Chapter 18 Option Overwriting

1. Chapter 18Option Overwriting

2. What’s a good way to raise the blood pressure of an Investor Relations Manager? Answer: Talk about the pros and cons of stock options. - Eilene H. Kirrane

3. Outline • Introduction • Using options to generate income • Combined hedging/income generation strategies • Multiple portfolio managers

4. Introduction • Option overwriting refers to creating and selling stock options in conjunction with a stock portfolio • Motives for overwriting: • To generate additional portfolio income • To purchase or sell stock at a better-than-market price

5. Using Options to Generate Income • Writing calls to generate income • Writing puts to generate income • Writing index options • A comparative example

6. Writing Calls to Generate Income • Writing covered calls • Writing naked calls

7. Writing Covered Calls • Writing covered calls: • Occurs when the investor writes options against stock he already owns • Is the most common use of stock options by both individual and institutional investors • Has a profit or loss determined by the long position and the short position

8. Writing Covered Calls (cont’d) • Covered call writing is very popular with foundations, pension funds, and other portfolios that need to produce periodic cash flows • In relatively stable or slightly declining markets, covered call writing can enhance investment returns

9. Writing Covered Calls (cont’d) Example Nile.com stock currently trades for $116 per share. Call options with a striking price of $120 and a $6 premium are available for Nile.com. Construct a worksheet and a profit and loss diagram to determine the profit or loss associated with writing a covered call for Nile.com. Assume the investor purchases the stock for $116. Use a range for the stock price at option expiration from $0 to $150.

10. Writing Covered Calls (cont’d) Example (cont’d) Solution: A possible worksheet is shown below:

11. Writing Covered Calls (cont’d) Example (cont’d) Maximum gain $10 $0 $120 -$110 Maximum loss

12. Writing Naked Calls • Writing naked calls: • Involves writing an option without owning the underlying stock • Has a potentially unlimited loss • Especially if the writer must buy the shares in the market • Is used by institutional heavyweights to make money for their firm

13. Writing Naked Calls (cont’d) • Naked call writing is not often used by individual investors • Brokerage houses may enforce high minimum account balances • Fiduciaries should be extremely careful about writing naked calls for a client

14. Writing Puts to Generate Income • Fiduciary puts • Put overwriting

15. Fiduciary Puts • A fiduciary put is a covered (short) put • The writer of a fiduciary put must depot the striking price of the option in an interest-bearing account or hold the necessary cash equivalents • The commission costs of fiduciary puts may be lower than writing covered calls

16. Fiduciary Puts (cont’d) Example February put options on Nile.com are available with an exercise price of $120 and an option premium of $7.25. Construct a profit and loss diagram for a fiduciary put, showing the maximum gain and maximum loss.

17. Fiduciary Puts (cont’d) Example (cont’d) Maximum gain $7.25 $0 $120 -$112.75 Maximum loss

18. Put Overwriting • Put overwriting: • Involves owning shares of stock and writing put options against them • Is a bullish strategy • Both owning shares and writing puts are bullish strategies • May be appropriate for portfolio managers who don’t want to write calls for fear of opportunity losses

19. Put Overwriting (cont’d) Example An investor buys Nile.com stock for $116 per share. Simultaneously, the investor writes a Nile.com FEB 115 put with an option premium of $4.25 per share. Construct a worksheet and a profit and loss diagram to determine the profit or loss associated with put overwriting. Use a range for the stock price at option expiration from $0 to $150.

20. Put Overwriting (cont’d) Example (cont’d) Solution: A possible worksheet is shown below:

21. Put Overwriting (cont’d) Example (cont’d) Maximum gain is unlimited $0 $115 -$226.75 Maximum loss

22. Writing Index Options • Introduction • Margin considerations in writing index call options • Using a cash account • Using a margin account • The risk of index calls • What is best?

23. Introduction • Index options: • Are one of the most successful innovations of all time • Include the S&P 100 and S&P 500 index options • Have little unsystematic risk

24. Margin Considerations in Writing Index Call Options • Using a margin account does not necessarily involve borrowing • Charitable funds or fiduciary accounts use margin accounts to provide the fund manager with added flexibility

25. Using A Cash Account • A portfolio manager can use a cash account to write index options: • If a custodian bank issues an OCC index option escrow receipt to the broker • If the bank certifies that it holds collateral sufficient to cover the writing of index calls and • If the writer can provide the necessary collateral by the deposit of cash, cash equivalents, marginable stock, or any combination of these

26. Using A Margin Account • The required funds in a margin account to write index calls: • Equal the market value of the options plus 15% of the index value times the index multiplier less any out-of-the-money amount and • Are subject to a minimum amount equal to the market value of the options plus 10% of the market value of the index times the index multiplier

27. Forms of Margin (Margin Equivalents)

28. The Risk of Index Calls • The risk of writing index calls is that the index will rise above the chosen exercise price • The lower the striking price: • The more income the portfolio receives • The higher is the likelihood that the option ends up in the money

29. The Risk of Index Calls (cont’d) • Cash settlement procedures for in-the-money index options: • Involve the transfer of cash rather than securities • The writer owes the call holder the intrinsic value of the call at option expiration

30. The Risk of Index Calls (cont’d) Example A portfolio manager wrote 90 FEB 690 OEX calls. On the expiration date, the S&P 100 index is at 693.00. What is the amount the portfolio manager must pay to the holder of the OEX options?

31. The Risk of Index Calls (cont’d) Example Solution: The manager must pay $27,000: (693.00 – 690.00) x $100 x 90 contracts = $27,000

32. What Is Best? • Advantages of writing index options over writing calls on portfolio components: • They require only a single option position • They vastly reduce aggregate commission costs • They carry much less unsystematic risk • There is less disruption of the portfolio when calls expire in-the-money and are exercised

33. A Comparative Example • Setup • Covered equity call writing • Covered index call writing • Writing fiduciary puts • Put overwriting • Risk/return comparisons

34. Setup • Consider three market scenarios: • An advance of 5% • No change • A decline of 5% • We are managing a portfolio of five stocks (see next slide)

36. Covered Equity Call Writing • Individual call options are written against each of the five securities in the portfolio • The following slide shows the manager’s selection of options and the resulting performance

38. Covered Equity Call Writing (cont’d) • Observations: • The portfolio makes money in each of the scenarios • The portfolio makes the most money when the market advances • The portfolio would lose all five securities • ARC and IP are called away when the market remains unchanged

39. Covered Index Call Writing • Covered index calls are written • The following slide shows the manager’s selection and performance

41. Covered Index Call Writing (cont’d) • Observations: • The greatest gain occurs when the market advances 5% • The manager does not have to sell any stocks because of cash settlement

42. Writing Fiduciary Puts • Index put options are written in anticipation of the underlying stock rising in value • The following slide shows the selection of puts and the resulting performance

44. Put Overwriting • Put overwriting is the most aggressive strategy • The following slide shows the selection of puts and the resulting performance

46. Risk/Return Comparisons • Put overwriting has the largest potential losses and gains • Writing covered equity calls is not always superior to writing covered index calls

47. Risk/Return Comparisons (cont’d)

48. Combined Hedging/Income Generation Strategies • Writing calls to improve on the market • Writing puts to acquire stock • Writing covered calls for downside protection

49. Writing Calls to Improve on the Market • Appropriate for someone who wants to sell shares of a stock but has no immediate need for the money • Income can be increased by writing deep-in-the money calls • The writer attempts to improve on the market • The expectation is that the calls will be exercised

50. Writing Calls to Improve on the Market (cont’d) Example Nile.com stock currently sells for $116 per share. An institution holds 1,000 shares and would like to sell the stock. JAN 100 calls on Nile.com are available for $18 per share. If the stock price on the expiration is $120, what would be the cash receipts to the institution if it writes 10 calls and sells the stock in January? What would be the cash receipts if it sold the stock today?