OPTIONS IN OPERATION

OPTIONS IN OPERATION

Two very recent posts discussed the basics of options. One post discussed Calls, the other Puts. This post will take a look at common Call and Put Strategies that a stock investor may employ in his or her portfolio.

ANOTHER MATRIX

Investors buy or sell options because of their beliefs about the future direction of stock prices. (There are options on other investments, but we will stick with stocks). The matrix below correlates future belief about stock prices with option types.

OPTION STRATEGY

If an Investor owns ICBM stock and:

1. Investor thinks Stock may fall somewhat or
maintain its current price: Sell Call
This Strategy is called selling a “Covered Call

2. Investor is concerned Stock will fall: Buy Put
This Strategy is called buying a Protective Put


If an Investors DOES NOT own ICBM Stock and:

3. Investor thinks Stock will rise
or remain the same: Sell Put
This strategy is called selling a Naked Put.
It is very risky.

4. Investor thinks Stock will fall or remain
the same: Sell Call
This strategy is called selling an Uncovered Call.
It is EXTREMELY risky.

5. Investor thinks Stock will fall: Buy Put
This strategy is somewhat risky.


COMMON STRATEGIES

Numbers 1 and 2 are commonly used strategies and they were the subjects of the prior posts. In the first post, Jane sold a covered Call against her ICBM stock. In the second post, Jane bought a protective Put for her ICBM stock. The analysis below will expand upon these strategies and the assumptions that underlie them.

Selling a Covered Call. This is an income generating strategy that a stockholder might use if they believe the stock price will remain steady or fall a small amount. The stockholder must also be ready to sell their shares if the stock rises. Jane owned 100 shares of ICBM. She felt that ICBM stock might fall or stay about the same. She did not think that the stock would rise, but if it did, she was willing to sell her ICBM stock if she was exercised. She had bought it at $40 and it was currently selling at $52. She sells a Covered Call at $55 and gets a $100 premium. Jane read that selling Covered Calls was a way to generate a little more money from a stock that she would be willing to sell anyway.

If Jane is right about ICBM falling in price or staying the same, she will keep her stock and the $100 Call premium. If she is wrong and ICBM goes up to $55 or beyond, she will probably have her stock exercised. She will make $15 per share from the sale of the stock and keep the $1 premium. (55 Call Strike Price - $40 basis on stock = $15 gain on ICBM share).

The downside for Jane is that if ICBM shoots up to $70, she will miss out on the price increase beyond $55, the Strike Price of the ICBM call. In summary, the assumptions behind a Covered Call sale are:

1. The belief that the Stock will fall somewhat or stay the same. (If you think it will fall a lot, you should sell it!).
2. A willingness to sell the stock at the Strike Price of the Call.


Buying a Protective Put. This is a common protective strategy to protect a stockholder from fall in the stock price. If Jane holds ICBM and is concerned that it may fall, she has two choices. She can sell the stock outright or buy a Put. Jane still likes ICBM’s prospects for the long term. To protect herself from a short-term price declines, she decides to buy a Protective Put. ICBM is currently trading at $52 and Jane buys a Put with a Strike Price of $50. If ICBM falls to $50 or below, Jane can exercise her Put and sell ICBM for $50.


MORE SPECULATIVE STRATEGY

Strategies 3 and 4 are strategies that the Author would not recommend to anyone because of the high risk and relatively low return. Strategy 5, however, is worth exploring. In a Secular Bear Market[i] like the one that we are in, there will be more stocks falling than rising. A popular strategy in a falling market is to sell stocks and indexes short. Short selling is a little complex and carries some measure of risk. Short selling was discussed in the Author’s post of October 9th [ii] . Another strategy is to buy a Put on the stock that you believe will fall in price. Sound confusing? It’s really rather logical and puts less capital at risk than short selling. Let’s look at an example:

Jungle Jim does a lot of stock research. He believes that the stock of the American motorcycle behemoth, Hogsome-Darlington (HOG), will fall in price. It is currently trading at $49 per share. Jim thinks that the stock is only worth $40 per share. He also thinks that its next earnings report, to be issued in early January 2006, will be very disappointing and will send the stock falling. Instead of selling HOG stock short, he buys a February 2006 Put with a Strike Price of $50.00.

This Put costs him $3.00 per share, or $300 for the standardized 100 share options contract. Because the stock is trading at $49 and Jim’s Put has a Strike Price of $50, this Put is considered an “In the Money Put”. The Put is considered “In the Money” because the Strike Price is higher than the price of the HOG stock.

If the Strike Price of HOG is $50 and the market price of HOG is $49, then Jim’s HOG Put is $1 “In the Money”. Puts (and Calls), can be “In the Money”, “At the Money” or “Out of the Money”. For an explanation of these terms, take a look at the chart below:

STRIKE PRICE HOG PRICE PUT STATUS

$50 $45 In the Money by $5
If Strike Price > Market
Strike Price-Market Price

$50 $49 In the Money by $1

$50 $50 At the Money
Strike Price=Market Price

$50 $55 Out of the Money by $5
If Market Price > Strike
Market Price-Strike Price

Now let’s keep in mind that Jim does not own HOG stock. He is hoping that HOG will fall in price and the Put will rise in price beyond the $3 he paid for it. And Jim knows that as the Price of HOG falls, his Put will rise in price. Remember, a Put gives you the right to sell the stock at the Strike Price. So if Jim (or some HOG stockholder) has the right to sell HOG shares at $50 when the market price of HOG is at $40, he has a valuable right.

Here is what will probably happen if HOG stock falls to $40. First, Jim has determined through research that HOG Puts have a delta of 1[iii]. The concept of Delta is very important when dealing with options, so we will take some time to define Delta and consider Delta in the concept of HOG options.

DELTA IS NOT A TRIANGULAR DEPOSIT OF SILT ON A RIVER IN EGYPT

Delta is a measure of the rate of change it. It is often written in its Greek form, D. You may see Delta printed this way in other publications. But to keep it simple for the Author, we will spell out “Delta”. If you know the historical Delta of an option, you can estimate how the option will probably change in value as the underlying stock price rises or falls[iv]. “In the Money” HOG Puts have an historical Delta of 1. That means for each $1 change in the value of HOG stock, the HOG Put also changes by $1. Let’s look at how it plays out:

STRIKE PRICE HOG PRICE PUT VALUE

$50 $49 $3 (Current Value)

$50 $47($49-$47= $2) $2 + $3 = $5

$50 $45($49-$45 = $4) $4 + $3 = $7

$50 $40($49-$40 = $9) $9 + $3 = $12

$50 $50($49-$50 = -$1) ($1) + $3 = $2[v]

So if Jim is right and HOG falls to $40, he can close out his Put (by selling it) and make $9 per share, or $900 for the Put contract. ($12 Put Value - $3 (Jim’s Cost)). Not a bad day’s work.

To determine Jim’s potential profit or loss on his HOG Put, go to the third column and subtract $3 (Jim’s cost) from the Put Value. If HOG falls to $45, Jim makes $4. ($7 Put Value –$3 Cost). But if HOG rises to $50, Jim loses $1. ($2 Put Value- $3 Cost).

Brokerage firms require that customers execute options agreements to trade options and that they understand the risks involved. In this last example, the risk of buying a Put when you do not own the underlying stock is that the price of the stock will rise instead of fall and that the put may expire worthless. The risk of buying a put is less than short-selling the underlying stock, however. In this case, Jim’s loss is capped at $300, the amount he spent on the Put. But if Jim sells HOG short and HOG rises, he will have to buy 100 shared of HOG to cover. If HOG makes a substantial move upward, Jim could lose thousands of dollars.

THERE ARE ALWAYS OPTIONS IN THE DESERT OF THE REAL!

[i] The Author has discussed the Secular Bear Market in several editions of the Newsletter and on the post of September 19th. http://desertoftherealecononomicanalysis.blogspot.com/2005_09_18_
desertoftherealecononomicanalysis_archive.html
[ii] http//desertoftherealecononomicanalysis.blogspot.com/2005_10_09_
desertoftherealecononomicanalysis_archive.html
[iii] http://www.cboe.com/. The website of the Chicago Board of Options Exchange has lots of information on all of these option topics, including Delta. The exchange will also send you a CD with Option information and tutorials.
[iv] There is of course no guarantee that the Option Delta will behave in the same way, but if we have done our research and there are no other major issues in play, the Delta pattern is likely to continue.
[v] When options move to “at the money” or “out of the money” status, Delta can change. But let’s keep it simple for this example.