Upload
pawanchauhan14
View
221
Download
0
Embed Size (px)
Citation preview
7/28/2019 Option Overwriting
1/61
1
Chapter 18
Option Overwriting
7/28/2019 Option Overwriting
2/61
2
Whats a good way to raise the blood pressure of an
Investor Relations Manager? Answer: Talk aboutthe pros and cons of stock options.
- Eilene H. Kirrane
7/28/2019 Option Overwriting
3/61
3
Outline Introduction
Using options to generate income
Combined hedging/income generation
strategies
Multiple portfolio managers
7/28/2019 Option Overwriting
4/61
4
Introduction Option overwritingrefers 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
7/28/2019 Option Overwriting
5/61
5
Using Options to
Generate Income Writing calls to generate income
Writing puts to generate income
Writing index options
A comparative example
7/28/2019 Option Overwriting
6/61
6
Writing Calls to
Generate Income Writing covered calls
Writing naked calls
7/28/2019 Option Overwriting
7/61
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
7/28/2019 Option Overwriting
8/61
8
Writing Covered Calls (contd) Covered call writing is very popular with
foundations, pension funds, and other
portfolios that need to produce periodiccash flows
In relatively stable or slightly decliningmarkets, covered call writing can enhanceinvestment returns
7/28/2019 Option Overwriting
9/61
9
Writing Covered Calls (contd)Example
Nile.com stock currently trades for $116 per share. Calloptions with a striking price of $120 and a $6 premiumare available for Nile.com.
Construct a worksheet and a profit and loss diagram to
determine the profit or loss associated with writing acovered call for Nile.com. Assume the investor purchasesthe stock for $116. Use a range for the stock price atoption expiration from $0 to $150.
7/28/2019 Option Overwriting
10/61
10
Writing Covered Calls (contd)Example (contd)
Solution: A possible worksheet is shown below:
+10+10+10+6-10-60-110Total
-24+1+6+6+6+6+6Short call
+34+9+40-16-66-116Long stock
150125120116100500
Stock Price at Option Expiration
7/28/2019 Option Overwriting
11/61
11
Writing Covered Calls (contd)Example (contd)
$0
-$110
$10
$120
Maximum gain
Maximum loss
7/28/2019 Option Overwriting
12/61
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
7/28/2019 Option Overwriting
13/61
13
Writing Naked Calls (contd)Naked call writing is not often used by
individual investors
Brokerage houses may enforce high minimumaccount balances
Fiduciaries should be extremely carefulabout writing naked calls for a client
7/28/2019 Option Overwriting
14/61
14
Writing Puts to
Generate Income Fiduciary puts
Put overwriting
7/28/2019 Option Overwriting
15/61
15
Fiduciary Puts Afiduciary putis 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
7/28/2019 Option Overwriting
16/61
16
Fiduciary Puts (contd)Example
February put options on Nile.com are available with anexercise 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.
7/28/2019 Option Overwriting
17/61
17
Fiduciary Puts (contd)Example (contd)
$0
-$112.75
$7.25
$120
Maximum gain
Maximum loss
7/28/2019 Option Overwriting
18/61
18
Put OverwritingPut overwriting:
Involves owning shares of stock and writing put
options against them Is a bullish strategyBoth owning shares and writing puts are bullish
strategies
May be appropriate for portfolio managers whodont want to write calls for fear of opportunitylosses
7/28/2019 Option Overwriting
19/61
19
Put Overwriting (contd)Example
An investor buys Nile.com stock for $116 per share.Simultaneously, the investor writes a Nile.com FEB 115put 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 putoverwriting. Use a range for the stock price at optionexpiration from $0 to $150.
7/28/2019 Option Overwriting
20/61
20
Put Overwriting (contd)Example (contd)
Solution: A possible worksheet is shown below:
+38.35+4.25+3.25-76.75-226.75Total
+4.25+4.25+4.25-35.75-110.75Short put+340-1-41-116Long stock
150116115750
Stock Price at Option Expiration
7/28/2019 Option Overwriting
21/61
21
Put Overwriting (contd)Example (contd)
$0
-$226.75
$115
Maximum gain
is unlimited
Maximum loss
7/28/2019 Option Overwriting
22/61
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?
7/28/2019 Option Overwriting
23/61
23
IntroductionIndex 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
7/28/2019 Option Overwriting
24/61
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
7/28/2019 Option Overwriting
25/61
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
7/28/2019 Option Overwriting
26/61
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
7/28/2019 Option Overwriting
27/61
27
Forms of Margin
(Margin Equivalents)
7/28/2019 Option Overwriting
28/61
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 endsup in the money
7/28/2019 Option Overwriting
29/61
29
The Risk of
Index Calls (contd) Cash settlementprocedures for in-the-
money index options:
Involve the transfer of cash rather thansecurities
The writer owes the call holder the intrinsicvalue of the call at option expiration
7/28/2019 Option Overwriting
30/61
30
The Risk of
Index Calls (contd)Example
A portfolio manager wrote 90 FEB 690 OEX calls. On theexpiration 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?
7/28/2019 Option Overwriting
31/61
31
The Risk of
Index Calls (contd)Example
Solution: The manager must pay $27,000:
(693.00 690.00) x $100 x 90 contracts = $27,000
7/28/2019 Option Overwriting
32/61
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 whencalls expire in-the-money and are exercised
7/28/2019 Option Overwriting
33/61
33
A Comparative Example Setup
Covered equity call writing
Covered index call writing
Writing fiduciary puts
Put overwriting
Risk/return comparisons
7/28/2019 Option Overwriting
34/61
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)
7/28/2019 Option Overwriting
35/61
35
7/28/2019 Option Overwriting
36/61
36
Covered Equity Call Writing Individual call options are written against
each of the five securities in the portfolio
The following slide shows the managers
selection of options and the resulting
performance
7/28/2019 Option Overwriting
37/61
37
7/28/2019 Option Overwriting
38/61
38
Covered Equity
Call Writing (contd) 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
7/28/2019 Option Overwriting
39/61
39
Covered Index Call Writing Covered index calls are written
The following slide shows the managersselection and performance
7/28/2019 Option Overwriting
40/61
40
7/28/2019 Option Overwriting
41/61
41
Covered Index
Call Writing (contd) Observations:
The greatest gain occurs when the market
advances 5%
The manager does not have to sell any stocks
because of cash settlement
7/28/2019 Option Overwriting
42/61
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
7/28/2019 Option Overwriting
43/61
43
7/28/2019 Option Overwriting
44/61
44
Put Overwriting Put overwriting is the most aggressive
strategy
The following slide shows the selection of
puts and the resulting performance
7/28/2019 Option Overwriting
45/61
45
7/28/2019 Option Overwriting
46/61
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
7/28/2019 Option Overwriting
47/61
47
Risk/Return
Comparisons (contd)
7/28/2019 Option Overwriting
48/61
48
Combined Hedging/Income
Generation Strategies
Writing calls to improve on the market
Writing puts to acquire stock
Writing covered calls for downsideprotection
7/28/2019 Option Overwriting
49/61
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
7/28/2019 Option Overwriting
50/61
50
Writing Calls to Improve on
the Market (contd)
Example
Nile.com stock currently sells for $116 per share. An
institution holds 1,000 shares and would like to sell thestock. JAN 100 calls on Nile.com are available for $18 pershare.
If the stock price on the expiration is $120, what would bethe cash receipts to the institution if it writes 10 calls andsells the stock in January? What would be the cashreceipts if it sold the stock today?
7/28/2019 Option Overwriting
51/61
51
Writing Calls to Improve on
the Market (contd)
Example (contd)
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
7/28/2019 Option Overwriting
52/61
52
Writing Puts to Acquire Stock
Involves writing in-the-money put options
A manager can improve on the market bypurchasing the stock when the put options
are exercised
7/28/2019 Option Overwriting
53/61
53
Writing Puts to
Acquire Stock (contd)
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?
7/28/2019 Option Overwriting
54/61
54
Writing Puts to
Acquire Stock (contd)
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
7/28/2019 Option Overwriting
55/61
55
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, butalternatives are: Buying puts
Using portfolio insurance
7/28/2019 Option Overwriting
56/61
56
Multiple Portfolio Managers
Separate responsibilities
Distinction between option overwriting and
portfolio splitting Integrating options and equity management
7/28/2019 Option Overwriting
57/61
57
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
7/28/2019 Option Overwriting
58/61
58
Option Overwriting
Versus Portfolio Splitting
Portfolio splittingmeans 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
7/28/2019 Option Overwriting
59/61
59
Integrating Options
and Equity Management
Hedging company-specific risk
Unity of command
7/28/2019 Option Overwriting
60/61
60
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 indexoptions
7/28/2019 Option Overwriting
61/61
61
Unity of Command
Index options increase the feasibility ofusing a single portfolio manager for bothequity and option positions
Index options do not require the transfer ofsecurities
The time requirement to overwrite with index
options is minimal The manager who has the flexibility of index
options can exercise more creativity