Reward: Unlimited on upside, limited to strike less total (two-leg)
premium on the downside
The Gist
The strangle is used when the market is undervaluing the likelihood that a
stock’s value is significantly above or below the present market price. It is a
more speculative position and, because both legs are OTM, a highly lever-
aged one. It can sometimes be useful for companies such as smaller drug
companies whose value hinges on the success or failure of a particular drug
or for companies that have a material chance of bankruptcy but if they can
206  •   The Intelligent Option Investor
avoid this extreme downside are worth much more than they are presently
trading at.
The entire premium paid must be treated as a realized loss because
it can never be recovered. If the stock fails to move into one of the areas
of exposure before option expiration, there will be no profit to offset this
realized loss.
There is no reason why you have to buy puts and calls in equal num-
bers. If you believe that both upside and downside scenarios are materially
possible but believe that the downside scenario is more plausible, you can
buy more puts than calls. This is called ratioing a position.
T enor Selection
Because the strangle is a combination of two strategies we have already
discussed, the considerations regarding tenor are the same as for each of
the components—that is, using the drift advantage in long-term equity an-
ticipating securities (LEAPS) and buying them or the longest-tenor calls
available and balancing the fight against drift and the cost of rolling and
buying perhaps shorter-tenor puts.
Strike Price Selection
A strangle is slightly different in nature from its two components—long
calls and long puts. A strangle is an option investor’s way of expressing
the belief that the market in general has underestimated the intrinsic
uncertainty in the valuation of a firm. Options are directional instru-
ments, but a strangle is a strategy that acknowledges that the investor
has no clear idea of which direction a stock will move but


ifferent in nature from its two components—long
calls and long puts. A strangle is an option investor’s way of expressing
the belief that the market in general has underestimated the intrinsic
uncertainty in the valuation of a firm. Options are directional instru-
ments, but a strangle is a strategy that acknowledges that the investor
has no clear idea of which direction a stock will move but only that
its future value under different scenarios is different from its present
market price.
Because both purchased options are OTM ones, this implies, in my
mind, a more speculative investment and one that lends itself to taking
profit on it before expiration. Nonetheless, my conservatism forces me to
select strike prices that would allow a profit on the entire position if the
stock price is at one of the two strikes at expiration. Because I am buying
exposure to both the upside and the downside, I always like to make sure
Gaining Exposure • 207
that if the option expires when the stock price is at either edge of my valu-
ation range, it is far enough in-the-money to pay me back for both legs of
the investment (plus an attractive return).
Portfolio Management
As mentioned earlier, this is naturally a more speculative style of option
investment, and it may well be more beneficial to close the successful leg of
the strategy before expiration than to hold the position to expiration. Com-
pared with the next strategy presented here (the straddle), the strangle ac-
tually generates worse returns if held to expiration, so if you are happy with
your returns midway through the investment, you should close the posi-
tion rather than waiting for expiration. The exception to this rule is that if
news comes out that convinces you that the value of the firm is materially
higher or lower than what you had originally forecast and uncertainty in
the other direction has been removed, you should assess the possibility of
making a more substantial investment in the company.
One common problem with investors—even experienced and sophis-
ticated ones—is that they check the past price history of a stock and decide
whether the stock has “more room” to move in a particular direction. The
most important two things to know when considering an investment are its
value and the uncertainty surrounding that value. Whether the stock was
cheaper three years ago or much more expensive does not matter—these are
backward-looking measures, and you cannot invest with a rear-view mirror.
One final note regarding this strategy is what to do with the unused
leg. If the stock moves up strongly and you take profits on the call, what
should you do with the put, in other words. Unfortunately, the unused leg is
almost always worthless, and often it will cost more than it’s worth to close
it. I usually keep this leg open because you never know what may happen,
and perhaps before it expires, you will be able to close it at a better price.
This is a speculative strategy—a bit of spice or an after-dinner mint
in the meal of investing. Don’t expect to get rich using it (if you do get rich
using it, it means that you were lucky because you would have had to have
used a lot of leverage in the process), but you may be pleasantly surprised
with the boost you get from these every once in a while.
Let’s now turn briefly to a related strategy—the straddle.
208  •   The Intelligent Option Investor
Straddle
GREEN
Downside: Undervalued
Upside: Undervalued
Execute: Simultaneously buy an ATM put and an ATM call
Risk: Amount of premium paid
Reward: Unlimited?
The Gist
I include the straddle here for completeness sake. I have not included a
lot of the fancier multioption strategies in this book because I have found
them to be more expensive than they are worth, especially for someone
with a definite directional view on a security. However, the straddle is re-
ferred to commonly and is deceptively attractive, so I include it here to
warn investors against its use, if for no other reason.
The straddle shares many similarities with the strangle, of course, but
straddles are enormously expensive because you are paying for every pos-
sible price the stock will move to over the term of the options. For example,
I just looked up option prices for BlackBerry (BBRY), whose stock was
trading at $9.00. For the 86 days to expiry, $9-strike calls (delta = 0.56) and
$9-strike puts (delta = –0.44) were priced at $1.03 and $1.13, respectively.
Gaining Exposure • 209
The total premium of $2.16 represents 24 percent of the stock’s price, which
means that if the implied volatility (around 60 percent) remains constant,
the stock would have to move 24 percent before an investor even breaks
even. It is true that during sudden downward stock price moves, implied
volatility usually rises, so it might take a little less of a stock price move-
ment to the downside to break even. However, during sudden upside
moves, implied volatility often drops, which would make it more difficult
to break even to the upside.
Despite this expense, a straddle will still give an investor a lower
breakeven point than a strangle on the same stock if held to expiration.
The key is that a strangle will almost always generate a higher profit than
a straddle if it is closed before expiration simply because the initial cost of
the strangle is lower and the relative leverage of each of its legs is higher.
This is yet another reason to consider closing a strangle early if and when
you are pleased with the profits made.
If you do not know whether a stock will move up or down, the best
you can hope for is to make a speculative bet on the company. When you
make speculative bets, it is best to reduce the amount spent on it or you will
whittle down all your capital on what amounts to a roulette wheel. Reduc-
ing the amount spent on a single bet is the reason an intelligent investor
should stay away from straddles.
With all the main strategies for gaining e


up or down, the best
you can hope for is to make a speculative bet on the company. When you
make speculative bets, it is best to reduce the amount spent on it or you will
whittle down all your capital on what amounts to a roulette wheel. Reduc-
ing the amount spent on a single bet is the reason an intelligent investor
should stay away from straddles.
With all the main strategies for gaining exposure covered, let’s now
turn to accepting exposure by selling options.
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211
Chapter 10
Accepting exposure
Brokerages and exchanges treat the acceptance of exposure by counter -
parties in a very different way from counterparties who want to gain expo-
sure. There is a good reason for this: although an investor gaining exposure
has an option to transact in the future, his or her counterparty—an investor
accepting exposure—has a commitment to transact in the future at the sole
discretion of the option buyer. If the investor accepting exposure does not
have the financial wherewithal to carry out the committed transaction, the
broker or exchange is on the hook for the liability.
1
For example, an investor selling a put option struck at $50 per share
is committing to buy the stock in question for $50 a share at some point
in the future—this is the essence of accepting exposure. If, however,
the investor does not have enough money to buy the stock at $50 at
some point in the future, the investor’s commitment to buy the shares is
economically worthless.
To guard against this eventuality, brokers require exposure-accepting
investors to post a security deposit called margin that will fully cover the fi-
nancial obligation to which the investor is committing. In the preceding ex-
ample, for instance, the investor would have to keep $5,000 (= $50 per share ×
100 shares/contract) in reserve and would not be able to spend those reserved
funds for stock or option purchases until the contract has expired worthless.
Because of this margin requirement, it turns out that one of our strat-
egies for accepting leverage—short puts—always carries with it a loss lev-
erage of –1.0—exactly the same as the loss leverage of a stock. Think about
it this way: what difference is there between using $50 to buy a stock and
212  •   The Intelligent Option Investor
setting $50 aside in an escrow account you can’t touch and promising that
you will buy the stock with the escrow funds in the future if requested to
do so? From a risk perspective, “very little” is the answer.
Short calls are more complicated, but I will discuss the leverage car -
ried by them using elements of the structure I set forth in Chapter 8. In the
following overviews, I add one new line item to the tables that details the
margin requirements of the positions.
Intelligent option investors accept exposure when the market over -
estimates the likelihood of a valuation that the investor believes is not a
rational outcome. In graphic terms, this means that either one or both of
the investor’s best- and worst-case valuation scenarios lie well within the
Black-Scholes-Merton model (BSM) cone.
Simple (one-option) strategies to accept exposure include
1. Short put
2. Short call (call spread)
Complex (multioption) strategies to accept exposure include the following:
1. Short straddle
2. Short strangle
Jargon introduced in this chapter includes the following:
Margin Put-call parity
Early exercise Cover (a position)
Writing (an option)
Short Put
RED
Accepting Exposure   • 213
Downside: Overvalued
Upside: Fairly valued
Execute: Sell a put contract
Risk: Strike price minus premium received [same as stock inves-
tor at the effective buy price (EBP)]
Reward: Limited to premium received
Margin: Notional amount of position
The Gist
The market is pricing in a relatively high probability that the stock price
will fall. An investor, from a longer investment time frame perspective,
believes that the value of the stock is likely worth at least the present mar-
ket value and perhaps more. The investor agrees to accept the downside
risk perceived by the market and, in return, receives a premium for doing
so. The premium cannot be fully realized unless the option expires out-
of-the money (OTM). If the option expires in-the-money (ITM), the
investor pays an amount equal to the strike price for the stock but can
partially offset the cost of the stock by the premium received. The inves-
tor thus promises to buy the stock in question at a price of the strike
price of the option less the premium received—what I call the effective
buy price.
I think of the short-put strategy as being very similar to buying cor -
porate bonds and believe that the two investment strategies share many
similarities. A bond investor is essentially looking to receive a specific
monetary return (in the form of interest) in exchange for accepting
the risk of the business failing. The only time a bond investor owns a
company’s assets is after the value of the firm’s equity drops to zero, and
the assets revert to the control of the creditors. Similarly, a short-put in-
vestor is looking to receive a specific monetary return (in the form of an
option premium) in exchange for accepting the risk that the company’s
stock will decrease in value. The only time a short-put investor owns a
company’s shares is after the market value of the shares expires below the
preagreed strike price.
Because the strategies are conceptually similar, I usually think of short-
put exposure in similar terms and compare the “yield” I am generating
214  •   The Intelligent Option Investor
from a portfolio of short puts with the yield I might generate from a cor -
porate bond portfolio. With this consideration, and keeping in mind that
these investments are unlevered, 2 the name of the game is to generate as
high a percentage return as possible over the investing time horizon while
minimizing the amount of real downside risk you are accepting.
T enor Selectio


gent Option Investor
from a portfolio of short puts with the yield I might generate from a cor -
porate bond portfolio. With this consideration, and keeping in mind that
these investments are unlevered, 2 the name of the game is to generate as
high a percentage return as possible over the investing time horizon while
minimizing the amount of real downside risk you are accepting.
T enor Selection
To maximize percentage return, in general, it is better to sell options with
relatively short-term expirations (usually tenors of from three to nine
months before expiration). This is just the other side of the coin of the
rule to buy long-tenor options: the longer the time to expiration, the less
time value there is on a per-day basis. The rule to sell shorter-tenor options
implies that you will make a higher absolute return by chaining together
two back-to-back 6-month short puts than you would by selling a single
12-month option at the beginning of the period.
During normal market conditions, selling shorter-tenor options is
the best tactical choice, but during large market downdrafts, when there
is terror in the marketplace and implied volatilities increase enormously
for options on all companies, you might be able to make more by sell-
ing a longer-tenor option than by chaining together a series of shorter-
tenor ones (because, presumably, the implied volatilities of options will
drop as the market stabilizes, and this drop means that you will make
less money on subsequent put sales). At these times of extreme market
stress, there are situations where you can find short-put opportunities
on long-tenor options that defy economic logic and should be invested
in opportunistically.
For example, during the terrible market drops in 2009, I found a
company whose slightly ITM put long-term equity anticipation securities
(LEAPS) were trading at such a high price that the effective buy price of
the stock was less than the amount of cash the firm had on its balance
sheet. Obviously, for a firm producing positive cash flows, the stock should
not trade at less than the value of cash presently on the balance sheet! I ef-
fectively got the chance to buy a firm with $6 of cash on the balance sheet
and the near certainty of generating about $2 more over the economic life
of the options for $5.50. The opportunity to buy $6–$8 worth of cash for
Accepting Exposure   • 215
$5.50 does not come along very often, so you should take advantage of it
when you see it.
Of course, the absolute value of premium you will receive by writing
(jargon that means selling an option) a short-term put is less than the ab-
solute value of the premium you will receive by writing a long-term one.
3
As such, an investor must balance the effective buy price of the stock (the
strike price of the option less the amount of premium to be received) in
which he or she is investing in the short-put strategy with the percentage
return he or she will receive if the put expires OTM.
I will talk more about effective buy price in the next section, but keep
in mind that we would like to generate the highest percentage return pos-
sible and that this usually means choosing shorter-tenor options.
Strike Price Selection
In general, the best policy is to sell options at as close to the 50-delta [at-
the-money (ATM)] mark as one can because that is where time value for
any option is at its absolute maximum. Our expectation is that the option’s
time value will be worthless at expiration, and if that is indeed the case,
we will be selling time value at its maximum and “closing” our time value
position at zero—its minimum. In this way, we are obeying (in reverse
order) the old investing maxim “Buy low, sell high. ” Selling ATM puts
means that our effective buy price will be the strike price at which we sold
less the amount of the premium we received. It goes without saying that
an intelligent investor would not agree to accept the downside exposure
to a stock if he or she were not prepared to buy the stock at the effective
buy price.
Some people want to sell OTM puts, thereby making the effective buy
price much lower than the present market price. This is an understandable
impulse, but simply attempting to minimize the effective buy price means
that you must ignore the other element of a successful short put strategy:
maximizing the return generated. There are times when you might like to
sell puts on a company but only at a lower strike price. Rather than accept-
ing a lower return for accepting that risk, I find that the best strategy is
simply to wait awhile until the markets make a hiccup and knock down the
price of the stock to your desired strike price.
216  •   The Intelligent Option Investor
Portfolio Management
As we have discussed, the best percentage returns on short-put investments
come from the sale of short-tenor ATM options. I find that each quarter there
are excellent opportunities to find a fairly constant stream of this type of short-
term bet that, when strung together in a portfolio, can generate annualized
returns in the high-single-digit to low-teens percentage range. This level of
returns—twice or more the yield recently found on a high-quality corporate
bond portfolio and closer to the bond yield on highly speculative small com-
panies with low credit ratings—is possible by investing in strong, high-quality
blue chip stocks. In my mind, it is difficult to allocate much money to corpo-
rate bonds when this type of alternative is available.
Some investors prefer to sell puts on stocks that are not very vola-
tile or that have had a significant run-up in price,
4 but if you think about
how options are priced, it is clear that finding stocks that the market
perceives as more volatile will allow you to generate higher returns. Y ou
can confirm this by looking at the diagrams of a short-put investment
given two different volatility scenarios. First, a diagram in which implied
v


hat are not very vola-
tile or that have had a significant run-up in price,
4 but if you think about
how options are priced, it is clear that finding stocks that the market
perceives as more volatile will allow you to generate higher returns. Y ou
can confirm this by looking at the diagrams of a short-put investment
given two different volatility scenarios. First, a diagram in which implied
volatility is low:
Advanced Building Corp. (ABC)
80
70
60
50
40
30
20
5/18/2012 5/20/2013 249 499 749 999
Date/Day Count
Stock Price
RED
Accepting Exposure   • 217
Now a diagram when implied volatility is higher:
RED
Advanced Building Corp. (ABC)
80
70
60
50
40
30
20
5/18/2012 5/20/2013 249 499 749 999
Date/Day Count
Stock Price
Obviously, there is much more of the put option’s range of exposure
bounded by the BSM cone in the second, high-volatility scenario, and this
means that the price received for accepting the same downside risk will be
substantially higher when implied volatility is elevated.
The key to setting up a successful allocation of short puts is to find
companies that have relatively low downside valuation risk but that also
have a significant amount of perceived price risk (as seen by the market)—
even if this risk is only temporary in nature. Quarterly earnings seasons are
nearly custom made for this purpose. Sell-side analysts (and the market
in general) mainly use multiples of reported earnings to generate a target
price for a stock. As such, a small shortfall in reported earnings as a result
of a transitory and/or nonmaterial accounting technicality can cause sell-
side analysts and other market participants to bring down their short-term
target price estimates sharply and can cause stock prices to drop sharply
as well.
5
These times, when a high-quality company drops sharply as a re-
sult of perceived risk by other investors, are a wonderful time to replen-
ish a portfolio of short puts. If you time the tenors well, your short-put
218  •   The Intelligent Option Investor
investment will be expiring just about the time another short-put invest-
ment is becoming attractive, so you can use the margin that has until re-
cently been used to support the first position to support the new one.
Obviously, this strategy only works when markets are generally trend-
ing upward or at least sideways over the investment horizon of your short
puts. If the market is falling, short-put positions expire ITM, so you are left
with a position in the underlying stocks. For an option trader (i.e., a short-
term speculator), being put a stock is a nightmare because he or she has
no concept of the underlying value of the firm. However, for an intelligent
option investor, being put a stock simply means the opportunity to receive
a dividend and enjoy capital appreciation in a strong stock with very little
downside valuation risk.
The biggest problem arises when an investor sells a put and then re-
vises down his or her lowest-case valuation scenario at a later time. For in-
stance, the preceding diagram shows a worst-case scenario of $55 per share.
What if new material information became known to you that changed your
lower valuation range to $45 per share just as the market price for the stock
dropped, as in the following diagram?
Advanced Building Corp. (ABC)
80
70
60
50 EBP = $47.50
Overvaluation of
downside exposure
40
30
20
5/18/2012 5/20/2013 249 499 749 999
Date/Day Count
Stock Price
RED
Accepting Exposure   • 219
Looking at this diagram closely, you should be able to see several
things:
1. The investor who is short this put certainly has a notable unrealized
loss on his or her position. Y ou can tell this because the put the
investor sold is now much more valuable than at the time of
the original sale (more of the range of exposure is carved out by
the BSM cone now). When you sell something at one price and the
value of that thing goes up in the future, you suffer an opportunity
loss on your original sale.
2. With the drop in price and the cut in fair value, the downside ex-
posure on this stock still looks overvalued.
3. If the company were to perform so that its share price eventually
hit the new, reduced best-case valuation mark, the original short-
put position would generate a profit—albeit a smaller profit than
the one originally envisioned.
At this point, there are a couple of choices open to the investor:
1. Convert the unrealized loss on the short-put position to a realized
one by buying $50-strike puts to close the position (a.k.a. cover the
position).
2. Leave the position open and manage it in the same way that the
investor would manage a struggling stock position.
It is rarely a sound idea to close a short put immediately after the re-
lease of information that drives down the stock price (the first choice above,
in other words). At these times, investors are generally panicked, and this
panic will cause the price of the option you buy to cover to be more expen-
sive than justified. Waiting a few days or weeks for the fear to drain out of
the option prices (i.e., for the BSM cone to narrow) and for the stock price
to stabilize some will usually allow you to close the option position at a more
favorable price. There is one exception to this rule: if your new valuation
suggests a fair value at or below the present market price, it is better to close
the position immediately and realize those losses. If you do not close the
position, you are simply gambling (as opposed to investing) because you no
longer have a better than even chance of making money on the investment.
220  •   The Intelligent Option Investor
The decision to leave the position open must depend on what other
potential investments you are able to make and how the stock position that
will likely be put to you at expiration of the option contract stacks up on a
relative basis. For instance, let’s assume that you had received a premium
of $2.50 for writing the puts struck at $50


n the investment.
220  •   The Intelligent Option Investor
The decision to leave the position open must depend on what other
potential investments you are able to make and how the stock position that
will likely be put to you at expiration of the option contract stacks up on a
relative basis. For instance, let’s assume that you had received a premium
of $2.50 for writing the puts struck at $50. This gives you an effective buy
price of $47.50. The stock is now trading at $43 per share, so you can think
of your position as an unlevered, unrealized loss of $4.50, or a little under
10 percent of your EBP . Y our new worst-case valuation is $55 per share,
which implies a gain of about 15 percent on your EBP; your new best-case
valuation is $65 per share, which implies a gain of 37 percent.
How do these numbers compare with other investments in your port-
folio? How much spare capacity does your portfolio have for additional
investments? (That is, do you have enough spare cash to increase the size
of this investment by selling more puts at the new market price or buying
shares of stock? And if so, would your portfolio be weighted too heavily on a
single industry or sector?) By answering these questions and understanding
how this presently losing investment compares with other existing or poten-
tial investments should govern your portfolio management of the position.
An investor cannot change the price at which he or she transacted
in a security. The best he or she can do is to develop a rational view of the
value of a security and judge that security by its relative merit versus other
possible investments. Whether you ever make an option transaction, this
is a good rule to keep in mind.
Let us now take a look at short calls and short-call spreads—the
strategy used for accepting upside exposure.
Short Call (Call Spread)
RED
Accepting Exposure   • 221
Downside: Fairly valued
Upside: Overvalued
Execute: Sell a call contract (short call); sell a call contract while
simultaneously buying a call contract at a higher strike
price (short-call spread)
Risk: Unlimited for short call; difference between strike prices
and premium received (short-call spread)
Reward: Limited to the amount of premium received
Margin: Variable for a short call; dollar amount equal to the differ-
ence between strike prices for a short-call spread
The Gist
The market overestimates the likelihood that the value of a firm is above its pre-
sent market price. An investor accepts the overvalued upside exposure in return
for a fixed payment of premium. The full amount of the premium will only flow
through to the investor if the price of the stock falls and the option expires OTM.
There are two variations of this investment—the short call and the
short-call spread. This book touches on the former but mainly addresses
the latter. A short call opens up the investor to potentially unlimited capital
losses (because stocks theoretically do not have an upper bound for their
price), and a broker will not allow you to invest using this strategy except
for the following conditions:
1. Y ou are a hedge fund manager and have the ability to borrow
stocks through your broker and sell them short.
2. Y ou are short calls not on a stock but on a diversified index (such
as the Dow Jones Industrial Index or the Standard and Poor’s 500
Index) through an exchange-traded fund (ETF) or a futures con-
tract and hold a diversified stock portfolio.
For investors fitting the first condition, short calls are margined in the
same way as the rest of your short portfolio. That is, you must deposit initial
margin on the initiation of the investment, and if the stock price goes up, you
must pay in variance margin to support the position. Obviously, as the stock
price falls, this margin account is settled in your favor. For investors fitting the
second condition, when you originally sell the call option, your broker should
222  •   The Intelligent Option Investor
indicate on your statements that a certain proportion of your account effec-
tively will be treated as margin. This means that you stand to receive the eco-
nomic benefit from your diversified portfolio of securities but will not be able
to liquidate all of it. If the market climbs higher, a larger proportion of your
portfolio will be considered as margin; if it falls lower, a smaller proportion
of your portfolio will be considered as margin. Basically, a proportion of any
gains from your diversified stock portfolio will be reapportioned to serve as
collateral for your short call when the market is rising, and a proportion of any
losses from your diversified stock portfolio will be offset by a freeing of margin
related to your profits on the short call when the market is falling.
Most brokers restrict the ability of individual investors to write un-
covered calls on individual stocks, so the rest of this discussion will cover
the short-call spread strategy for individual stocks.
T enor Selection
Tenors for short-call spreads should be fairly short under the same reason-
ing as that for short puts—one receives more time value per day for short-
er-tenor options. Look for calls in the three- to nine-month tenor range.
The tenor of the purchased call (at the higher strike price) should be the
same as the tenor of the sold calls (at the lower strike price). Theoretically,
the bought calls could be longer, but it is hard to think of a valuation justifi-
cation for such a structure. By buying a longer-tenor call for the upside leg
of the investment, you are expressing an investment opinion that the stock
will likely rise over the long term—this exactly contradicts the purpose of
this strategy: expressing a bearish investment opinion.
Strike Price Selection
Theoretically, you can choose any two strike prices, sell the call at the lower
price, and buy the call at the higher price and execute this investment. If you
sold an ITM call, you would receive premium t


n investment opinion that the stock
will likely rise over the long term—this exactly contradicts the purpose of
this strategy: expressing a bearish investment opinion.
Strike Price Selection
Theoretically, you can choose any two strike prices, sell the call at the lower
price, and buy the call at the higher price and execute this investment. If you
sold an ITM call, you would receive premium that consists of both time and
intrinsic value. If the stock fell by expiration, you would realize all the wasted
time value plus the difference between the intrinsic value at initiation and the
intrinsic value at expiration.
Despite the theory, however, in practice, the lower strike option is usually
sold ATM or OTM because of the threat of assignment. Assignment is the pro-
cess the exchange goes through when investors choose to exercise the option
Accepting Exposure   • 223
they own rather than trade them away for a profit. Recall from Chapter 2
that experienced option investors do not do this most of the time; they
know that because of the existence of time value, it is usually more beneficial
for them to sell their option in the market and use the proceeds to buy the stock
if they want to hold the underlying. Inexperienced investors, however, often are
not conscious of the time-value nuance and sometimes elect to exercise their
option. In this case, the exchange randomly pairs the option holders who wish
to exercise with an option seller who has promised to sell at that exercise price.
There is one case in which a sophisticated investor might chose to
exercise an ITM call option early, related to a principle in option pricing
called put-call parity. This rule, which was used to price options before
advent of the BSM, simply states that a certain relationship must exist be-
tween the price of a put at one strike price, the price of a call at that same
strike price, and the market price of the underlying stock. Put-call parity
is discussed in Appendix C. In this appendix, you can learn what the exact
put-call parity rule is (it is ridiculously simple) and then see how it can be
used to determine when it is best to exercise early in case you are long a
call and when your short-call (spread) position is in danger of early exercise
because of a trading strategy known as dividend arbitrage.
The assignment process is random, but obviously, the more contracts
you sell, the better the chance is that you will be assigned on some part or all
of your sold contracts. Even if you hold until expiration, there is still a chance
that you may be assigned to fulfill a contract that was exercised on settlement.
Clearly, from the standpoint of option sale efficiency, an ATM call is the
most sensible to sell for the same reason that a short put also was most efficient
ATM. As such, the discussion that follows assumes that you are selling the
ATM strike and buying back a higher strike to cover.
In a call-spread strategy, the capital you have at risk is the difference be-
tween the two strike prices—this is the amount that must be deposited into
margin. Depending on which strike price you use to cover, the net premium
received differs because the cost of the covering call is cheaper the further
OTM you cover. As the covering call becomes more and more OTM, the ratio
of premium received to capital at risk changes. Put in these terms, it seems
that the short-call spread is a levered strategy because leverage has to do with
altering the capital at risk in order to change the percentage return. This con-
trasts with the short-call spread’s mirror strategy on the put side—short puts—
in that the short-put strategy is unlevered.
224  •   The Intelligent Option Investor
For instance, here are data from ATM and OTM call options on IBM
(IBM) expiring in 80 days. I took these data when IBM’s shares were trad-
ing at $196.80 per share.
Sell a Call at 195
Cover at ($) Net Premium Received ($) Percent Return Capital at Risk ($)
200 2.40 48 5
205 4.26 43 10
210 5.47 36 15
215 6.17 31 20
220 6.51 26 25
225 6.70 22 30
230 6.91 20 35
235 6.90 17 40
240 6.96 15 45
In this table, net premium received was calculated by selling at the $195
strike’s bid price and buying at each of the listed strike price’s ask prices. Percent
return is the proportion of net premium received as a percentage of the capital
at risk—the width of the spread. This table clearly shows that accepting expo-
sure with a call spread is a levered strategy. The potential return on a percent-
age basis can be raised simply by lowering the amount of capital at risk.
However, although accepting exposure with a call spread is un-
deniably levered from this perspective, there is one large difference: un-
like the leverage discussed earlier in this book for a purchase of call op-
tions—in which your returns were potentially unlimited—the short-call
spread investor receives premium up front that represents the maximum
return possible on the investment. As such, in the sense of the investor’s
potential gains being limited, the short-call spread position appears to be
an unlevered investment.
Considering the dual nature of a short-call spread, it is most help-
ful to think about managing these positions using a two-step process with
both tactical and strategic aspects. We will investigate the tactical aspect
of leverage in the remainder of this section and the strategic aspect in the
portfolio management section.
Accepting Exposure   • 225
Tactically, once an investor has decided to accept exposure to a stock’s
upside potential using a call spread, he or she has a relatively limited choice
of investments. Let’s assume that we sell the ATM strike; in the IBM ex-
ample shown earlier, there is a choice of nine strike prices at which we
can cover. The highest dollar amount of premium we can receive—what I
will call the maximum return—is received by covering at the most distant
strike. Every strike between the ATM and the most dis


all spread, he or she has a relatively limited choice
of investments. Let’s assume that we sell the ATM strike; in the IBM ex-
ample shown earlier, there is a choice of nine strike prices at which we
can cover. The highest dollar amount of premium we can receive—what I
will call the maximum return—is received by covering at the most distant
strike. Every strike between the ATM and the most distant strike will at
most generate some percentage of this maximum return.
Now let’s look at the risk side. Let’s say that we sell the $195-strike call
and cover using the $210-strike call. Now assume that some bit of good
news about IBM comes out, and the stock suddenly moves to exactly $210.
If the option expires when IBM is trading at $210, we will have lost the
entire amount of margin we posted to support this investment—$15 in all.
This $15 loss will be offset by the amount of premium we received from
selling the call spread—$5.47 in the IBM example—generating a net loss of
$9.53 (= $5.47 − $15). Compare this with the loss that we would suffer if we
had covered using the most distant call strike. In this case, we would have
received $6.96 in premium, so if the option expires when IBM is trading at
the same $210 level as earlier, our net loss would be $8.04 (= $6.96 − $15).
Because our maximum return is generated with the widest spread, it fol-
lows that our minimum loss for the stock going to any intermediate strike
price also will be generated with the widest spread.
At the same time, if we always select the widest spread, we face an
entirely different problem. That is, the widest spread exposes us to the great-
est potential loss. If the stock goes only to $210, it is true that the widest
spread will generate a smaller loss than the $195–$210 spread. However, in
the extreme, if the stock moves up strongly to $240, we would lose the $45
gross amount supporting the margin account and a net amount of $38.04
(= $45 – $6.96). Contrast this with a net loss of $9.53 for the $195–$210
spread. Put simply, if the stock moves up only a bit, we will do better with
the wider spread; if it moves up a lot, it is better to choose a narrower
spread.
In short, when thinking about call spreads, we must balance our
amount of total exposure against the exposure we would have for an inter-
mediate outcome against the total amount of premium we are receiving. If
we are too protective and initiate the smallest spread possible, our chance
226  •   The Intelligent Option Investor
of losing the entire margin amount is higher, but the margin amount lost
is smaller. On the other hand, if we attempt to maximize our winnings
and initiate the widest spread possible, our total exposure is greatest, even
though the chance of losing all of it is lower.
Plotting these three variables on a graph, here is what we get:
200 (11%)
0%
20%
40%
60%
80%
106% 102%
94%89%
100%
120%
140%
160%
180%
200%
205 (22%) 210 (33%) 215 (44%) 220 (56%) 225 (67%) 230 (78%) 235 (89%) 240 (100%)
Strike (% of Total Exposure)
Risk & Return of Call Spreads vs. Maximum Spread
Risk Comparison Return Comparison
Here, on the horizontal axis, we have the value of the covering strike and
the size of the corresponding spread as a percentage of the widest spread.
This shows how much proportional capital is at risk (e.g., at the $215-strike,
we are risking a total of $20 of margin; $20 is 44 percent of total exposure
of $45 if we covered at the $240-strike level). The top line shows how much
greater the loss would be if we used that strike to cover rather than the
maximum strike and the option expired at that strike price (e.g., if we cover
at the $215-strike and the option expires when the stock is trading at $215,
our loss would be 6 percent greater than the loss we would suffer if we
covered at the $240-strike). The bottom line shows the premium we will
realize as income if the stock price declines as a percentage of the total pre-
mium possible if we covered at the maximum strike price. Here are the val-
ues from the graph in tabular format so that you can see the numbers used:
Strike
Price
Dollar
Spread
Percent of
Maximum
Spread (a)
Bid
Price
Ask
Price
Covering at Strike
Covering at Maximum
Strike
Difference
Risk
Comparison
(%) (b)
Return
Comparison
(%) (c)
Potential
Gain
Worst-Case
(Loss)
Potential
Gain
Worst-Case
Gain (Loss)
195 — — 7.05 7.10 — — — — — — —
200 5 11 4.55 4.65 2.40 (2.60) 6.96 1.96 (3.55) N.C. 34
205 10 22 2.75 2.79 4.26 (5.74) 6.96 (3.04) 2.29 189 61
210 15 33 1.54 1.58 5.47 (9.53) 6.96 (8.04) 0.87 119 79
215 20 44 0.84 0.88 6.17 (13.83) 6.96 (13.04) 0.53 106 89
220 25 56 0.38 0.54 6.51 (18.49) 6.96 (18.04) 0.39 102 94
225 30 67 0.12 0.35 6.70 (23.30) 6.96 (23.04) 0.30 101 96
230 35 78 0.11 0.14 6.91 (28.09) 6.96 (28.04) 0.25 100 99
235 40 89 0.03 0.15 6.90 (33.10) 6.96 (33.04) 0.21 100 99
240 45 100 0.02 0.09 6.96 (38.04) 6.96 (38.04) 0.18 100 100
227
228  •   The Intelligent Option Investor
With a table like this, you can balance, on the one hand, the degree
you are reducing your overall exposure in a worst-case scenario (by look-
ing at column a) against how much risk you are taking on for a bad-case
(intermediary upward move of the stock) scenario (by looking at column
b) against how much less premium you stand to earn if the stock does go
down as expected (by looking at column c).
There are no hard and fast rules for which is the correct covering strike to
select—that will depend on your confidence in the valuation and timing, your
risk profile, and the position size—but looking at the table, I tend to be drawn
to the $215 and $220 strikes. With both of those strikes, you are reducing your
worst-case exposure by about half, increasing your bad-case exposure just
marginally, and taking only a small haircut on the premium you are receiving.
6
Now that we have an idea of how to think about the potential risk and
return on a per-contract basis, let’s turn to leverage in the s


he table, I tend to be drawn
to the $215 and $220 strikes. With both of those strikes, you are reducing your
worst-case exposure by about half, increasing your bad-case exposure just
marginally, and taking only a small haircut on the premium you are receiving.
6
Now that we have an idea of how to think about the potential risk and
return on a per-contract basis, let’s turn to leverage in the strategic sense—
figuring out how much capital to commit to a given bearish idea.
Portfolio Management
When we thought about leverage from a call buyer’s perspective, we
thought about how large of an allocation we wanted to make to the idea
itself and changed our leverage within that allocation to modify the profits
we stood to make. Let’s do this again with IBM—again assuming that we are
willing to allocate 5 percent of our portfolio to an investment in the view
that this company’s stock price will not go higher. At a price of $196.80, a
5 percent allocation would mean controlling a little more than 25 shares for
every $100,000 of portfolio value.
7 Because options have a contract size of
100 shares, an unlevered 5 percent allocation to this investment would
require a portfolio size of $400,000.
The equation to calculate the leverage ratio on the basis of notional
exposure is
× =Notional valueo fo ne contract
Dollarv alue of allocation number of contractsl everager atio
So, for instance, if we had a $100,000 portfolio of which we were willing to
commit 5 percent to this short-call spread on IBM, our position would have a
leverage ratio of
Accepting Exposure   • 229
×= ≈$19,500
$5,000 13 .9 4: 1leverage
Selling the $195/$220 call spread will generate $651 worth of pre-
mium income and put at risk $2,500 worth of capital. Nothing can change
these two numbers—in this sense, the short-call spread has no leverage.
The 4:1 leverage figure merely means that the percentage return will ap-
pear nearly four times as large on a given allocation as a 1:1 allocation
would appear. The following table—assuming the sale of one contract of
the $195/$220 call spread—shows this in detail:
Winning Case Losing Case
Premium
Received
($)
Target
Allocation
($) Leverage
Stock
Move ($)
Percent
Return on
Allocation
Stock
Move
($)
Dollar
Return
Percent
Return on
Allocation
651 20,000 1:1 –2 3.3 +25 –1,849 –9.2
651 10,000 2:1 –2 6.5 +25 –1,849 –18.5
651 5,000 4:1 –2 13.0 +25 –1,849 –37.0
Note: The dollar return in the losing case is calculated as the loss of the $2,500 of margin
per contract less than the premium received of $651.
Notice that the premium received never changes, nor does the worst-
case return. Only the perception of the loss changes with the size of our
target allocation.
Now that we have a sense of how to calculate what strategic leverage
we are using, let’s think about how to size the position and about how much
risk we are willing to take. When we are selling a call or call spread, we are
committing to sell a stock at the strike price. If we were actually selling the
stock at that price rather than committing to do so, where would we put
our stop loss—in other words, when would we close the position, assuming
that our valuation or our timing was not correct?
Let’s say that for this stock, if the price rose to $250, you would be
willing to admit that you were wrong and would realize a loss of $55 per share,
or $5,500 per hundred shares. This figure—the $5,500 per hundred shares
you would be willing to lose in an unlevered short stock position—can be
used as a guide to select the size of your levered short-call spread.
230  •   The Intelligent Option Investor
In this case, you might choose to sell a single $195–$240 call spread, in
which case your maximum exposure would be $4,500 [= 1 × (240 – 195) × 100]
at the widest spread. This investment would have a leverage ratio of approxi-
mately 1:1. Alternatively, you could choose to sell two $195–$220 spreads, in
which case your maximum exposure would be $5,000 [= 2 × (220 − 195) ×
100], with a leverage ratio of approximately 2:1. Which choice you select will
depend on your assessment of the valuation of the stock, your risk tolerance,
and the composition of your portfolio (i.e., how much of your portfolio is al-
located to the tech sector, in this example of an investment in IBM). Because
the monetary returns from a short-call or call-spread strategy are fixed and
the potential for losses are rather high, I prefer to execute bearish investments
using the long-put strategy discussed in the “Gaining Exposure” section.
With this explanation of the short-call spread complete, we have all the
building blocks necessary to understand all the other strategies mentioned
in this book. Let’s now turn to two nonrecommended complex strategies
for accepting exposure—the short straddle and the short strangle—both of
which are included not because they are good strategies but rather for the
sake of completeness.
Short Straddle/Short Strangle
Short Straddle
RED
Downside: Overvalued
Upside: Overvalued
Execute: Sell an ATM put; simultaneously sell an ATM call spread
Accepting Exposure   • 231
Risk: Amount equal to upper strike price minus premium received
Reward: Limited to premium received
Margin: Dollar amount equal to upper strike price
Short Strangle
RED
RED
Downside: Overvalued
Upside: Overvalued
Execute: Sell an OTM put; simultaneously sell an OTM call spread
Risk: Call-spread leg: Amount equal to difference between
strikes and premium received. Put leg: Amount equal to
strike price minus premium received. Total exposure is
the sum of both legs.
Reward: Limited to premium received
Margin: Call-spread leg: Amount equal to difference between
strikes. Put leg: Amount equal to strike price. Total mar -
gin is the sum of both legs.
The Gist
In my opinion, these are short-term trades rather than investments. Even
though a short put uses a short-tenor option, the perspective of the inves-
tor is that he or she is buying s


the sum of both legs.
Reward: Limited to premium received
Margin: Call-spread leg: Amount equal to difference between
strikes. Put leg: Amount equal to strike price. Total mar -
gin is the sum of both legs.
The Gist
In my opinion, these are short-term trades rather than investments. Even
though a short put uses a short-tenor option, the perspective of the inves-
tor is that he or she is buying shares. These strategies are a way to express
the belief that the underlying stock price will not move over a short time.
In my experience, there is simply no way to develop a rational view of how
a single stock will move over a short time frame. In the short term, markets
232  •   The Intelligent Option Investor
fluctuate based on animal spirits, fads, and various other insanities. Why
subject yourself to the torture of trying to figure out these insanities and
profit from them when there are easier, more intelligent ways of doing so?
Of the two strategies, the short straddle is preferable because it yields
the greatest amount of premium. Use this strategy at your own peril,
however.
Let’s turn now to a discussion of how to mix exposure—simultane-
ously gaining and accepting exposure and overlaying options on stock po-
sitions.
233
Chapter 11
Mixing ExposurE
Mixing exposure uses combinations of gaining and accepting exposure,
employing strategies that we already discussed to create what amounts to
sort of a short-term synthetic position in a stock (either long or short).
These strategies, nicknamed “diagonals” can be extremely attractive and
extremely financially rewarding in cases where stocks are significantly mis-
priced (in which case, exposure to one direction is overvalued, whereas the
other is extremely undervalued).
Frequently, using one of these strategies, an investor can enter a po-
sition in a levered out-of-the-money (OTM) option for what, over time,
becomes zero cost (or can even net a cash inflow) and zero downside expo-
sure. This is possible because the investor uses the sale of one shorter-tenor
at-the-money (ATM) option to subsidize the purchase of another longer-
tenor OTM one. Once the sold option expires, another can be sold again,
and whatever profit is realized from that sale goes to further subsidize the
position.
This strategy works well because of a couple of rules of option pricing
that we have already discussed:
1. ATM options are more expensive than OTM options of the same
tenor.
2. Short-tenor options are worth less than long-tenor options, but
the value per day is higher for the short-tenor options.
234  •   The Intelligent Option Investor
I provide actual market examples of these strategies in this chapter and will
point out the effect of both these points in those examples.
Because these strategies are a mix of exposures, it makes sense
that they are just complex (i.e., multioption) positions. I will discuss the
following:
1. Long diagonal
2. Short diagonal
Note that the nomenclature I use here is a bit different from what others
in the market may use. What I term a diagonal in this book is what others
might call a “spit-strike synthetic stock. ” Since Bernie Madoff ’s infamous
“split-strike conversion” fraud, this term doesn’t have a very good ring to
it. For other market participants, a diagonal means simultaneously buying
and selling options of the same type (i.e calls or puts). In this book, it means
selling an option of one kind and buying the other kind.
I will also talk about what is known in the options world as overlays. One
of the most useful things about options is the way that they can be grafted or
overlain onto an existing common stock position in a way that alters the port-
folio’s overall risk-reward profile. The strategies I will review here are as follows:
1. Covered calls
2. Protective puts
3. Collars
These strategies are popular but often misunderstood ways to alter your
portfolio’s risk-reward profile.
Coming this far in this book, you already have a good understand-
ing about how options work, so the concepts presented here will not be
difficult, but I will discuss some nuances that will help you to evaluate
investment choices and make sound decisions regarding the use of these
strategies. I will refer to strike selection and tenor selection in the following
pages, but for these, along with “The Gist” section, I’ll include an “Execu-
tion” section and a “Common Pitfalls” section.
Covered calls are an easy strategy to understand once you understand
short puts, so I will discuss those first. Protective puts share a lot of simi-
larities with in-the-money (ITM) call options, and I will discuss those next.
Mixing Exposure  •  235
Collars are just a combination of the other two overlay strategies and so are
easiest left to the end.
Long Diagonal
GREEN
RED
Downside: Overvalued
Upside: Undervalued
Execute: Sell an ATM put option (short put) and simultaneously
buy an OTM call option (long call)
Risk: Sum of put’s strike price and net premium paid for call
Reward: Unlimited
Margin: Amount equal to put’s strike price
The Gist
Other than the blank space in the middle of the diagram and the disparity
between the lengths of the tenors, the preceding diagram looks very much like
the risk-return profile diagram for a long stock—accepting downside exposure
in return for gaining upside exposure. As you can see from the diagram, the
range of exposure for the short put lies well within the Black-Scholes-Merton
model (BSM) cone, but the range of exposure for the long call is well outside
the cone. It is often possible to find short-put–long-call combinations that al-
low for an immediate net credit when setting up this investment.
236  •   The Intelligent Option Investor
Because we must fully margin a short-put investment, that leg of
the long diagonal carries with it a loss leverage ratio of –1.0. However, the
OTM call leg represents an immediate realized loss coupled with a very
high lambda value for gains.


find short-put–long-call combinations that al-
low for an immediate net credit when setting up this investment.
236  •   The Intelligent Option Investor
Because we must fully margin a short-put investment, that leg of
the long diagonal carries with it a loss leverage ratio of –1.0. However, the
OTM call leg represents an immediate realized loss coupled with a very
high lambda value for gains. As such, if the put option expires ITM, the
long diagonal is simply a levered strategy; if the put option expires OTM,
the investment is a very highly levered one because the unlevered put
ceases to influence the leverage equation. Another short put may be written
after the previous short put expires; this further subsidizes the cost of the
calls and so greatly increases the leverage on the strategy.
If the stock moves quickly toward the upper valuation range, this
structure becomes extremely profitable on an unrealized basis. If the put
option expires ITM, the investor is left with a levered long investment in
the stock in addition to the long position in the OTM. As in any other
complex structure, the investment may be ratioed—for instance, by buying
one call for every two puts sold or vice versa.
Strike Price Selection
The put should be sold ATM or close to ATM in order to maximize the time
value sold, as explained earlier in the short-put summary. The call strike may be
bought at any level depending on the investor’s appetite for leverage but is usu-
ally purchased OTM. The following table shows the net debit or credit associated
with the long diagonal between the ATM put ($55 strike price, delta of –0.42,
priced at the bid price) with an expiration of 79 days and each call strike (at the
ask price) listed, all of which are long-term equity anticipated securities (LEAPS)
having expirations in 534 days. The lambda figure for the OTM calls is also given
to provide an idea of the comparative leverage of each call option. For this exam-
ple, I am using JP Morgan Chase (JPM) when its stock was trading for $56.25.
Strike Delta (Debit) Credit Call Lambda (%)
57.50 0.43 (2.52) 5.6
60.00 0.37 (1.57) 6.1
62.50 0.31 (0.76) 6.7
65.00 0.26 (0.25) 7.0
70.00 0.16 0.78 8.4
75.00 0.10 1.28 9.5
80.00 0.06 1.56 10.5
Mixing Exposure  •  237
Here we can see that for a long diagonal using 79-day ATM puts
and 594-day LEAPS that are OTM by just over 15 percent, we are
paying a net of only $25 per contract for notional control of 100
shares. On a per-contract basis, at the following settlement prices,
we would generate the following profits (or losses, in the case of the
first row):
Settlement Price ($) Dollar Profit per Contract
Percentage Return on Original
Investment (%)
65 0 –100
66 100 300
67 200 700
68 300 1,100
69 400 1,500
70 500 1,900
71 600 2,300
72 700 2,700
73 800 3,100
74 900 3,500
75 1,000 3,900
If the stock price moves up very quickly, it might be more beneficial
to close the position or some portion of the position before expiration. Let’s
say that my upper-range estimate for this stock was $75. From the preced-
ing table, I can see that my profit per contract if the stock settles at my fair
value range is $1,000. If there is enough time value on a contract when
the stock is trading in the upper $60 range to generate a realized profit of
$1,000, I am likely to take at least some profits at that time rather than wait-
ing for the calls to expire.
In Chapter 9, I discussed portfolio composition and likened the use
of leverage as a side dish to a main course. This is an excellent side dish that
can be entered into when we see a chance to supplement the main meal of
a long stock–ITM call option position with a bit more spice. Let’s now turn
to its bearish mirror—the short diagonal.
238  •   The Intelligent Option Investor
Short Diagonal
RED
GREEN
Downside: Undervalued
Upside: Overvalued
Execute: Sell an ATM call option while buying one to cover at a
higher price (short-call spread) and simultaneously buy
an OTM put option (long put)
Risk: Sum of put’s strike price and net premium paid for call
Reward: Amount equal to the put’s strike price minus any net
premium paid for it
Margin: Amount equal to spread between call options
The Gist
The diagram for a short diagonal is just the inverse of the long diagonal and, of
course, looks very similar to the risk-return profile diagram for a short stock—
accepting upside exposure in return for gaining downside exposure. The gist
of this strategy is simply the short-exposure equivalent to the long diagonal, so
the comments about the long diagonal are applicable to this strategy as well.
The one difference is that because you must spend money to cover the short
call on the upside, the subsidy that the option sale leg provides to the option
purchase leg is less than in the case of the long diagonal. Also, of course, a stock
price cannot turn negative, so your profit upside is capped at an amount equal
to the effective sell price. This investment also may be ratioed (e.g., by using
one short-call spread to subsidize two long puts).
Mixing Exposure  •  239
Strike Price Selection
Strike price selection for a short diagonal is more difficult because there
are three strikes to price this time. Looking at the current pricing for a
call spread with the short call struck at $55, I get the following selection of
credits:
Upper Call Strike ($)
Call Spread
Net Credit ($)
Percent Total
Risk Percent Total Return
57.50 1.27 17 49
60.00 2.14 33 83
62.50 2.44 50 94
65.00 2.51 67 97
70.00 2.59 100 100
Looking at this, let’s say we decide to go with the $55.00/$62.50 call
spread. Doing so, we would receive a net credit of $2.44. Now selecting the
put to purchase is a matter of figuring out the leverage of the position with
which you are comfortable.
Strike ($) Delta (Debit) Credit ($) Put Lambda (%)
20.00 –0.02 2.20 –4.5
23.00 –0.02 2.11 –4.6
25.00 –0.03 2.05 –4.6
28.00 –0.04 1.91 –4.8
30.00 –0.05 1.78 –4.8
33.00 –0.07 1.57 –4.8
35.00


with the $55.00/$62.50 call
spread. Doing so, we would receive a net credit of $2.44. Now selecting the
put to purchase is a matter of figuring out the leverage of the position with
which you are comfortable.
Strike ($) Delta (Debit) Credit ($) Put Lambda (%)
20.00 –0.02 2.20 –4.5
23.00 –0.02 2.11 –4.6
25.00 –0.03 2.05 –4.6
28.00 –0.04 1.91 –4.8
30.00 –0.05 1.78 –4.8
33.00 –0.07 1.57 –4.8
35.00 –0.09 1.38 –4.8
38.00 –0.12 0.99 –4.8
40.00 –0.15 0.67 –4.7
42.00 –0.17 0.30 –4.7
45.00 –0.23 (0.43) –4.5
47.00 –0.26 (1.01) –4.4
50.00 –0.33 (1.91) –4.4
52.50 –0.39 (3.11) –4.0
240  •   The Intelligent Option Investor
Notice that there is much less leverage on the long-put side than on
the long-call side. This is a function of the volatility smile and the abnor -
mally high pricing on the far OTM put side. It turns out that the $20-strike
puts have an implied volatility of 43.3 percent compared to an ATM im-
plied volatility of 22.0 percent.
Obviously, the lower level of leverage will make closing before expira-
tion less attractive, so it is important to select a put strike price between the
present market price and your worst-case fair value estimate. In this way,
if the option does expire when the stock is at that level, you will at least be
able to realize the profit of the intrinsic value.
With these explanations of the primary mixed-exposure strategies,
now let’s turn to overlays—where an option position is added to a stock
position to alter the risk-return characteristics of the investor’s portfolio.
Covered Call
Contingent Upside Exposure
Contingent Downside Exposure
LIGHT GREEN
RED
LIGHT RED
Downside: Overvalued
Upside: Fairly valued or undervalued
Mixing Exposure  •  241
Execute: Buy common stock and simultaneously sell a call option
Risk: Strike price minus premium received
Reward: Limited to premium and, as long as the shares are not called,
the dividends received during the tenor of the option
Margin: None as long as stock and option positions are evenly
matched—long stock position serves as collateral for the
sold call
The Gist
If you look just as far as the option tenor lasts on the preceding diagram,
you will see that the risk-return profile is identical to that of a short put. As
evidence, please compare the following two diagrams:
We have sold
away the upside
exposure so are
left with only
the acceptance
of downside
exposure here.
RED
Covered call
242  •   The Intelligent Option Investor
We accepted
downside
exposure when
we sold this
put, so have no
exposure to the
upside here.
RED
The top of the “Covered call” diagram is grayed out because we have
sold away the upside exposure to the stock by selling the call option, and
we are left only with the acceptance of the stock’s downside exposure. The
pictures are slightly different, but the economic impact is the same.
The other difference you will notice is that after the option expires, in the
case of the covered call, we have represented the graphic as though there is some
residual exposure. This is represented in this way because if the option expires
ITM, you will have to deliver your stock to the counterparty who bought your
call options. As such, your future exposure to the stock is contingent on another
investor’s actions and the price movement of the stock. This is an important point
to keep in mind, and I will discuss it more in the “Common Pitfalls” section.
Execution
Because this strategy is identical from a risk-reward perspective to short
puts, the execution details should be the same as well. Indeed, covered
calls should—like short puts—be executed ATM to get the most time value
possible and preferably should be done on a stock that has had a recent fall
and whose implied volatility has spiked. However, these theoretical points
Short put
Mixing Exposure  •  243
ignore the fact that most people simply want to generate a bit of extra in-
come out of the holdings they already have and so are psychologically re-
sistant to both selling ATM (because this makes it more likely for their
shares to be called away) and selling at a time when the stock price sud-
denly drop (because they want to reap the benefit of the shares recovering).
Although I understand these sentiments, it is important to realize
that options are financial instruments and not magical ones. It would be
nice if we could simply find an investment tool that we could bolt onto
our present stock holdings that would increase the dividend a nice amount
but that wouldn’t put us at risk of having to deliver our beloved stocks to a
complete stranger; unfortunately, this is not the case for options.
For example, let’s say that you own stock in a company that is paying out
a very nice dividend yield of 5 percent at present prices. This is a mature firm
that has tons of cash flow but few opportunities for growth, so management
has made the welcome choice to return cash to shareholders. The stock is trad-
ing at $50 per share, but because the dividend is attractive to you, you are loathe
to part with the stock. As such, you would prefer to write the covered call at a
$55 or even a $60 strike price. A quick look at the BSM cone tells us why you
should not be expecting a big boost in yield from selling the covered calls:
80
Sold call
range of
exposure
70
60
50
40
30
20
5/18/2012 5/20/2013 249 499 749 999
Cash Flows R Us, Inc. (CASH)
Date/Day Count
Stock Price
GREEN
LIGHT GREENGRAY
LIGHT REDRED
244  •   The Intelligent Option Investor
Clearly, the range of exposure for the $55-strike call is well above the
BSM cone. The BSM cone is pointing downward because the dividend rate
is 5 percent—higher than the risk-free rate. This means that BSM drift will
be lower. In addition, because this is an old, mature, steady-eddy kind of
company, the expected forward volatility is low. Basically, this is a perfect
storm for a low option price.
My suggestion is to either write calls on stocks you don’t mind de-
livering to someone else—stocks


ng downward because the dividend rate
is 5 percent—higher than the risk-free rate. This means that BSM drift will
be lower. In addition, because this is an old, mature, steady-eddy kind of
company, the expected forward volatility is low. Basically, this is a perfect
storm for a low option price.
My suggestion is to either write calls on stocks you don’t mind de-
livering to someone else—stocks for which you are very confident in the
valuation range and are now at or above the upper bound—or simply to
look for a portfolio of short-put/covered-call investments and treat it like
a high-yield bond portfolio, as I described in Chapter 10 when explaining
short puts. It goes without saying that if you think that a stock has a lot of
unappreciated upside potential, it’s not a good idea to sell that exposure
away!
One other note about execution: as I have said, short puts and cov-
ered calls are the same thing, but a good many investors do not realize this
fact or their brokerages prevent them from placing any trade other than a
covered call. This leads to a situation in which there is a tremendous sup-
ply of calls. Any time there is a lot of supply, the price goes down, and you
will indeed find covered calls on some companies paying a lot less than
the equivalent short put. Because you will be accepting the same downside
exposure, it is better to get paid more for it, so my advice is to write the put
rather than the covered call in such situations.
To calculate returns for covered calls, I carry out the following steps:
1. Assume that you buy the underlying stock at the market price.
2. Deduct the money you will receive from the call sale as well as
any projected dividends—these are the two elements of your cash
inflow—from the market price of the stock. The resulting figure is
your effective buy price (EBP).
3. Divide your total cash inflow by the EBP .
I always include the projected dividend payment as long as I am writ-
ing a short-tenor covered call and there are no issues with the company
that would prevent it from paying the dividend. Owners of record have a
right to receive dividends, even after they have written a covered call on the
Mixing Exposure  •  245
stock, so it makes sense to count the dividend inflow as one element that
reduces your EBP . In formula form, this turns out to be
−−Coveredc allr eturn= premiumr eceivedf romc all+ projectedd ividends
stockp rice premiumf romc allp rojected dividends
For a short put, you have no right to receive the dividend, so I find the
return using the following formula:
−Shortp ut return= premiumr eceivedf roms hort put
strikepricep remium from shortp ut
Common Pitfalls
Taking Profit
One mistake I hear people make all the time is saying that they are going
to “take profit” using a covered call. Writing a covered call is taking profit
in the sense that you no longer enjoy capital gains from the stock’s appre-
ciation, but it is certainly not taking profit in the sense of being immune
to falls in the market price of the stock. The call premium you receive will
cushion a stock price drop, but it will certainly not shield you from it. If
you want to take profits on a successful stock trade, hit the “Sell” button.
Locking in a Loss
A person sent me an e-mail telling me that she had bought a stock at $17,
sold covered calls on it when it got to $20 (in order to “take profits”), and
now that the stock was trading for $11, she wanted to know how she could
“repair” her position using options. Unfortunately, options are not magical
tools and cannot make up for a prior decision to buy a stock at $17 and ride
it down to $11.
If you are in such a position, don’t panic. It will be tempting to write
a new call at the lower ATM price ($11 in this example) because the cash
inflow from that covered call will be the most. Don’t do it. By writing a
covered call at the lower price, you are—if the shares are called away—
locking in a realized loss on the position. Y ou can see this clearly if you list
each transaction in the example separately.
246  •   The Intelligent Option Investor
No. Buy/Sell Instrument
Price of
Instrument
Effective
Buy (Sell)
Price of
Stock Note
1 Buy Stock $17/share $17/share Original purchase
2 Sell Call option $1/share $16/share Selling a covered call
to take profits when
stock reaches $20/
share leaves the
investor with down-
side exposure and $1
in premium income.
3 Sell Call option $0.75 ($11.75/
share)
Stock falls to $11, and
investor sells another
covered call to
generate income to
ameliorate the loss.
In transaction 1, the investor buys the shares for $17. In transaction 2,
when the stock hits $20 per share, the investor sells a covered call and receives
$1 in premium. This reduces the effective buy price to $16 per share and
means that the investor will have to deliver the shares if the stock is trad-
ing at $20 or above at expiration. When the stock instead falls to $11, the
investor—wanting to cushion the pain of the loss—sells another ATM cov-
ered call for $0.75. This covered call commits the investor to sell the shares
for $11.75. No matter how you look at it, buying at $16 per share and sell-
ing at $11.75 per share is not a recipe for investing success.
The first step in such a situation as this—when the price of a stock
on which you have accepted downside exposure falls—is to look back
to your valuation. If the value of the firm has indeed dropped because
of some material negative news and the position no longer makes sense
from an economic perspective, just sell the shares and take the lumps.
If, however, the stock price has dropped but the valuation still makes
for a compelling investment, stay in the position; if the investment is
Mixing Exposure  •  247
compelling enough, this is the time to figure out a clever way to get more
exposure to it.
Y ou can write calls as long as they are at least at the same strike
price as your previous purchase price or EBP; th


nd take the lumps.
If, however, the stock price has dropped but the valuation still makes
for a compelling investment, stay in the position; if the investment is
Mixing Exposure  •  247
compelling enough, this is the time to figure out a clever way to get more
exposure to it.
Y ou can write calls as long as they are at least at the same strike
price as your previous purchase price or EBP; this just means that you
are buying at $16 and agreeing to sell at at least $16, in other words. Also
keep in mind that any dividend payment you receive you can also think
of as a reduction of your EBP—that cash inflow is offsetting the cost of
the shares. Factoring in dividends and the (very small) cash inflow as-
sociated with writing far OTM calls will, as long as you are right about
the valuation, eventually reduce your EBP enough so that you can make
a profit on the investment.
Over-/Underexposure
Options are transacted in contract sizes of 100 shares. If you hold a number
of shares that is not evenly divisible by 100, you must decide whether you
are going to sell the next number down of contracts or the next number
up. For example, let’s say that you own 250 shares of ABC. Y ou can either
choose to sell two call contracts (in which case you will not be receiving
yield on 50 of your shares) or sell three call contracts (in which case you
will be effectively shorting 50 shares). My preference is to sell fewer con-
tracts controlling fewer shares than I hold, and in fact, your broker may or
may not insist that you do so as well. If not, it is an unpleasant feeling to get
a call from a broker saying that you have a margin call on a position that
you didn’t know you had.
Getting Assigned
If you write covered calls, you live with the risk that you will have to deliver
your beloved shares to a stranger. Y ou can deliver your shares and use the
proceeds from that sale (the broker will deposit an amount equal to the
strike price times the contract multiplier into your account, and you get
to keep the premium you originally received) to buy the shares again, but
there is no way around delivering the shares if assigned.
248  •   The Intelligent Option Investor
Now that you understand covered calls, let’s turn to protective
puts.
Protective Puts
LIGHT GREEN
RED
GRAY
Downside: Irrelevant
Upside: Undervalued
Execute: Buy common stock and simultaneously buy a put op-
tion (the diagram shows the purchase of an OTM put
option)
Risk: Purchase price of stock minus strike price of put option
minus premium paid
Reward: Unlimited, less premium paid for put option, which can-
not be recovered
Margin: None because this is a purchase of an option
The Gist
If you look just as far as the option tenor lasts in the preceding diagram,
you will see that the risk-return profile is identical to that of a short put. As
evidence, please compare the following two diagrams:
Mixing Exposure  •  249
GREEN
RED
GRAY
GREEN
ORANGE
Protective put
ITM call
250  •   The Intelligent Option Investor
The graphic conventions are a little different, but both diagrams show
the acceptance of a narrow band of downside exposure offset by a bound-
less gain of upside exposure. The area below the protective put’s strike price
shows that economic exposure has been neutralized, and the area below
the ITM call shows no economic exposure. The pictures are slightly differ-
ent, but the economic impact is the same.
The objective of a protective put is obvious—allow yourself the
economic benefits from gaining upside exposure while shielding yourself
from the economic harm of accepting downside exposure. The problem is
that this protection comes at a price. I will provide more infromation about
this in the next section.
Execution
Everyone understands the concept of protective puts—it’s just like the
home insurance you buy every year to insure your property against dam-
age. If you buy an OTM protective put (let’s say one struck at 90 percent of
the current market price of the stock), the exposed amount from the stock
price down to the put strike can be thought of as your “deductible” on your
home insurance policy. The premium you pay for your put option can be
thought of as the “premium” you pay on your home insurance policy.
Okay—let’s go shopping for stock insurance. Apple (AAPL) is trad-
ing for $452.53 today, so I’ll price both ATM and OTM put insurance for
these shares with an expiration of 261 days in the future. I’ll also annualize
that rate.
Strike ($) “Deductible” ($) “Premium” ($)
Premium as
Percent of
Stock Price
Annualized
Premium (%)
450 2.53 40.95 9.1 12.9
405 47.53 20.70 4.6 6.5
360 92.53 8.80 1.9 2.7
Now, given these rates and assuming that you are insuring a $500,000
house, the following table shows what equivalent deductibles, annual
premiums, and total liability to a home owner would be for deductibles
equivalent to the strike prices I’ve picked for Apple:
Mixing Exposure  •  251
Equivalent
AAPL Strike ($) Deductible ($) Annual Premium ($)
Total Liability to Home
Owner ($)
450 2,795 64,500 67,295
405 52,516 32,500 85,016
360 102,236 13,500 115,736
I know that I would not be insuring my house at these rates and under
those conditions! In light of these prices, the first thing you must consider
is whether protecting a particular asset from unrealized price declines is
worth the huge realized losses you must take to buy put premium. Buying
ATM put protection on AAPL is setting up a 12.9 percent hurdle rate that
the stock must surpass in one year just for you to start making a profit on
the position, and 13 percent per year is quite a hurdle rate!
If there is some reason why you believe that you need to pay for insurance,
a better option—cheaper from a realized loss perspective—would be to sell
the shares and use part of the proceeds to buy call options as an option-based
replacement for the stock position. This approach has a few benefits:
1. The risk-reward profile is exactly the sa