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:

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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 same between the two
structures.
2. Any ATM or ITM call will be more lightly levered than any OTM
put, meaning a lower realized loss on initiation.
3. For dividend-paying stocks, call owners do not have the right to
receive dividends, but the amount of the projected dividend is de-
ducted from the premium (as part of the drift calculation shown
in the section on covered calls). As such, although not being paid
dividends over time, you are getting what amounts to a one-time
upfront dividend payment.
4. If you do not like the thought of leverage in your portfolio, you can
self-margin the position (i.e., keep enough cash in reserve such that
you are not “borrowing” any money through the call purchase).
I do not hedge individual positions, but I do like the ITM call op-
tion as an alternative for people who feel the need to do so. For hedg-
ing of a general portfolio, rather than hedging of a particular holding in
a portfolio, options on sector or index exchange-traded funds (ETFs) are
more reasonably priced. Here are the ask prices for put options on the SPX

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

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

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

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290  •   The Intelligent Option Investor
preceding equation, we can see that the left side of the equation is levered
(because it contains only options, and options are levered instruments),
and the right side is unlevered. Obviously, then, the two cannot be exactly
the same.
We can fix this problem by delevering the left side of the preceding
equation. Any time we sell a put option, we have to place cash in a mar -
gin account with our broker. Recall that a short put that is fully margined
is an unlevered instrument, so margining the short put should delever
the entire option position. Let’s add a margin account to the left side and
put $K in it:
C
K − PK + K = S
This equation simply says that if you sell a put struck at K and put $K
worth of margin behind it while buying a call option, you’ll have the same
risk, return, and leverage profile as if you bought a stock—just as in our
big-picture diagram.
But this is not quite right if one is dealing with small differences.
First, let’s say that you talk your broker into funding the margin ac-
count using a risk-free bond fund that will pay some fixed amount of
interest over the next year. To fund the margin account, you tell your
broker you will buy enough of the bond account that one year from
now, when the put expires, the margin account’s value will be exactly
the same as the strike price. In this way, even by placing an amount less
than the strike price in your margin account originally, you will be able
to fulfill the commitment to buy the stock at the strike price if the put
expires in the money (ITM). The amount that will be placed in margin
originally will be the strike price less the amount of interest you will
receive from the risk-free bond. In mathematical terms, the preceding
equation becomes
C
K − PK + (K – Int) = S
Now all is right with the world. For a non-dividend-paying stock, this fully
expresses the technical definition of put-call parity.
However, because we are talking about dividend arbitrage, we have to
think about how to adjust our equation to include dividends. We know that
a call option on a dividend-paying stock is worth less because the dividend

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Appendix C: Put-Call Parity   • 291
acts as a “negative drift” term in the BSM. When a dividend is paid, theory
says that the stock price should drop by the amount of the dividend. Be-
cause a drop in price is bad for the holder of a call option, the price of a call
option is cheaper by the amount of the expected dividend.
Thus, for a dividend-paying stock, to establish an option-based position
that has exactly the same characteristics as a stock portfolio, we have to keep
the expected amount of the dividend in our margin account.
1 This money
placed into the option position will make up for the dividend that will be
paid to the stock holder. Here is how this would look in our equation:
C
K − PK + (K − Int) + Div = S
With the dividend payment included, our equation is complete.
Now it is time for some algebra. Let’s rearrange the preceding equa-
tion to see what the call option should be worth:
CK = PK + Int − Div + (S − K)
Taking a look at this, do you notice last term (S – K )? A stock’s price
minus the strike price of a call is the intrinsic value. And we know that
the value of a call option consists of intrinsic value and time value. This
means that
/dncurlybracketleft/dncurlybracketmid/horizcurlybracketext/horizcurlybracketext/dncurlybracketright/horizcurlybracketext/horizcurlybracketext/dncurlybracketleft/dncurlybracketmid/dncurlybracketright=+ −−CP SKKK IntD iv + ()
Time valueI ntrinsic value
So now let’s say that time passes and at the end of the year, the stock
is trading at $70—deep ITM for our $50-strike call option. On the day
before expiration, the time value will be very close to zero as long as the op-
tion is deep ITM. Building on the preceding equation, we can put the rule
about the time value of a deep ITM option in the following mathematical
equation:
P
K + Int − Div ≈ 0
If the time value ever falls below 0, the value of the call would trade for less
than the intrinsic value. Of course, no one would want to hold an option
that has negative time value. In mathematical terms, that scenario would
look like this:
P
K + Int − Div < 0

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292  •   The Intelligent Option Investor
From this equation, it follows that if
PK + Int < Div
your call option has a negative implied time value, and you should sell the
option in order to collect the dividend.
This is what is meant by dividend arbitrage . But it is hard to get the
flavor for this without seeing a real-life example of it. The following table
shows the closing prices for Oracle’s stock and options on January 9, 2014,
when they closed at $37.72. The options had an expiration of 373 days in
the future—as close as I could find to one year—the one-year risk-free rate
was 0.14 percent, and the company was expected to pay $0.24 worth of
dividends before the options expired.
Calls Puts
Bid Ask Delta Strike Bid Ask Delta
19.55 19.85 0.94 18 0.08 0.13 −0.02
17.60 17.80 0.94 20 0.13 0.15 −0.03
14.65 14.85 0.92 23 0.25 0.28 −0.05
12.75 12.95 0.91 25 0.36 0.39 −0.07
10.00 10.25 0.86 28 0.66 0.69 −0.12
8.30 8.60 0.81 30 0.97 1.00 −0.17
6.70 6.95 0.76 32 1.40 1.43 −0.23
4.70 4.80 0.65 35 2.33 2.37 −0.34
3.55 3.65 0.56 37 3.15 3.25 −0.43
2.22 2.26 0.42 40 4.80 4.90 −0.57
1.55 1.59 0.33 42 6.15 6.25 −0.65
0.87 0.90 0.22 45 8.25 8.65 −0.75
0.31 0.34 0.10 50 12.65 13.05 −0.87
In the theoretical option portfolio, we are short a put, so its value to
us is the amount we would have to pay if we tried to flatten the position by
buying it back—the ask price. Conversely, we are long a call, so its value to
us is the price we could sell it for—the bid price.
Let’s use these data to figure out which calls we might want to exercise
early if a dividend payment was coming up.

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Chapter 1: Definitions s
Striking Price. Striking prices are generally spaced 5 points apart for stocks,
although for more expensive stocks, the striking prices may be 10 points apart.
A $35 stock might, for example, have options with striking prices, or "strikes," of
30, 35, and 40, while a $255 stock might have one at 250 and one at 260.
Moreover, some stocks have striking prices that are 2½ points apart - generally
those selling for less than $35 per share. That is, a $17 stock might have strikes
at 15, 17½, and 20.
These striking price guidelines are not ironclad, however. Exchange officials
may alter the intervals to improve depth and liquidity, perhaps spacing the strikes 5
points apart on a nonvolatile stock even if it is selling for more than $100. For exam
ple, if a $155 stock were very active, and possibly not volatile, then there might well
be a strike at 155, in addition to those at 150 and 160.
Expiration Dates. Options have expiration dates in one of three fixed cycles:
L the January/April/July/October cycle,
2. the February/May/August/November cycle, or
3. the March/June/September/December cycle.
In addition, the two nearest months have listed options as well. However, at any given
time, the longest-term expiration dates are normally no farther away than 9 months.
Longer-term options, called LEAPS, are available on some stocks (see Chapter 25).
Hence, in any cycle, options may expire in 3 of the 4 major months (series) plus the
near-term months. For example, on February 1 of any year, XYZ options may expire
in February, March, April, July, and October - not in January. The February option
( the closest series) is the short- or near-term option; and the October, the far- or long
term option. If there were LEAPS options on this stock, they would expire in January
of the following year and in January of the year after that.
The exact date of expiration is fixed within each month. The last trading day for
an option is the third Friday in the expiration month. Although the option actually
does not expire until the following day (the Saturday following), a public customer
must invoke the right to buy or sell stock by notifying his broker by 5:30 P.M., New
York time, on the last day of trading.
THE OPTION ITSELF: OTHER DEFINITIONS
Classes and Series. A class of options refers to all put and call contracts on the
same underlying security. For instance, all IBM options - all the puts and calls at
various strikes and expiration months - form one class. A series, a subset of a class,

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6 Part I: Basic Properties of Stock Options
consists of all contracts of the same class (IBM, for example) having the same expi
ration date and striking price.
Opening and Closing Transactions. An opening transaction is the ini
tial transaction, either a buy or a sell. For example, an opening buy transaction
creates or increases a long position in the customer's account. A closing trans
action reduces the customer's position. Opening buys are often followed by clos
ing sales; correspondingly, opening sells often precede closing buy trades.
Open Interest. The option exchanges keep track of the number of opening
and closing transactions in each option series. This is called the open interest.
Each opening transaction adds to the open interest and each closing transaction
decreases the open interest. The open interest is expressed in number of option
contracts, so that one order to buy 5 calls opening would increase the open
interest by 5. Note that the open interest does not differentiate between buyers
and sellers - there is no way to tell if there is a preponderance of either one.
While the magnitude of the open interest is not an extremely important piece of
data for the investor, it is useful in determining the liquidity of the option in
question. If there is a large open interest, then there should be little problem in
making fairly large trades. However, if the open interest is small - only a few
hundred contracts outstanding - then there might not be a reasonable second
ary market in that option series.
The Holder and Writer. Anyone who buys an option as the initial transac
tion - that is, buys opening - is called the holder. On the other hand, the
investor who sells an option as the initial transaction - an opening sale - is called
the writer of the option. Commonly, the writer ( or seller) of an option is referred
to as being short the option contract. The term "writer" dates back to the over
the-counter days, when a direct link existed between buyers and sellers of
options; at that time, the seller was the writer of a new contract to buy stock. In
the listed option market, however, the issuer of all options is the Options
Clearing Corporation, and contracts are standardized. This important difference
makes it possible to break the direct link between the buyer and seller, paving
the way for the formation of the secondary markets that now exist.
Exercise and Assignment. An option owner ( or holder) who invokes the
right to buy or sell is said to exercise the option. Call option holders exercise to
buy stock; put holders exercise to sell. The holder of most stock options may
exercise the option at any time after taking possession of it, up until 8:00 P.M. on

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O,apter 1: Definitions 7
the last trading day; the holder does not have to wait until the expiration date
itself before exercising. (Note: Some options, called "European" exercise
options, can be exercised only on their expiration date and not before - but they
are generally not stock options.) These exercise notices are irrevocable; once
generated, they cannot be recalled. In practical terms, they are processed only
once a day, after the market closes. Whenever a holder exercises an option,
somewhere a writer is assigned the obligation to fulfill the terms of the option
contract: Thus, if a call holder exercises the right to buy, a call writer is assigned
the obligation to sell; conversely, if a put holder exercises the right to sell, a put
writer is assigned the obligation to buy. A more detailed description of the exer
cise and assignment of call options follows later in this chapter; put option exer
cise and assignment are discussed later in the book.
RELATIONSHIP OF THE OPTION PRICE AND STOCK PRICE
In- and Out-of-the-Money. Certain terms describe the relationship between
the stock price and the option's striking price. A call option is said to be out-of-the
money if the stock is selling below the striking price of the option. A call option is in
the-money if the stock price is above the striking price of the option. (Put options
work in a converse manner, which is described later.)
Example: XYZ stock is trading at $47 per share. The XYZ July 50 call option is out
of-the-money, just like the XYZ October 50 call and the XYZ July 60 call. However,
the XYZ July 45 call, XYZ October 40, and XYZ January 35 are in-the-money.
The intrinsic value of an in-the-money call is the amount by which the stock
price exceeds the striking price. If the call is out-of-the-money, its intrinsic value is
zero. The price that an option sells for is commonly referred to as the premium. The
premium is distinctly different from the time value premium ( called time premium,
for short), which is the amount by which the option premium itself exceeds its intrin
sic value. The time value premium is quickly computed by the following formula for
an in-the-money call option:
Call time value premium = Call option price + Striking price - Stock price
Example: XYZ is trading at 48, and XYZ July 45 call is at 4. The premium - the total
price - of the option is 4. With XYZ at 48 and the striking price of the option at 45,
the in-the-money amount (or intrinsic value) is 3 points (48-45), and the time value
isl(4-3).

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8 Part I: Basic Properties ol Stoclc Options
If the call is out-of-the-money, then the premium and the time value premium
are the same.
Example: With XYZ at 48 and an XYZ July 50 call selling at 2, both the premium and
the time value premium of the call are 2 points. The call has no intrinsic value by
itself with the stock price below the striking price.
An option normally has the largest amount of time value premium when the
stock price is equal to the striking price. As an option becomes deeply in- or out-of
the-money, the time value premium shrinks substantially. Table 1-1 illustrates this
effect. Note that the time value premium increases as the stock nears the striking
price (50) and then decreases as it draws away from 50.
Parity. An option is said to be trading at parity with the underlying security if
it is trading for its intrinsic value. Thus, if XYZ is 48 and the xyz July 45 call is
selling for 3, the call is at parity. A common practice of particular interest to
option writers ( as shall be seen later) is to refer to the price of an option by relat
ing how close it is to parity with the common stock. Thus, the XY2 July 45 call
is said to be a half-point over parity in any of the cases shown in Table 1-2.
TABLE 1-1.
Changes in time value premium.
XYZ Stock XYZ Jul 50 Intrinsic Time Value
Price Call Price Value Premium
40 1/2 0 ¼
43 1 0 1
35 2 0 2
47 4 0 3
➔50 5 0 5
53 7 3 4
55 8 5 3
57 9 7 2
60 101/2 10 ¼
70 191/2 20 -1/20
asimplistically, a deeply in-the-money call may actually trade at a discount from intrinsic value,
because call buyers are more interested in less expensive calls that might return better percentage
profits on an upward move in the stock. This phenomenon is discussed in more detail when arbitrage
techniques are examined.

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Cl,apter 1: Definitions 9
TABLE 1-2.
Comparison of XYZ stock and call prices.
XYZ July 45 XYZ Stock Over
Striking Price + Coll Price Price Parity
(45 + 45 1/2) 1/2
(45 + 21/2 47 ) 1/2
(45 + 51/2 50 ) ½
(45 + 151/2 60 ) 1/2
FACTORS INFLUENCING THE PRICE OF AN OPTION
An option's price is the result of properties of both the underlying stock and the terms
of the option. The major quantifiable factors influencing the price of an option are
the:
1.. price of the underlying stock,
2. striking price of the option itself,
3. time remaining until expiration of the option,
4. volatility of the underlying stock,
5. current risk-free interest rate (such as for 90-day Treasury bills), and
6. dividend rate of the underlying stock.
The first four items are the major determinants of an option's price, while the latter
two are generally less important, although the dividend rate can be influential in the
case of high-yield stock.
THE FOUR MAJOR DETERMINANTS
Probably the most important influence on the option's price is the stock price,
because if the stock price is far above or far below the striking price, the other fac
tors have little influence. Its dominance is obvious on the day that an option expires.
On that day, only the stock price and the striking price of the option determine the
option's value; the other four factors have no bearing at all. At this time, an option is
worth only its intrinsic value.
Example: On the expiration day in July, with no time remaining, an XYZ July 50 call
has the value shown in Table 1-3; each value depends on the stock price at the time.

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10 Part I: Basic Properties of Stock Options
TABLE 1-3.
XYZ option's values on the expiration day.
XYZ July 50 Coll
(Intrinsic) Value
XYZ Stock Price ot Expiration
40
45
48
50
52
55
60
0
0
0
0
2
5
10
The Call Option Price Curve. The call option price curve is a curve that
plots the prices of an option against various stock prices. Figure 1-1 shows the
axes needed to graph such a curve. The vertical axis is called Option Price. The
horizontal axis is for Stock Price. This figure is a graph of the intrinsic value.
When the option is either out-of-the-money or equal to the stock price, the
intrinsic value is zero. Once the stock price passes the striking price, it reflects
the increase of intrinsic value as the stock price goes up. Since a call is usually
worth at least its intrinsic value at any time, the graph thus represents the min
imum price that a call may be worth.
FIGURE 1-1.
The value of an option at expiration, its intrinsic value.
~
it
C:
.Q
15..
0 The intrinsic value line
bends at the
st~iking ~
pnce. ~
Stock Price

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Chapter 1: Definitions 11
When a call has time remaining to its expiration date, its total price consists of
its intrinsic value plus its time value premium. The resultant call option price curve
takes the form of an inverted arch that stretches along the stock price axis. If one
plots the data from Table 1-4 on the grid supplied in Figure 1-2, the curve assumes
two characteristics:
1. The time value premium ( the shaded area) is greatest when the stock price and
the striking price are the same.
2. When the stock price is far above or far below the striking price (near the ends
of the curve), the option sells for nearly its intrinsic value. As a result, the curve
nearly touches the intrinsic value line at either end. [Figure 1-2 thus shows both
the intrinsic value and the option price curve.]
This curve, however, shows only how one might expect the XYZ July 50 call
prices to behave with 6 months remaining until expiration. As the time to expiration
grows shorter, the arched line drops lower and lower, until, on the final day in the life
of the option, it merges completely with the intrinsic value line. In other words, the
call is worth only its intrinsic value at expiration. Examine Figure 1-3, which depicts
three separate XYZ calls. At any given stock price (a fixed point on the stock price
scale), the longest-term call sells for the highest price and the nearest-term call sells
for the lowest price. At the striking price, the actual differences in the three option
prices are the greatest. Near either end of the scale, the three curves are much clos
er together, indicating that the actual price differences from one option to another
are small. For a given stock price, therefore, option prices decrease as the expiration
date approaches.
TABLE 1-4.
The prices of a hypothetical July 50 call with 6 months of time
remaining, plotted in Figure 1-2.
XYZ Stock Price
(Horizontal Axis)
40
45
48
➔SO
52
55
60
XYZ July 50
Call Price
(Vertical Axis)
2
3
4
5
61/2
11
Intrinsic
Value
0
0
0
0
2
5
10
Time Value
Premium
(Shading)
2
3
4
3
11/2
1

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Chapter 1: Definitions 13
This statement is true no matter what the stock price is. The only reservation is
that with the stock deeply in- or out-of-the-money, the actual difference between the
January, April, and July calls will be smaller than with XYZ stock selling at the strik
ing price of 50.
Time Value Premium Decay. In Figure 1-3, notice that the price of the 9-
month call is not three times that of the 3-month call. Note next that the curve
in Figure 1-4 for the decay of time value premium is not straight; that is, the rate
of decay of an option is not linear. An option's time value premium decays much
more rapidly in the last few weeks of its life ( that is, in the weeks immediately
preceding expiration) than it does in the first few weeks of its existence. The rate
of decay is actually related to the square root of the time remaining. Thus, a 3-
month option decays (loses time value premium) at twice the rate of a 9-month
option, since the square root of 9 is 3. Similarly, a 2-month option decays at
twice the rate of a 4-month option (-..f4 = 2).
This graphic simplification should not lead one to believe that a 9-month option
necessarily sells for twice the price of a 3-month option, because the other factors
also influence the actual price relationship between the two calls. Of those other fac
tors, the volatility of the underlying stock is particularly influential. More volatile
underlying stocks have higher option prices. This relationship is logical, because if a
FIGURE 1-4.
Time value premium decay, assuming the stock price remains con
stant.
9 4
Time Remaining Until Expiration
(Months)
0

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14 Part I: Basic Properties ol Stodc Options
stock has the ability to move a relatively large distance upward, buyers of the calls are
willing to pay higher prices for the calls - and sellers demand them as well. For exam
ple, if AT&T and Xerox sell for the same price (as they have been known to do), the
Xerox calls would be more highly priced than the AT&T calls because Xerox is a more
volatile stock than AT&T.
The interplay of the four major variables - stock price, striking price, time, and
volatility can be quite complex. While a rising stock price (for example) is directing
the price of a call upward, decreasing time may be simultaneously driving the price
in the opposite direction. Thus, the purchaser of an out-of-the-money call may wind
up with a loss even after a rise in price by the underlying stock, because time has
eroded the call value.
THE TWO MINOR DETERMINANTS
The Risk-Free Interest Rate. This rate is generally construed as the current
rate of 90-day Treasury bills. Higher interest rates imply slightly higher option pre
miums, while lower rates imply lower premiums. Although members of the financial
community disagree as to the extent that interest rates actually affect option price,
they remain a factor in most mathematical models used for pricing options. (These
models are covered much later in this book.)
The Cash Dividend Rate of the Underlying Stock. Though not clas
sified as a major determinant in option prices, this rate can be especially impor
tant to the writer (seller) of an option. If the underlying stock pays no dividends
at all, then a call option's worth is strictly a function of the other five items.
Dividends, however, tend to lower call option premiums: The larger the dividend
of the underlying common stock, the lower the price of its call options. One of
the most influential factors in keeping option premiums low on high-yielding
stock is the yield itself.
Example: XYZ is a relatively low-priced stock with low volatility selling for $25 per
share. It pays a large annual dividend of $2 per share in four quarterly payments of
$.50 each. What is a fair price of an XYZ call with striking price 25?
A prospective buyer of XYZ options is determined to figure out a fair price. In
six months XYZ will pay $1 per share in dividends, and the stock price will thus be
reduced by $1 per share when it goes ex-dividend over that time period. In that case,
if XYZ's price remains unchanged except for the ex-dividend reductions, it will then
be $24. Moreover, since XYZ is a nonvolatile stock, it may not readily climb back to
25 after the ex-dividend reductions. Therefore, the call buyer makes a low bid - even

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18 Part I: Basic Properties of Stock Options
bring greater potential to a portfolio. Or if the customer is already short the XYZ
stock, he is going to have to buy 100 shares and pay the commissions sooner or later
in any case; so exercising the call at the lower stock price of 45 may be more desir
able than buying at the current price of 55.
ANTICIPATING ASSIGNMENT
The writer of a call often prefers to buy the option back in the secondary market,
rather than fulfill the obligation via a stock transaction. It should be strJssed again that
once the writer receives an assignment notice, it is too late to attempt to buy back
(cover) the call. The writer must buy before assignment, or live up to the terms upon
assignment. The writer who is aware of the circumstances that generally cause the
holders to exercise can anticipate assignment with a fair amount of certainty. In antic
ipation of the assignment, the writer can then close the contract in the secondary mar
ket. As long as the writer covers the position at any time during a trading day, he can
not be assigned on that option. Assignment notices are determined on open positions
as of the close of trading each day. The crucial question then becomes, "How can the
writer anticipate assignment?" Several circumstances signal assignments:
1. a call that is in-the-money at expiration,
2. an option trading at a discount prior to expiration, or
3. the underlying stock paying a large dividend and about to go ex-dividend.
Automatic Exercise. Assignment is all but certain if the option is in-the
money at expiration. Should the stock close even a half-point above the striking
price on the last day of trading, the holder will exercise to take advantage of the
half-point rather than let the option expire. Assignment is nearly inevitable even
if a call is only a few cents in-the-money at expiration. In fact, even if the call
trades in-the-money at any time during the last trading day, assignment may be
forthcoming. Even if a holder forgets that he owns an option and fails to exer
cise, the OCC automatically exercises any call that is ¾-point in-the-money at
expiration, unless the individual brokerage firm whose customer is long the call
gives specific instructions not to exercise. This automatic exercise mechanism
ensures that no investor throws away money through carelessness.
Example: XYZ closes at 51 on the third Friday of January (the last day of trading for
the January option series). Since options don't expire until Saturday, the next day, the
OCC and all brokerage firms have the opportunity to review their records to issue
assignments and exercises and to see if any options could have been profitably exer-

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Gapter 1: Definitions 19
cised but were not. If XYZ closed at 51 and a customer who owned a January 45 call
option failed to either sell or exercise it, it is automatically exercised. Since it is worth
$600, this customer stands to receive a substantial amount of money back, even after
stock commissions.
In the case of an XYZ January 50 call option, the automatic exercise procedure
is not as clear-cut with the stock at 51. Though the OCC wants to exercise the call
automatically, it cannot identify a specific owner. It knows only that one or more XYZ
January calls are still open on the long side. When the OCC checks with the broker
age firm, it may find that the firm does not wish to have the XYZ January 50 call exer
cised automatically, because the customer would lose money on the exercise after
incurring stock commissions. Yet the OCC must attempt to automatically exercise
any in-the-money calls, because the holder may have overlooked a long position.
When the public customer sells a call in the secondary market on the last day of
trading, the buyer on the other side of the trade is very likely a market-maker. Thus,
when trading stops, much of the open interest in in-the-money calls held long
belongs to market-makers. Since they can profitably exercise even for an eighth of a
point, they do so. Hence, the writer may receive an assignment notice even if the
stock has been only slightly above the strike price on the last trading day before expi
ration.
Any writer who wishes to avoid an assignment notice should always buy back ( or
cover) the option if it appears the stock will be above the strike at expiration. The
probabilities of assignment are extremely high if the option expires in-the-money.
Early Exercise Due to Discount. When options are exercised prior to
expiration, this is called early, or premature, exercise. The writer can usually
expect an early exercise when the call is trading at or below parity. A parity or
discount situation in advance of expiration may mean that an early exercise is
forthcoming, even if the discount is slight. A writer who does not want to deliv
er stock should buy back the option prior to expiration if the option is apparently
going to trade at a discount to parity. The reason is that arbitrageurs (floor
traders or member firm traders who pay only minimal commissions) can take
advantage of discount situations. (Arbitrage is discussed in more detail later in
the text; it is mentioned here to show why early exercise often occurs in a dis
count situation.)
Example: XYZ is bid at $50 per share, and an XYZ January 40 call option is offered
at a discount price of 9.80. The call is actually "worth" 10 points. The arbitrageur can
take advantage of this situation through the following actions, all on the same day:

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20 Part I: Basic Properties ol Stoclc Options
1. Buy the January 40 call at 9.80.
2. Sell short XYZ common stock at 50.
3. Exercise the call to buy XYZ at 40.
The arbitrageur makes 10 points from the short sale of XYZ (steps 2 and 3), from
which he deducts the 9.80 points he paid for the call. Thus, his total gain is 20 cents
- the amount of the discount. Since he pays only a minimal commission, this trans-
action results in a net profit. '
Also, if the writer can expect assignment when the option has no time value pre
mium left in it, then conversely the option will usually not be called if time premium
is left in it.
Example: Prior to the expiration date, XYZ is trading at 50½, and the January 50 call
is trading at 1. The call is not necessarily in imminent danger of being called, since it
still has half a point of time premium left.
Time value Call Striking Stock
= + premium price price price
= 1 + 50 50½
= ½
Early Exercise Due to Dividends on the Underlying Stock. Some
times the market conditions create a discount situation, and sometimes a large
dividend gives rise to a discount. Since the stock price is almost invariably
reduced by the amount of the dividend, the option price is also most likely
reduced after the ex-dividend. Since the holder of a listed option does not receive
the dividend, he may decide to sell the option in the secondary market before the
ex-date in anticipation of the drop in price. If enough calls are sold because of
the impending ex-dividend reduction, the option may come to parity or even to a
discount. Once again, the arbitrageurs may move in to take advantage of the sit
uation by buying these calls and exercising them.
If assigned prior to the ex-date, the writer does not receive the dividend for he
no longer owns the stock on the ex-date. Furthermore, if he receives an assignment
notice on the ex-date, he must deliver the stock with the dividend. It is therefore very
important for the writer to watch for discount situations on the day prior to the ex
date.

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CHAPl'ER 2
Covered Call Writing
Covered call writing is the name given to the strategy by which one sells a call option
while simultaneously owning the obligated number of shares of underlying stock.
The writer should be mildly bullish, or at least neutral, toward the underlying stock.
By writing a call option against stock, one always decreases the risk of owning the
stock. It may even be possible to profit from a covered write if the stock declines
somewhat. However, the covered call writer does limit his profit potential and there
fore may not fully participate in a strong upward move in the price of the underlying
stock. Use of this strategy is becoming so common that the strategist must under
stand it thoroughly. It is therefore discussed at length.
THE IMPORTANCE OF COVERED CALL WRITING
COVERED CALL WRITING FOR DOWNSIDE PROTECTION
Example: An investor owns 100 shares of XYZ common stock, which is currently sell
ing at $48 per share. If this investor sells an XYZ July 50 call option while still hold
ing his stock, he establishes a covered write. Suppose the investor receives $300 from
the sale of the July 50 call. If XYZ is below 50 at July expiration, the call option that
was sold expires worthless and the investor earns the $300 that he originally received
for writing the call. Thus, he receives $300, or 3 points, of downside protection. That
is, he can afford to have the XYZ stock drop by 3 points and still break even on the
total transaction. At that time he can write another call option if he so desires.
Note that if the underlying stock should fall by more than 3 points, there will be
a loss on the overall position. Thus, the risk in the covered writing strategy material
izes if the stock falls by a distance greater than the call option premium that was orig
inally taken in.
39

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40 Part II: Call Option Strategies
THE BENEFITS OF AN INCREASE IN STOCK PRICE
If XYZ increases in price moderately, the trader may be able to have the best of both
worlds.
Example: If XYZ is at or just below 50 at July expiration, the call still expires worth
less, and the investor makes the $300 from the option in addition to having a small
profit from his stock purchase. Again, he still owns the stock.
Should XYZ increase in price by expiration to levels above 50, the covered
writer has a choice of alternatives. As one alternative, he could do nothing, in which
case the option would be assigned and his stock would be called away at the striking
price of 50. In that case, his profits would be equal to the $300 received from selling
the call plus the profit on the increase of his stock from the purchase price of 48 to
the sale price of 50. In this case, however, he would no longer own the stock. If as
another alternative he desires to retain his stock ownership, he can elect to buy back
( or cover) the written call in the open market. This decision might involve taking a
loss on the option part of the covered writing transaction, but he would have a cor
respondingly larger profit, albeit unrealized, from his stock purchase. Using some
specific numbers, one can see how this second alternative works out.
Example: XYZ rises to a price of 60 by July expiration. The call option then sells near
its intrinsic value of 10. If the investor covers the call at 10, he loses $700 on the
option portion of his covered write. (Recall that he originally received $300 from the
sale of the option, and now he is buying it back for $1,000.) However, he relieves the
obligation to sell his stock at 50 ( the striking price) by buying back the call, so he has
an unrealized gain of 12 points in the stock, which was purchased at 48. His total
profit, including both realized and unrealized gains, is $500.
This profit is exactly the same as he would have made if he had let his stock be
called from him. If called, he would keep the $300 from the sale of the call, and he
would make 2 points ( $200) from buying the stock at 48 and selling it, via exercise, at
50. This profit, again, is a total of $500. The major difference between the two cases
is that the investor no longer owns his stock after letting it be called away, whereas
he retains stock ownership if he buys back the written call. Which of the two alter
natives is the better one in a given situation is not always clear.
No matter how high the stock climbs in price, the profit from a covered write is
limited because the writer has obligated himself to sell stock at the striking price. The
covered writer still profits when the stock climbs, but possibly not by as much as he
might have had he not written the call. On the other hand, he is receiving $300 of
immediate cash inflow, because the writer may take the premium immediately and

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46 Part II: Call Option Strategies
philosophy is more like being a stockholder and trading options against one's stock
position than actually operating a covered writing strategy. In fact, some covered
writers will attempt to buy back written options for quick profits if such profits mate
rialize during the life of the covered write. This, too, is a stock ownership philosophy,
not a covered writing strategy. The total return concept represents the true strategy
in covered writing, whereby one views the entire position as a single entity and is not
predominantly concerned with the results of his stock ownership.
THE CONSERVATIVE COVERED WRITE
Covered writing is generally accepted to be a conservative strategy. This is because
the covered writer always has less risk than a stockholder, provided that he holds the
covered write until expiration of the written call. If the underlying stock declines, the
covered writer will always offset part of his loss by the amount of the option premi
um received, no matter how small.
As was demonstrated in previous sections, however, some covered writes are
clearly more conservative than others. Not all option writers agree on what is meant
by a conservative covered write. Some believe that it involves writing an option
(probably out-of-the-money) on a conservative stock, generally one with high yield
and low volatility. It is true that the stock itself in such a position is conservative, but
the position is more aptly termed a covered write on a conservative stock. This is dis
tinctly different from a conservative covered write.
A true conservative covered write is one in which the total position is conserva
tive - offering reduced risk and a good probability of making a profit. An in-the-money
wiite, even on a stock that itself is not conservative, can become a conservative total
position when the option itself is properly chosen. Clearly, an investor cannot write
calls that are too deeply in-the-money. If he did, he would get large amounts of down
side protection, but his returns would be severely limited. If all that one desired was
maximum protection of his money at a nominal rate of profit, he could leave the
money in a bank. Instead, the conservative covered writer strives to make a potential
ly acceptable return while still receiving an above-average amount of protection.
Example: Again assume XYZ common stock is selling at 45 and an XYZ July 40 call
is selling at 8. A covered write of the XYZ July 40 would require, in a cash account,
an investment of $3,700 - $4,500 to purchase 100 shares of XYZ, less the $800
received in option premiums. The write has a maximum profit potential of $300. The
potential return from this position is therefore $300/$3, 700, just over 8% for the peri
od during which the write must be held. Since it is most likely that the option has 9
months of life or less, this return would be well in excess of 10% on a per annum

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Chapter 2: Covered Call Writing 47
basis. If the write were done in a margin account, the return would be considerably
higher.
Note that we have ignored dividends paid by the underlying stock and commis
sion charges, factors that are discussed in detail in the next section. Also, one should
be aware that if he is looking at an annualized return from a covered write, there is
no guarantee that such a return could actually be obtained. All that is certain is that
the writer could make 8% in 9 months. There is no guarantee that 9 months from
now, when the call expires, there will be an equivalent position to establish that will
extend the same return for the remainder of the annualization period. Annual returns
should be used only for comparative purposes between covered writes.
The writer has a position that has an annualized return (for comparative pur
poses) of over 10% and 8 points of downside protection. Thus, the total position is an
investment that will not lose money unless XYZ common stock falls by more than 8
points, or about 18%; and is an investment that could return the equivalent of 10%
annually should XYZ common stock rise, remain the same, or fall by 5 points (to 40).
This is a conservative position. Even if XYZ itself is not a conservative stock, the
action of writing this option has made the total position a conservative one. The only
factor that might detract from the conservative nature of the total position would be
if XYZ were so volatile that it could easily fall more than 8 points in 9 months.
In a strategic sense, the total position described above is better and more con
servative than one in which a writer buys a conservative stock -yielding perhaps 6 or
7% - and writes an out-of-the-money call for a minimal premium. If this conserva
tive stock were to fall in price, the writer would be in danger of being in a loss situa
tion, because here the option is not providing anything more than the most minimal
downside protection. As was described earlier, a high-yielding, low-volatility stock
will not have much time premium in its in-the-money options, so that one cannot
effectively establish an in-the-money write on such a "conservative" stock.
COMPUTING RETURN ON INVESTMENT
Now that the reader has some general feeling for covered call writing, it is time to
discuss the specifics of computing return on investment. One should always know
exactly what his potential returns are, including all costs, when he establishes a cov
ered writing position. Once the procedure for computing returns is clear, one can
more logically decide which covered writes are the most attractive.
There are three basic elements of a covered write that should be computed
before entering into the position. The first is the return if exercised. This is the return
on investment that one would achieve if the stock were called away. For an out-of-the-

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48 Part II: Call Option Strategies
money covered write, it is necessary for the stock to rise in price in order for the return
if exercised to be achieved. However, for an in-the-money covered write, the return if
exercised would be attained even if the stock were unchanged in price at option expi
ration. Thus, it is often advantageous to compute the return if unchanged - that is, the
return that would be realized if the underlying stock were unchanged when the option
expired. One can more fairly compare out-of-the-money and in-the-money covered
writes by using the return if unchanged, since no assumption is made concerning stock
price movement. The third important statistic that the covered writer should consid
er is the exact downside break-even point after all costs are included. Once this down
side break-even point is known, one can readily compute the percentage of downside
protection that he would receive from selling the call.
Example 1: An investor is considering the following covered write of a 6-month call:
Buy 500 XYZ common at 43, sell 5 XYZ July 45 calls at 3. One must first compute the
net investment required (Table 2-3). In a cash account, this investment consists of
paying for the stock in full, less the net proceeds from the sale of the options. Note
that this net investment figure includes all commissions necessary to establish the
position. (The commissions used here are approximations, as they vary from firm to
firm.) Of course, if the investor withdraws the option premium, as he is free to do,
his net investment will consist of the stock cost plus commissions. Once the neces
sary investment is known, the writer can compute the return if exercised. Table 2-4
illustrates the computation. One first computes the profit if exercised and then
divides that quantity by the net investment to obtain the return if exercised. Note
that dividends are included in this computation; it is assumed that XYZ stock will pay
$500 in dividends on the 500 shares during the life of the call. Moreover, all com
missions are included as well - the net investment includes the original stock pur
chase and option sale commissions, and the stock sale commission is explicitly listed.
For the return computed here to be realized, XYZ stock would have to rise in
price from its current price of 43 to any price above 45 by expiration. As noted ear
lier, it may be more useful to know what return could be made by the writer if the
stock did not move anywhere at all. Table 2-5 illustrates the method of computing the
TABLE 2-3.
Net investment required-cash account.
Stock cost (500 shares at 43)
Plus stock purchase commissions
Less option premiums received
Plus option sale commissions
Net cash investment
+
$21,500
320
1,500
+ 60
$20,380

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52
TABLE 2-10.
Return if unchanged-margin account.
Method 1
Unchanged stock value (500
shares at 43)
Plus dividends
Less margin interest charges
(10% on $10,910 debit for
6 months)
Less debit balance
Less net investment (margin)
Net profit if unchanged
margin
$21,500
+ 500
545
10,910
- 9 470
$ 1,075
Part II: Call Option Strategies
Method 2
Profit if unchanged-cash
Less margin interest charges -
Net profit if unchanged
margin
$1,620
545
$1,075
Return if unchanged = $ l ,075 = 11 .4%
$9,470
TABLE 2-11.
Break-even point-margin write.
Net margin investment
Plus debit balance
Less dividends
Plus margin interest charges
Total stock cost to expiration
Divide by shares held
Break-even point-margin
TABLE 2-12.
Percent downside protection-margin write.
Initial stock price
Less break-even price-margin
Points of protection
Divide by original stock price
Equals percent downside protection-margin
$ 9,470
+ 10,910
500
+ 545
$20,425
+ 500
40.9
43
-40.9
2.1
+43
4.9%
The return if exercised is 18.4% for the covered write using margin. In Example
1 the return if exercised for a cash write was computed as 11.2%. Thus, the return if
exercised from a margin write is considerably higher. In fact, unless a fairly deep in
the-money write is being considered, the return on margin will always be higher than

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Cl,apter 2: Covered Call Writing 53
the return from cash. The farther out-of-the-money that the written call is, the big
ger the discrepancy between cash and margin returns will be when the return if exer
cised is computed.
As with the computation for return if exercised for a write on margin, the return
if unchanged calculation is similar for cash and margin also. The only difference is the
subtraction of the margin interest charges from the profit. The return if unchanged is
also higher for a margin write, provided that there is enough option premium to com
pensate for the margin interest charges. The return if unchanged in the cash example
was 7.9% versus 11.4% for the margin write. In general, the farther from the strike in
either direction - out-of-the-money or in-the-money - the less the return if
unchanged on margin will exceed the cash return if unchanged. In fact, for deeply out
of-the-money or deeply in-the-money calls, the return if unchanged will be higher on
cash than on margin. Table 2-11 shows that the break-even point on margin, 40.9, is
higher than the break-even point from a cash write, 39.8, because of the margin inter
est charges. Again, the percent downside protection can be computed as shown in
Table 2-12. Obviously, since the break-even point on margin is higher than that on
cash, there is less percent downside protection in a margin covered write.
One other point should be made regarding a covered write on margin: The bro
kerage firm will loan you only half of the strike price amount as a maximum. Thus, it
is not possible, for example, to buy a stock at 20, sell a deeply in-the-money call struck
at 10 points, and trade for free. In that case, the brokerage firm would loan you only
5 - half the amount of the strike.
Even so, it is still possible to create a covered call write on margin that has little or
even zero margin .requirement. For example, suppose a stock is selling at 38 and that a
long-term LEAPS option struck at 40 is selling for 19. Then the margin requirement is
zero! This does not mean you're getting something for free, however. True, your invest
ment is zero, but your risk is still 19 points. Also, your broker would ask for some sort of
minimum margin to begin with and would of course ask for maintenance margin if the
underlying stock should fall in price. Moreover, you would be paying margin interest all
during the life of this long-term LEAPS option position. Leverage can be a good thing or
a bad thing, and this strategy has a great deal of leverage. So be careful if you utilize it.
COMPOUND INTEREST
The astute reader will have noticed that our computations of margin interest have
been overly simplistic; the compounding effect of interest rates has been ignored.
That is, since interest charges are normally applied to an account monthly, the
investor will be paying interest in the later stages of a covered writing position not
only on the original debit, but on all previous monthly interest charges. This effect is
described in detail in a later chapter on arbitrage techniques. Briefly stated, rather

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54 Part II: Call Option Strategies
than computing the interest charge as the debit times the interest rate multiplied by
the time to expiration, one should technically use:
Margin interest charges = Debit [(l + r/ -1]
where r is the interest rate per month and t the number of months to expiration. (It
would be incorrect to use days to expiration, since brokerage firms compute interest
monthly, not daily.)
In Example 2 of the preceding section, the debit was $10,910, the time was 6
months, and the annual interest rate was 10%. Using this more complex formula, the
margin interest charges would be $557, as opposed to the $545 charge computed
with the simpler formula. Thus, the difference is usually small, in terms of percent
age, and it is therefore comrrwn practice to use the simpler method.
SIZE OF THE POSITION
So far it has been assumed that the writer was purchasing 500 shares of XYZ and sell
ing 5 calls. This requires a relatively considerable investment for one position for the
individual investor. However, one should be aware that buying too few shares for cov
ered writing purposes can lower returns considerably.
Example: If an investor were to buy 100 shares of XYZ at 43 and sell l July 45 call
for 3, his return if exercised would drop from the 11.2% return (cash) that was com
puted earlier to a return of9.9% in a cash account. Table 2-13 verifies this statement.
Since commissions are less, on a per-share basis, when one buys more stock and
sells more calls, the returns will naturally be higher with a 500- or 1,000-share posi
tion than with a 100- or 200-share position. This difference can be rather dramatic, as
Tables 2-14 and 2-15 point out. Several interesting and worthwhile conclusions can be
drawn from these tables. The first and most obvious conclusion is that the rrwre shares
TABLE 2-13.
Cash investment vs. return.
Net Investment-Cash ( l 00 shares)
Stock cost $4,300
Plus commissions + 85
Less option premium 300
Plus option commissions + 25
Net investment $4,110
Return If Exercised-Cash ( l 00 shares)
Stock sale price
Stock commissions
Plus dividend
Less net investment
Net profit if exercised
$4,500
85
+ 100
- 4 110
$ 405
Return if exercised = $4 05 = 9. 9%
$4,110

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82 Part II: Call Option Strategies
has amassed a fairly large series of debits from previous rolls; or (2) he begins to sell
some out-of-the-money naked puts to bring in credits to reduce the cost of continu
ally rolling the calls up for debits. This latter action is even worse, because the entire
position is now leveraged tremendously, and a sharp drop in the stock price may
cause horrendous losses - perhaps enough to wipe out the entire account. As fate
would have it, these mistakes are usually made when the stock is near a top in price.
Any price decline after such a dramatic rise is usually a sharp and painful one.
The best way to avoid this type of potentially serious mistake is to allow the
stock to be called away at some point. Then, using the funds that are released, either
establish a new position in another stock or perhaps even utilize another strategy for
a while. If that is not feasible, at least avoid making a radical change in strategy after
the stock has had a particularly strong rise. Leveraging the position through naked
put sales on top of rolling the calls up for debits should expressly be avoided.
The discussion to this point has been directed at rolling up before expiration. At
or near expiration, when the time value premium has disappeared from the written
call, one may have no choice but to write the next-higher striking price if he wants to
retain his stock. This is discussed when we analyze action to take at or near expiration.
If the underlying stock rises, one's choices are not necessarily limited to rolling
up or doing nothing. As the stock increases in price, the written call will lose its time
premium and may begin to trade near parity. The writer may decide to close the posi
tion himself - perhaps well in advance of expiration - by buying back the written call
and selling the stock out, hopefully near parity.
Example: A customer originally bought XYZ at 25 and sold the 6-month July 25 for
3 points - a net of 22. Now, three months later, XYZ has risen to 33 and the call is
trading at 8 (parity) because it is so deeply in-the-money. At this point, the writer may
want to sell the stock at 33 and buy back the call at 8, thereby realizing an effective
net of 25 for the covered write, which is his maximum profit potential. This is cer
tainly preferable to remaining in the position for three more months with no more
profit potential available. The advantage of closing a parity covered write early is that
one is realizing the maximum return in a shorter period than anticipated. He is there
by increasing his annualized return on the position. Although it is generally to the
cash writer's advantage (margin writers read on) to take such action, there are a few
additional costs involved that he would not experience if he held the position until
the call expired. First, the commission for the option purchase (buy-back) is an addi
tional expense. Second, he will be selling his stock at a higher price than the striking
price, so he may pay a slightly higher commission on that trade as well. If there is a
dividend left until expiration, he will not be receiving that dividend if he closes the

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Chapter 2: Covered Call Writing 83
write early. Of course, if the trade was done in a margin account, the writer will be
reducing the margin interest that he had planned to pay in the position, because the
debit will be erased earlier. In most cases, the increased commissions are very small
and the lost dividend is not significant compared to the increase in annualized return
that one can achieve by closing the position early. However, this is not always true,
and one should be aware of exactly what his costs are for closing the position early.
Obviously, getting out of a covered writing position can be as difficult as estab
lishing it. Therefore, one should place the order to close the position with his bro
kerage firm's option desk, to be executed as a "net" order. The same traders who facil
itate establishing covered writing positions at net prices will also facilitate getting out
of the positions. One would normally place the order by saying that he wanted to sell
his stock and buy the option "at parity" or, in the example, at "25 net." Just as it is
often necessary to be in contact with both the option and stock exchanges to estab
lish a position, so is it necessary to maintain the same contacts to renwve a position
at parity.
ACTION TO TAKE AT OR NEAR EXPIRATION
As expiration nears and the time value premium disappears from a written call, the
covered writer may often want to roll forward, that is, buy back the currently written
call and sell a longer-term call with the same striking price. For an in-the-money call,
the optimum time to roll forward is generally when the time value premium has com
pletely disappeared from the call. For an out-of-the-money call, the correct time to
move into the more distant option series is when the return offered by the near-term
option is less than the return offered by the longer-term call.
The in-the-money case is quite simple to analyze. As long as there is time pre
mium left in the call, there is little risk of assignment, and therefore the writer is
earning time premium by remaining with the original call. However, when the option
begins to trade at parity or a discount, there arises a significant probability of exer
cise by arbitrageurs. It is at this time that the writer should roll the in-the-money call
forward. For example, if XYZ were offered at 51 and the July 50 call were bid at 1,
the writer should be rolling forward into the October 50 or January 50 call.
The out-of-the-money case is a little more difficult to handle, but a relatively
straightforward analysis can be applied to facilitate the writer's decision. One can
compute the return per day remaining in the written call and compare it to the net
return per day from the longer-term call. If the longer-term call has a higher return,
one should roll forward.

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84 Part II: Call Option Strategies
Example: An investor previously entered a covered writing situation in which he
wrote five January 30 calls against 500 XYZ common. The following prices exist cur
rently, l month before expiration:
XYZ common, 29¼;
January 30 call,¼; and
April 30 call, 2¼.
The writer can only make ¼ a point more of time premium on this covered write for
the time remaining until expiration. It is possible that his money could be put to bet
ter use by rolling forward to the April 30 call. Commissions for rolling forward must
be subtracted from the April 30's premium to present a true comparison.
By remaining in the January 30, the writer could make, at most, $250 for the 30
days remaining until January expiration. This is a return of $8.33 per day. The com
missions for rolling forward would be approximately $100, including both the buy
back and the new sale. Since the current time premium in the April 30 call is $250
per option, this would mean that the writer would stand to make 5 times $250 less
the $100 in commissions during the 120-day period until April expiration; $1,150
divided by 120 days is $9.58 per day. Thus, the per-day return is higher from the April
30 than from the January 30, after commissions are included. The writer should roll
forward to the April 30 at this time.
Rolling forward, since it involves a positive cash flow ( that is, it is a credit trans
action) simultaneously increases the writer's maximum profit potential and lowers the
break-even point. In the example above, the credit for rolling forward is 2 points, so
the break-even point will be lowered by 2 points and the maximum profit potential
is also increased by the 2-point credit.
A simple calculator can provide one with the return-per-day calculation neces
sary to make the decision concerning rolling forward. The preceding analysis is only
directly applicable to rolling forward at the same striking price. Rolling-up or rolling
down decisions at expiration, since they involve different striking prices, cannot be
based solely on the differential returns in time premium values offered by the options
in question.
In the earlier discussion concerning rolling up, it was mentioned that at or near
expiration, one may have no choice but to write the next higher striking price if he
wants to retain his stock. This does not necessarily involve a debit transaction, how
ever. If the stock is volatile enough, one might even be able to roll up for even money
or a slight credit at expiration. Should this occur, it would be a desirable situation and
should always be taken advantage of.

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86 Part II: Call Option Strategies
AVOIDING THE UNCOVERED POSITION
There is a margin rule that the covered writer must be aware of if he is considering
taking any sort of follow-up action on the day that the written call ceases trading. If
another call is sold on that day, even though the written call is obviously going to
expire worthless, the writer will be considered uncovered for margin purposes over
the weekend and will be obligated to put forth the collateral for an uncovered option.
This is usually not what the writer intends to do; being aware of this rule will elimi
nate unwanted margin calls. Furthermore, uncovered options may be considered
unsuitable for many covered writers.
Example: A customer owns XYZ and has January 20 calls outstanding on the last day
of trading of the January series (the third Friday of January; the calls actually do not
expire until the following day, Saturday). IfXYZ is at 15 on the last day of trading, the
January 20 call will almost certainly expire worthless. However, should the writer
decide to sell a longer-term call on that day without buying back the January 20, he
will be considered uncovered over the weekend. Thus, if one plans to wait for an
option to expire totally worthless before writing another call, he must wait until the
Monday after expiration before writing again, assuming that he wants to remain cov
ered. The writer should also realize that it is possible for some sort of news item to
be announced between the end of trading in an option series and the actual expira
tion of the series. Thus, call holders might exercise because they believe the stock will
jump sufficiently in price to make the exercise profitable. This has happened in the
past, two of the most notable cases being IBM in January 1975 and Carrier Corp. in
September 1978.
WHEN TO LET STOCK BE CALLED AWAY
Another alternative that is open to the writer as the written call approaches expira
tion is to let the stock be called away if it is above the striking price. In many cases,
it is to the advantage of the writer to keep rolling options forward for credits, there
by retaining his stock ownership. However, in certain cases, it may be advisable to
allow the stock to be called away. It should be emphasized that the writer often has
a definite choice in this matter, since he can generally tell when the call is about to
be exercised - when the time value premium disappears.
The reason that it is normally desirable to roll forward is that, over time, the
covered writer will realize a higher return by rolling instead of being called. The
option commissions for rolling forward every three or six months are smaller than the
commissions for buying and selling the underlying stock every three or six months,
and therefore the eventual return will be higher. However, if an inferior return has

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Cl,opter 2: Covered Call Writing 87
to be accepted or the break-even point will be raised significantly by rolling forward,
one must consider the alternative of letting the stock be called away.
Example: A covered write is established by buying XYZ at 49 and selling an April 50
call for 3 points. The original break-even point was thus 46. Near expiration, suppose
XYZ has risen to 56 and the April 50 is trading at 6. If the investor wants to roll for
ward, now is the time to do so, because the call is at parity. However, he notes that
the choices are somewhat limited. Suppose the following prices exist with XYZ at 56:
XYZ October 50 call, 7; and XYZ October 60 call, 2. It seems apparent that the pre
mium levels have declined since the original writing position was established, but
that is an occurrence beyond the control of the writer, who must work in the current
market environment.
If the writer attempts to roll forward to the October 50, he could make at most
1 additional point of profit until October (the time premium in the call). This repre
sents an extremely low rate of return, and the writer should reject this alternative
since there are surely better returns available in covered writes on other securities.
On the other hand, if the writer tries to roll up and forward, it will cost 4 points
to do so - 6 points to buy back the April 50 less 2 points received for the October 60.
This debit transaction means that his break-even point would move up from the orig
inal level of 46 to a new level of 50. If the common declines below 54, he would be
eating into profits already at hand, since the October 60 provides only 2 points of pro
tection from the current stock price of 56. If the writer is not confidently bullish on
the outlook for XYZ, he should not roll up and forward.
At this point, the writer has exhausted his alternatives for rolling. His remaining
choice is to let the stock be called away and to use the proceeds to establish a cov
ered write in a new stock, one that offers a more attractive rate of return with rea
sonable downside protection. This choice of allowing the stock to be called away is
generally the wisest strategy if both of the following criteria are met:
1. Rolling forward offers only a minimal return.
2. Rolling up and forward significantly raises the break-even point and leaves the
position relatively unprotected should the stock drop in price.
SPECIAL WRITING SITUATIONS
Our discussions have pertained directly to writing against common stock. However,
one may also write covered call options against convertible securities, warrants, or
LEAPS. In addition, a different type of covered writing strategy - the incremental

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88 Part II: Call Option Strategies
return concept - is described that has great appeal to large stockholders, both indi
viduals and institutions.
COVERED WRITING AGAINST A CONVERTIBLE SECURITY
It may be more advantageous to buy a security that is convertible into common stock
than to buy the stock itself, for covered call writing purposes. Convertible bonds and
convertible preferred stocks are securities commonly used for this purpose. One
advantage of using the convertible security is that it often has a higher yield than does
the common stock itself.
Before describing the covered write, it may be beneficial to review the basics of
convertible securities. Suppose XYZ common stock has an XYZ convertible Preferred
A stock that is convertible into 1.5 shares of common. The number of shares of com
mon that the convertible security converts into is an important piece of information
that the writer must know. It can be found in a Standard & Poor's Stock Guide (or
Bond Guide, in the case of convertible bonds).
The writer also needs to determine how many shares of the convertible securi
ty must be owned in order to equal 100 shares of the common stock. This is quickly
determined by dividing 100 by the conversion ratio - 1.5 in our XYZ example. Since
100 divided by 1.5 equals 66.666, one must own 67 shares of XYZ cv Pfd A to cover
the sale of one XYZ option for 100 shares of common. Note that neither the market
prices of XYZ common nor the convertible security are necessary for this computa
tion.
When using a convertible bond, the conversion information is usually stated in
a form such as, "converts into 50 shares at a price of 20." The price is irrelevant. What
is important is the number of shares that the bond converts into - 50 in this case.
Thus, if one were using these bonds for covered writing of one call, he would need
two (2,000) bonds to own the equivalent of 100 shares of stock.
Once one knows how much of the convertible security must be purchased, he
can use the actual prices of the securities, and their yields, to determine whether a
covered write against the common or the convertible is more attractive.
Example: The following information is known:
XYZ common, 50;
XYZ CV Pfd A, 80;
XYZ July 50 call, 5;
XYZ dividend, 1.00 per share annually; and
XYZ cv Pfd A dividend, 5.00 per share annually.

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90 Part II: Call Option Strategies
The writer should also be aware of whether or not the convertible is catlable
and, if so, what the exact terms are. Once the convertible has been called by the com
pany, it will no longer trade in relation to the underlying stock, but will instead trade
at the call price. Thus, if the stock should climb sharply, the writer could be incur
ring losses on his written option without any corresponding benefit from his con
vertible security. Consequently, if the convertible is called, the entire position should
normally be closed immediately by selling the convertible and buying the option
back.
Other aspects of covered writing, such as rolling down or forward, do not
change even if the option is written against a convertible security. One would take
action based on the relationship of the option price and the common stock price, as
usual.
WRITING AGAINST WARRANTS
It is also possible to write covered call options against warrants. Again, one must own
enough warrants to convert into 100 shares of the underlying stock; generally, this
would be 100 warrants. The transaction must be a cash transaction, the warrants
must be paid for in full, and they have no loan value. Technically, listed warrants may
be marginable, but many brokerage houses still require payment in full. There may
be an additional investment requirement. Warrants also have an exercise price. If the
exercise price of the warrant is higher than the striking price of the call, the covered
writer must also deposit the difference between the two as part of his investment.
The advantage of using warrants is that, if they are deeply in-the-money, they
may provide the cash covered writer with a higher return, since less of an investment
is involved.
Example: XYZ is at 50 and there are XYZ warrants to buy the common at 25. Since
the warrant is so deeply in-the-money, it will be selling for approximately $25 per
warrant. XYZ pays no dividend. Thus, if the writer were considering a covered write
of the XYZ July 50, he might choose to use the warrant instead of the common, since
his investment, per 100 shares of common, would only be $2,500 instead of the
$5,000 required to buy 100 XYZ. The potential profit would be the same in either
case because no dividend is involved.
Even if the stock does pay a dividend (warrants themselves have no dividend),
the writer may still be able to earn a higher return by writing against the warrant than
against the common because of the smaller investment involved. This would depend,
of course, on the exact size of the dividend and on how deeply the warrant is in-the
money.

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Cbapter 2: Covered Call Writing 91
Covered writing against warrants is not a frequent practice because of the small
number of warrants on optionable stocks and the problems inherent in checking
available returns. However, in certain circumstances, the writer may actually gain a
decided advantage by writing against a deep in-the-money warrant. It is often not
advisable to write against a warrant that is at- or out-of-the-money, since it can
decline by a large percentage if the underlying stock drops in price, producing a high
risk position. Also, the writer's investment may increase in this case if he rolls down
to an option with a striking price lower than the warrant's exercise price.
WRITING AGAINST LEAPS
A form of covered call writing can be constructed by buying LEAPS call options and
selling shorter-term out-of-the-money calls against them. This strategy is much like
writing calls against warrants. This strategy is discussed in more detail in Chapter 25
on LEAPS, under the subject of diagonal spreads.
PERCS
The PERCS (Preferred Equity Redemption Cumulative Stock) is a form of covered
writing. It is discussed in Chapter 32.
THE INCREMENTAL RETURN CONCEPT OF COVERED WRITING
The incremental return concept of covered call writing is a way in which the covered
writer can earn the full value of stock appreciation between todays stock price and a
target sale price, which may be substantially higher. At the same time, the writer can
earn an incremental, positive return from writing options.
Many institutional investors are somewhat apprehensive about covered call
writing because of the upside limit that is placed on profit potential. If a call is writ
ten against a stock that subsequently declines in price, most institutional managers
would not view this as an unfavorable situation, since they would be outperforming
all managers who owned the stock and who did not write a call. However, if the stock
rises substantially after the call is written, many institutional managers do not like
having their profits limited by the written call. This strategy is not only for institu
tional money managers, although one should have a relatively substantial holding in
an underlying stock to attempt the strategy - at least 500 shares and preferably 1,000
shares or more. The incremental return concept can be used by anyone who is plan
ning to hold his stock, even if it should temporarily decline in price, until it reaches a
predetermined, higher price at which he is willing to sell the stock.

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92 Part II: Call Option Strategies
The basic strategy involves, as an initial step, selecting the target price at which
the writer is willing to sell his stock.
Example: A customer owns 1,000 shares of XYZ, which is currently at 60, and is will
ing to sell the stock at 80. In the meantime, he would like to realize a positive cash
flow from writing options against his stock. This positive cash flow does not neces
sarily result in a realized option gain until the stock is called away. Most likely, with
the stock at 60, there would not be options available with a striking price of 80, so one
could not write 10 July 80's, for example. This would not be an optimum strategy
even if the July 80's existed, for the investor would be receiving so little in option pre
miums - perhaps 10 cents per call - that writing might not be worthwhile. The incre
mental return strategy allows this investor to achieve his objectives regardless of the
existence of options with a higher striking price.
The foundation of the incremental return strategy is to write against only a part
of the entire stock holding initially, and to write these calls at the striking price near
est the current stock price. Then, should the stock move up to the next higher strik
ing price, one rolls up for a credit by adding to the number of calls written. Rolling
for a credit is mandatory and is the key to the strategy. Eventually, the stock reaches
the target price and the stock is called away, the investor sells all his stock at the tar
get price, and in addition earns the total credits from all the option transactions.
Example: XYZ is 60, the investor owns 1,000 shares, and his target price is 80. One
might begin by selling three of the longest-term calls at 60 for 7 points apiece. Table
2-26 shows how a poor case - one in which the stock climbs directly to the target
price - might work. As Table 2-26 shows, if XYZ rose to 70 in one month, the three
original calls would be bought back and enough calls at 70 would be sold to produce
a credit - 5 XYZ October 70's. If the stock continued upward to 80 in another month,
the 5 calls would be bought back and the entire position - 10 calls - would be writ
ten against the target price.
If XYZ remains above 80, the stock will be called away and all 1,000 shares will
be sold at the target price of 80. In addition, the investor will earn all the option cred
its generated along the way. These amount to $2,800. Thus, the writer obtained the
full appreciation of his stock to the target price plus an incremental, positive return
from option writing.
In a flat market, the strategy is relatively easy to monitor. If a written call loses
its time value premium and therefore might be subject to assignment, the writer can
roll forward to a more distant expiration series, keeping the quantity of written calls
constant. This transaction would generate additional credits as well.

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C1,,,pter 2: Covered Call Writing
TABLE 2-26.
Two months of incremental return strategy.
Day 1 : XYZ = 60
Sell 3 XYZ October 60's at 7
One month later: XYZ = 70
Buy back the 3 XYZ Oct 60's at 11 and
sell 5 XYZ Oct 70's at 7
Two months later: XYZ = 80
Buy back the 5 Oct 70's at 11 and
sell 10 XYZ Oct 80's at 6
COVERED CALL WRITING SUMMARY
93
+$2, 100 credit
-$3,300 debit
+$3,500 credit
-$5 ,500 debit
+$6.000 credit
+$2,800 credit
This concludes the chapter on covered call writing. The strategy will be referred to
later, when compared with other strategies. Here is a brief summary of the more
important points that were discussed.
Covered call writing is a viable strategy because it reduces the risk of stock own
ership and will make one's portfolio less volatile to short-term market movements. It
should be understood, however, that covered call writing may underperform stock
ownership in general because of the fact that stocks can rise great distances, while a
covered write has limited upside profit potential. The choice of which call to write
can make for a more aggressive or more conservative write. Writing in-the-money
calls is strategically more conservative than writing out-of-the-money calls, because
of the larger amount of downside protection received. The total return concept of
covered call writing attempts to achieve the maximum balance between income from
all sources - option premiums, stock ownership, and dividend income - and down
side protection. This balance is usually realized by writing calls when the stock is near
the striking price, either slightly in- or slightly out-of-the-money.
The writer should compute various returns before entering into the position:
the return if exercised, the return if the stock is unchanged at expiration, and the
break-even point. To truly compare various writes, returns should be annualized, and
all commissions and dividends should be included in the calculations. Returns will be
increased by taking larger positions in the underlying stock - 500 or 1,000 shares.
Also, by utilizing a brokerage firm's capability to produce "net" executions, buying the
stock and selling the call at a specified net price differential, one will receive better
executions and realize higher returns in the long run.

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92 Part II: Call Option Strategies
The basic strategy involves, as an initial step, selecting the target price at which
the writer is willing to sell his stock
Example: A customer owns 1,000 shares ofXYZ, which is currently at 60, and is will
ing to sell the stock at 80. In the meantime, he would like to realize a positive cash
flow from writing options against his stock This positive cash flow does not neces
sarily result in a realized option gain until the stock is called away. Most likely, with
the stock at 60, there would not be options available with a striking price of 80, so one
could not write 10 July 80's, for example. This would not be an optimum strategy
even if the July 80's existed, for the investor would be receiving so little in option pre
miums - perhaps 10 cents per call - that writing might not be worthwhile. The incre
mental return strategy allows this investor to achieve his objectives regardless of the
existence of options with a higher striking price.
The foundation of the incremental return strategy is to write against only a part
of the entire stock holding initially, and to write these calls at the striking price near
est the current stock price. Then, should the stock move up to the next higher strik
ing price, one rolls up for a credit by adding to the number of calls written. Rolling
for a credit is mandatory and is the key to the strategy. Eventually, the stock reaches
the target price and the stock is called away, the investor sells all his stock at the tar
get price, and in addition earns the total credits from all the option transactions.
Example: XYZ is 60, the investor owns 1,000 shares, and his target price is 80. One
might begin by selling three of the longest-term calls at 60 for 7 points apiece. Table
2-26 shows how a poor case - one in which the stock climbs directly to the target
price - might work. As Table 2-26 shows, if XYZ rose to 70 in one month, the three
original calls would be bought back and enough calls at 70 would be sold to produce
a credit - 5 XYZ October 70's. If the stock continued upward to 80 in another month,
the 5 calls would be bought back and the entire position - 10 calls - would be writ
ten against the target price.
IfXYZ remains above 80, the stock will be called away and all 1,000 shares will
be sold at the target price of 80. In addition, the investor will earn all the option cred
its generated along the way. These amount to $2,800. Thus, the writer obtained the
full appreciation of his stock to the target price plus an incremental, positive return
from option writing.
In a flat market, the strategy is relatively easy to monitor. If a written call loses
its time value premium and therefore might be subject to assignment, the writer can
roll f01ward to a more distant expiration series, keeping the quantity of written calls
constant. This transaction would generate additional credits as well.

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