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Chapter 18

Option Overwriting

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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

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Outline Introduction Using options to generate income Combined hedging/income generation

strategies Multiple portfolio managers

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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

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Using Options to Generate Income

Writing calls to generate income Writing puts to generate income Writing index options A comparative example

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Writing Calls to Generate Income

Writing covered calls Writing naked calls

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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

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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

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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.

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Writing Covered Calls (cont’d)Example (cont’d)

Solution: A possible worksheet is shown below:

Stock Price at Option Expiration

0 50 100 116 120 125 150

Long stock -116 -66 -16 0 +4 +9 +34

Short call +6 +6 +6 +6 +6 +1 -24

Total -110 -60 -10 +6 +10 +10 +10

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Writing Covered Calls (cont’d)Example (cont’d)

$0

-$110

$10

$120

Maximum gain

Maximum loss

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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

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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

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Writing Puts to Generate Income

Fiduciary puts Put overwriting

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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

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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.

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Fiduciary Puts (cont’d)Example (cont’d)

$0

-$112.75

$7.25

$120

Maximum gain

Maximum loss

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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

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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.

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Put Overwriting (cont’d)Example (cont’d)

Solution: A possible worksheet is shown below:

Stock Price at Option Expiration

0 75 115 116 150

Long stock -116 -41 -1 0 +34

Short put -110.75 -35.75 +4.25 +4.25 +4.25

Total -226.75 -76.75 +3.25 +4.25 +38.35

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Put Overwriting (cont’d)Example (cont’d)

$0

-$226.75

$115

Maximum gainis unlimited

Maximum loss

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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?

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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

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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

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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

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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

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Forms of Margin (Margin Equivalents)

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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

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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

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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?

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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

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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

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

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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)

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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

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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

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Covered Index Call Writing Covered index calls are written

The following slide shows the manager’s selection and performance

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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

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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

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Put Overwriting Put overwriting is the most aggressive

strategy

The following slide shows the selection of puts and the resulting performance

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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

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Risk/Return Comparisons (cont’d)

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Combined Hedging/Income Generation Strategies

Writing calls to improve on the market Writing puts to acquire stock Writing covered calls for downside

protection

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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

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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?

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Writing Calls to Improve on the Market (cont’d)

Example (cont’d)

Solution: If the institution sells the shares immediately, it would receive $116,000 (1,000 shares x $116).

If it wrote 10 calls, it would receive $118,000 in January:Option premium:

$18 x 100 x 10 = $18,000

Stock sale when options are exercised: $100 x 1,000 shares = $100,000

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Writing Puts to Acquire Stock Involves writing in-the-money put options

A manager can improve on the market by purchasing the stock when the put options are exercised

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Writing Puts to Acquire Stock (cont’d)

Example

You want to buy 500 shares of Western Oil, which currently trades at $66.75 per share. January 70 puts sells for $5.

What is the cost of acquiring the shares now? What is the cost of acquiring the shares if you write 5 WO JAN 70 puts and the options are in-the-money on the expiration day?

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Writing Puts to Acquire Stock (cont’d)

Example

Solution: Outright purchase of the shares now would cost $33,375 (500 shares x $66.75).

If you write 5 puts, you would pay $32,500 for the shares:Option premium received:

5 x 100 x $5 = $2,500Amount paid for shares when options are exercised:

5 x 100 x $70 = $35,000

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Writing Covered Calls for Downside Protection

Appropriate for an investor who:• Owns shares of stock• Suspects the market will turn down in the near future• Does not want to sell the shares at the moment

Provides some downside protection, but alternatives are:• Buying puts• Using portfolio insurance

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Multiple Portfolio Managers Separate responsibilities Distinction between option overwriting and

portfolio splitting Integrating options and equity management

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Separate Responsibilities Assume:

• A stock portfolio is assembled by a manager for a client

• The stock portfolio is used by a different manager for writing covered options

Management of the stock portfolio is the most important concern

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Option Overwriting Versus Portfolio Splitting

Portfolio splitting means managing a portfolio in accordance with more than one objective• E.g., half is growth of income, half is capital

appreciation Option overwriting seeks to generate

additional profits for the fund through the receipt of option premiums

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Integrating Options and Equity Management

Hedging company-specific risk Unity of command

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Hedging Company-Specific Risk

To hedge a company-specific risk of a particular firm in a portfolio use individual equity options

To hedge industry risk, employ options on an industry index

To hedge the entire portfolio, use index options

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Unity of Command Index options increase the feasibility of

using a single portfolio manager for both equity and option positions• Index options do not require the transfer of

securities• The time requirement to overwrite with index

options is minimal• The manager who has the flexibility of index

options can exercise more creativity