This article will focus on the situation where an investor is limited to 100% covered calls, and 100% cash covered puts. Investors that are willing to assume more risk and leverage should take the quantitative principles outlined here, and apply them to the more highly leveraged margin based naked puts and naked calls.
Quick background:
First a quick refresher on buying and selling call and put options. With options there are basically 4 positions that you can take:
- long the call option - in this case you are buying a contract that gives you the right to purchase an underlying on or before a future date at a predetermined ‘strike ’ price. You give up some money so that you can hold this right.
- short the call option - in this case you are the party that sells a contract which gives someone else the right to purchase (from you) an underlying on or before a future date at the strike price.
- long the put option - in this case you are buying a contract that gives you the right, but not the obligation, to sell an underlying on or before a future date at the strike price.
- short the put option - in this case you are selling to someone else a contract that gives them the right, but not the obligation, to sell an underlying (to you) on or before a future date at the strike price.
In order to fully understand Covered Calls, please see the article:
Buy-Write or Covered Call Strategy Analysis
Ground Rules:
Based on the ground rules which will be enforced here, an investor wanting to engage in selling calls will have to make 2 transactions each time he/she enters into the contract. The investor will have to buy n*100 shares of a given stock or ETF, and sell n call contracts against it. Some brokerage houses will actually make this a single atomic transaction.
Covered Call Outcomes:
- Stock price stays below the call strike price. The option expires worthless, and the investor keeps the proceeds.
- Stock price moves above the call strike price, and the investor is forced to sell the stock at the strike price to a counter party.
In case 1, if the stock price remains relatively unchanged, then the investor did good because he/she generated cash flow from the owning of a stock.
In case 2, the investor did ok because he/she made money. Which is good.
There is also a 3rd case, the stock drops in price. This is the worst possible case because due to the investors long-stock position, the investor will loose money.
This position has 2 somewhat unfortunate issues, the first is that a strong bull market will outperform a covered call strategy, and in a bear market, an investor will only have the protection of the premium generated from the sale of the call.
The maximum upside is the capital gain from the stock plus the proceeds from the sale of the call option.
In a very strong bull market, it is difficult to get out of this position before expiry. What that means is that you may have a large amount of cash "tied up" and waiting for expiry.
Cash Covered Put:
Here one is selling a put, and using "Cash" to back the contract. In this case, only 1 trade is required, that trade is the sale of n put contracts.
This position allows an investor to exit the position very easily in a bull market because the investor can buy back the put cheaply in the event of a bull market, and if desired immediately re-sell another n put contracts with a higher strike price. Because of this, this strategy does not have the opportunity cost associated with being forced hold an strategy until expiry.
Issue: in a strong bear market, this investor is forced to "buy" a depressed stock above the fair market value.
Strategies to "Hedge" against a bear market include selling in-the-money puts, and buying out-of-the money puts. This allows the investor to capitalize on the bull market, while protecting from a bear situation.
Concrete example:
6/22/2010:
Sell 4 contracts of Ford with a strike price of 12.00 USD,
Buy 4 contracts of Ford with a strike price of 10.00 USD,
Cash IN 292.98 (76 *4 - commission)
Cash OUT 44.01 (9*4 + commission)
At Expiry, the payout will exactly match the "intrinsic" value of the position:
Therefore, the maximum profit will be 292.98 - 44.01 = 248.97
The maximum loss will be 800.00 - 248.97 = 551.03
Max Profit: 248.97
Max Lost: 551.03
However, with options, at any time before expiry, the maximum loss will be less than 551.03 because as the stock price drops the put with a strike price of $12.00 will approach the intrinsic value, whereas the put option with a strike price of $10.00 will be composed mostly of its implied volatility value.
Of course as an investor if you find yourself in a position where the stock has taken a loss, you will have to make the decision to "close" out the position at a loss before expiry to ensure that you don't get caught with the maximum lost of 551.03.
