Preparación de la superficie

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CHAPTER

10

Covered Calls and Naked Options LEAPS of Faith

FOREX Options

Philadelphia Options Market

In this chapter, I want to expose you to some of the more advanced uses of options and some special places to shop for options. It is critical that you understand my purpose is to do no more than familiarize you with the possibilities options offer. None of these strategies should be attempted until you have spent considerable time studying and paper trading and have developed a written option-trading plan, discussed in the final chapter.

In addition to buying calls or puts and some simple spreads, another conser- vative strategy for new option traders to experiment with is selling covered calls. There are two basic motivations for selling, writing, or granting covered calls. The first is income, and the second is the downside protection of existing assets. Like everything you do in the market, if the risk is controlled, so is the profit potential.

Notice that I use three terms—sell, write, and grant—interchangeably. Options were once called permissions, as in one having the permission of the owner to as- sume the underlying entity at a predetermined price and time. Therefore, the per- son offering the entity granted the buyer the right—of course, for a price. Early options were over-the-counter; thus they were written by the party of the first part, which brought the phrase “to write an option” into the traders’ lexicon. Since the person granting the option was the one in power, he or she did the writing. Last but not least, if someone bought an option, someone had to sell it. Thus the expression “selling an option” became commonplace, especially on exchange floors. All three terms mean the same thing, so they are used interchangeably.

Think for a moment about how stocks behave. They go up, down, or sideways. And, they do these three things vigorously or languorously. How do you determine if market conditions are right for writing covered calls? The answer, of course, is your old friends, volatility and price chart analysis. The first thing you do, as you consider the possibility of granting an option on a stock in your portfolio, is study the recent price activity and the volatility of the overall market, the stock’s sector, and the volatility of the stock and the specific option under consideration. If your objective is increasing the income from a core asset in your account, meaning that you do not want the stock called away, you look for low volatility and mildly up- trending markets. If you are after ordinary income, you look for high volatility and strongly uptrending markets.

Why is this so? If you write or sell a call on a stock you own and you do not want that stock called away from you, a neutral trading climate is best. You will be long the stock (or other underlying entity) and short an option on that stock or hedged. The trading objective is to sell a call, collect the premium, and wait for the option to expire worthless. If you bought the stock for the sole purpose of writing calls against it, the more market volatility, the better, within reason. Your objective this time is to collect a high premium because volatility is high and to have the stock called away, which provides additional income as the stock gains value. As volatility increases, if prices move high enough, the owner of the option exercises the option and you deliver your stock. You receive both the option’s premium and the gains on the stock as it moves from the CMV to the option’s striking price. In both cases, you get some downside protection from falling prices. As the price of the stock declines, the short call protects you from loss up to the amount of the premium.

Regarding the call that you sell, why must the striking price be above the CMV of the underlying stock? Think about it. Why could the striking price not be below the CMV of the underlying security? If it were, the owner of the call would exer- cise it immediately, compelling you to deliver the stock. The only exception is if the stock is only slightly above the option’s striking price, not enough above it to pay back the entire premium and the commissions to the owner of the option. Be

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aware that some clever floor trader who is paying pocket change per trade in com- missions can call your option for a risk-free profit as quickly as an e-mail traverses the Internet.

There are two basic types of covered calls: at- or near at-the-money and out-of- the-money. Your outlook on the market and your intentions dictate the type you uti- lize. If you think there is a chance that the underlying security could move several points higher and you are using this strategy to generate income, you would select an out-of-the-money option to sell. This way, you get some income from the pre- mium, and there is less chance that the stock will be called away than if you chose an option with a strike price close to the security’s CMV. On the other hand, if your intentions are to extract a few extra points out of the market on the sale of your stock, you might sell an option that is almost in-the-money. This results in a higher premium to you because the options price is closer to the CMV, making it more desirable.

For example, suppose the CMV of your stock is $62 per share when you decide to sell a 65 call with three weeks to expiration and the volatility of the underlining security is above its six-month average. What are your intentions regarding the un- derlying stock? This call is near in-the-money, and therefore it would bring a de- cent premium. As a rule of thumb, the more out-of-the-money an option is, the lower the premium. Time value must also be considered. The longer the option has

to exceed $65 per share, the more likely it is that your stock could be called away. As you learned earlier, traders rarely pay up for time value. “It is the volatility that counts!” It is normally best to sell covered options near expiration.

The objective is to make a few extra bucks when selling a position. Remember how to calculate breakeven for the owner of a long option: premium plus two com- missions. In this case, call this amount $4.00. Your expectation is that the stock will shortly trade in the $67–$68 range. In other words, you hope to make another $2 or $3 per share plus the premium on the sale. If you do not, you either hold onto the stock or sell it at the market on the rally. If you really want to dump the stock, the risk is that the stock does not get called away and the CMV declines.

In this example, the CMV of the stock is $62 and a 65 call sells for 4 points. When the stock is called away, you get to keep the premium of $4 plus the $3 gain on the stock. The total return would be approximately $7 less the commission, or about 10 percent more than selling at-the-market. Not too shabby, unless the stock never stops climbing until it hits $80 per share. The risk in this strategy is lost op- portunity if the analysis is incorrect. When this happens, just say to yourself, “Self, you will never go broke taking profits.”

If you do not want to give up the stock, you would sell an option that is more out-of-the money. In this case, you would be looking for a time when volatility is low and the overall markets are calm. Many people do this with blue chip stocks traded on the New York Stock Exchange, relying on the specialist to keep trading under control. This has worked well in the past, but in recent times, even this staid old institution has become more volatile. In other words, take nothing for granted and do your homework.

What if you wanted to write a covered call on a stock you did not own? This is a common strategy. You would select a stock whose technical characteristics, such as volatility and recent trading strength, fit your trade criteria. Then you would study the options available to find one whose price matched your strategy. Now, do you buy the stock first or the option? Your trading technique here is the same as was discussed regarding spreads. The key is entering both positions, the stock and the option, at as close to the same time as possible. This is the only way to make sure you get the desired price relationship. You just add additional risk if it takes too long to leg into the positions. Even losing a small amount from the desired spread alters the outcome.

For example, in our earlier example, if you were opening the trade from scratch, you would be looking to make 10 percent on the trade. You are buying a stock at $62 per share and selling a 65 call for a $4 premium. You expect to pick up $3 on the stock price and $4 on for the option, for a total of $7 after transaction costs, on a net position of $58, or a gross profit of 12 percent. You would naturally settle for buying the stock at $62.10 and receiving a $4.10 premium because the net is the same. If you got the stock for $64 and sold the option for only $2, however, you

would gain only $1 on the stock and $2 on the option, missing your profit objec- tive. Buying and selling with precision is often the challenge. One answer is a bro- kerage firm or computerized trading platform that accepts conditional orders like: “Buy 100 shares of ABXC at 62 or better and sell one June ABXC 65 call at $4 or better.” The problem is that these are “not held” orders, meaning that the broker- age firm does not guarantee to fill the orders. Not getting a fill is often better than getting a bad fill if it is not within an acceptable parameter. Some brokerage firms require a minimum size, say 500 shares and 5 option contracts, to do to this type of trade. Your second choice is to buy the stock first and then sell the option. Once you know the price of the stock, you can make an adjustment on the option side. The risk is being long a stock that is losing value and having the option you sell, because of the $5 increments, deliver minimal downside protection. Your response is to bail out and try again. Double-check your analytic tools for errors.

What about a covered put position? There is no covered put position compar- able to covered call. If a covered call is being long a stock and short a call option, a covered put would be the opposite, that is, being short the stock and long a put option. When you short stock, you profit when the price of the stock declines, which is the same as with a long put. This would be a short-short position, not a hedged long-short position. The only other alternative would be to short the stock and sell a put. If you sell a put, you have the obligation to deliver a short position to the buyer. If you were short the stock, selling a put would give you no protection because you would be under an obligation to deliver a short position, which would double your liability, not cover or limit it. What is sometimes called a covered put is when someone buys a corresponding put with a strike price equal to or greater than the strike price of a put that person has already sold. In reality, this is a put spread, where one put is covering another.

The whole concept of shorting has never caught on with the investing public, even many professionals. It somehow goes against the grain, as if it is somehow unpatriotic to be bearish on the stock market. In addition, shorting is not well un- derstood. Individual investors have problems intellectualizing the concept of sell- ing something they do not own and buying it back at a lower price at a later date. The risk is also higher in that markets fall faster than they rise. This is because once the buying dries up, the stock has no place to go but down. Therefore, no one wants to buy the stock, and anyone who shorts it just drives it lower faster.

Upward or bullish movements are more methodical. Some buying starts. Then there is a pause, and investors think about where and how high a particular entity could or should go. Then another group of buyers joins the buying crowd. At some point, every pundit on the tube and the Internet is hawking the stock, and news of it reaches the public. The great unwashed are just in time for the blowoff top as the professionals sell into the public buying frenzy. Then slam, bam . . . it is over, and the stock crashes and burns! When you study call and put trading volume, you

notice that there are usually more calls in play than puts, especially in the more distant trading months and even when the market is heading south.

Now to the most dangerous of options strategies—selling naked calls and puts. Naked options are pegged the most dangerous because, unlike buying an option, the risk is not limited to the premium and transaction costs. The price of the un- derlying entity can theoretically rise to an infinite level or plunge to zero. Addi- tionally, the seller must deliver the underlying entity at the whim of the buyer. Since the seller of a naked option does not have the underlying entity in his or her possession, she or he will have to venture into the open market and acquire it at the CMV, which may be miles from the strike price at which he or she sold the option. An example: You sell some 20 June calls on Intel when Intel is trading at 15. Right after you sell it, Intel announces a new, faster, smaller, more versatile chip— bingo! It is trading at 30, and those folks who bought calls from you at 20 want the stock. You have to come up with 100 shares for every option you sold. When the process of exercising begins, you have to deliver the stock. Do you get the luxury of placing some limit orders in the market and seeing if you can find fills at 28 or 29? No! You must deliver posthaste, which means using a market order, which fills at any price. Intel could be at 40 by the time you get your fills. (See Appendix 2 for an explanation of the different types of orders used in securities trading, if you are not familiar with them.) Your brokerage firm is responsible for delivering your po- sitions in case you are late or default. It must deliver promptly, whether you have the stock or not. Your broker will be on you like red paint on a fire truck. You are forced to get the stock to replace what your brokerage firm delivered to the contra side of the option. If you do not, you face margin calls, and your broker will do everything possible to get its money back.

What is the problem with market orders? Most of them fill at or near the high of the trading range. With futures contracts, as you will read soon, it can be worse. In this example, the stock opened at 30 the day you received notice that your stock was being called away, but you do not get a 30 fill. Yours is in the 35 to 40 price range, or whatever the market wants to give you, depending on how fast it is mov- ing or how strong volatility is. The fills are on the high side because the market is running away from your striking price. If your fill comes in at 35, you lose $15 per share, or the difference between the striking price and your fill price. That is $1,500 per contract less the premium; call it 3 points per share, or $300, netting out to $1,200 per option plus transaction fees. Your maximum reward, the pre- mium less transaction costs, was approximately $300 per option, and you lost $1,200. That is what is meant by saying that this is the riskiest of strategies, a neg- ative risk-reward ratio of 4:1. It could have been a lot worse. Intel could have gone up 50 or 100 points. There is no telling when a blowoff top occurs.

Are you up to that? On the other hand, you could have sold a put. Intel’s arch competitor could have announced a new chip that was going to take most of Intel’s

business away. If Intel was trading at 15 at the time and you sold 121_⁄

2 puts, you

would at least have known that the lowest Intel could drop would be to zero. If In- tel went out of business and the stock disappeared from the exchange, you would still settle with the trader who bought the puts in cash.

Moving on, many individual traders find LEAPS interesting. The acronym stands for long-term equity anticipation securities. LEAPS are listed options that are similar to the listed equity options discussed so far, but there are some important differences. The biggest is the term, that is, long-term means 2 to 21_⁄

2years compared to 9 months

with regular options. Another difference is that LEAPS do not have standard strike prices, but the strike prices assigned conform to the intervals of regular options. For example, you may look at an option price array and see calls and puts as 55, 65, and 80, rather than the more orderly $5 intervals of regular options. Strike prices are