Moneyblock Option Strategies

8/12/2019 Moneyblock Option Strategies

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Who Should Consider Using Covered Calls? An investor who is neutral to moderately bullish on some of the equities in his portfolio.

An investor who is willing to limit his upside potential in exchange for some downside

protection.

An investor who would like to be paid for assuming the obligation of selling a particular

stock at a specified price.

This strategy would work equally well for a cash,

margin, Keogh account or IRA. Although thisstrategy may not be suitable for everyone, any of the

investors above may benefit from using the covered

call.

Definition

Covered call writing is either the simultaneous

purchase of stock and the sale of a call option or the

sale of a call option against a stock currently held by

an investor. Generally, one call option is sold for

every 100 shares of stock. The writer receives cashfor selling the call but will be obligated to sell the

stock at the strike price of the call if the call is

assigned to his account. In other words, an investor

is "paid" to agree to sell his holdings at a certain

level (the strike price). In exchange for being paid,

the investor gives up any increase in the stock above

the strike price.

HowtoUseCoveredCalls

If an investor is neutral to moderately bullish on a

stock currently owned, the coved call might be a

strategy he would consider. Lets say that 100

shares are currently held in his account. If the

investor was to sell one slightly out-of-the-money

call, he would be paid a premium to be obligated to

sell the stock at a predetermined price, the strike

price. In addition to receiving the premium, the

investor would also continue to receive the

dividends (if any) as long as he still owns the stock.

The covered call can also be used if the investor is

considering buying a stock on which he is

moderately bullish for the near term. A call could

be sold at the same time the stock is purchased. The

premium collected reduces the effective cost of the

stock and he will continue to collect dividends (if

any) for as long as the stock is held.


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In either case the investor is at risk of losing the stock if it rises above the strike price. Remember, in exchange

for receiving the premium for having sold the calls, the investor is obligated to sell the stock. However, as you

will see in the following example, even though he has given up some upside potential there can still be a good

return on the investment.

Stock ZYX currently is priced at 41.75, and the investor thinks this might be a good purchase. The three-

month 45 calls can be sold for 1.25. Historically, ZYX has paid a quarterly dividend of 25 cents. By selling

the three-month 45 call the investor is agreeing to sell ZYX at 45 should the owner of the call decide to

exercise his right to buy the stock. Keep in mind that the call owner may exercise the option if the stock is

above 45, because he will be able to buy the stock for less than it is currently trading for in the open market.

But, as you will see, his return will be greater than if he had held the stock until it reached 45 and then sold

it at that price.

Lets take a look at what happens to a covered call position as the underlying stock moves up or down.

Commissions have not been taken into consideration in these examples; however, they can have a significant

effect on your returns.

Buying 100 ZYX at 41.75 and Selling 1 Three-Month 45 Call at 1.25

I. ZYX remains below 45 between now and expiration--call not assigned.

The call option will expire worthless. The premium of 1.25 and the stock position will be retained. In effect

you have paid 40.50 (which is also the breakeven price) for ZYX (41.75 purchase cost - 1.25 premium

received for sale of call). This would be offset by any dividends that were received, which in this example

would be 25.

When the ZYX call expires worthless, the covered call writer can sell another call going further out in time

taking in additional premium. Once again, this produces an even lower purchase cost or breakeven.

If ZYX remains below 45 for an entire year, the investor can sell these calls four times. For this example we

will make the hypothetical assumption that the price of the stock and option premiums remain constant

throughout the year.

1.25 (Call Premium Received) x 4 = $5 in Premium + Any Dividends Paid = Total Income.


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II. ZYX rises above 45 between now and expiration--call assigned.

The call buyer can exercise his right to buy the stock and the call seller will have to sell ZYX at 45, even

though ZYX has risen above 45. But remember the call seller has taken in the premium of the call and has

been earning dividends (if any) on the stock.

If ZYX stock is called away at expiration:

Receive: $45 for Stock $4,500.00

Less: Net Investment (Stock Cost - Premium Received)

[$4,175 - $125] ($4,050)

Return: 11.11% $450*

*In three months plus dividends (if any) received.

III. ZYX is right at 45 at expiration.

The seller of a call may be in situation I or II. The stock may be called away and the call writer will be

obligated to sell ZYX at 45. Alternatively, the stock may not be called away. A call could then be sold goingfurther out in time, bringing in additional premium and further reducing the breakeven point.

Summary

The covered call write is a strategy that has the ability to meet the needs of a wide range of investors. It can be

used in your Keogh, margin, cash account or IRA against stock you already own or are planning on buying.

Currently, there are short-term options listed on more than 1,400 stocks and more than 350 of those stocks

also have LEAPS, Long-term Equity AnticiPation SecuritiesTM, which are simply long-term stock and index

options. Todays investor has a choice of short-term and long-term expirations, as well as multiple strike

prices. This strategy is actually more conservative than just buying stock, due to the fact that you have taken

in premium and lowered your breakeven price on the stock position. The covered write allows you to be paidfor assuming the obligation of selling a particular stock at a specified price.


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Who Should Consider Using the Stock Repair Strategy An investor who owns shares purchased at a price above the current market price,

and who is looking to break-even on this position.

An investor who is willing to give up any profit potential above his break-even point.

An investor who is unwilling to commit additional funds to his current position.

An investor who is unwilling to assume any additionaldownside risk.

*Please note: This transaction must be done in a margin account

The goal of the strategy is to reduce the investors break-even price, without having to assume

any additional downside risk.

DefinitionThe Repair Strategy is built around an existing stock

position, usually a stock that is now trading at a lower

price than the investors original cost. For every 100

shares held, 1 call option is purchased, and 2 call

options with a higher strike price are sold; these

purchases and sales are structured in such a fashion

that the investors cash outlay is minimal or none.

How to Use the Repair StrategyPlease note: Commissions and taxes have not beentaken into consideration in these examples, and can

have a significant effect on returns.

An investor purchased a non-optionablestock and

seeing its value decline after this purchase, and who is

now simply looking to break-even, has two choices:

hold and hope or double up.

The hold and hope strategy requires that the stock

retraces its fall all the way back to the investors

purchase price, an event that may be a long time in the

making. The double up strategy, i.e., purchasing

additional shares at a now lower price, does lower the

investors break-even point, but it requires that

additional funds be committed to the strategy, and it

increases the downside risk of the position.

An investor who finds himself with an unrealized loss

on an optionablestock, has a third alternative: the

Repair Strategy. For example, an investor could have

purchased 500 shares of YZYZ stock at $50 and seen

the value of these shares fall to the current price of

$40. To establish the Repair Strategy, this investorcould purchase 5 60-day 40 calls at $3 and simulta-

neously sell 10 60-day 45 calls at $1.50. Note that

the cost of the purchased calls ($3 x 5 x 100 =

$1,500) is fully offset by premium received from the

sale of the written calls ($1.50 x 10 x 100 = $1,500).

The 5 purchased calls give the investor the right to

purchase an additional 500 shares at a cost of $40 per

share. The 10 written calls means that the investor

could be obligated to sell 1,000 shares of YZYZ at

$45. He currently holds only 500 shares, but, if

needed, could exercise his long calls and purchase

another 500 shares at $40.


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Establishing the Repair Strategy:Long 5 60-day 40 Calls,Short 10 60-day 45 Calls

I. YZYZ falls to $35 at option expiration

in 60 days

If at expiration in 60-days, the price of YZYZ has

continued to decline and is now at $35, both the long

40 calls will expire worthless, and the short 45 calls

will expire worthless. Since the investor initiated the

option position at no cost and all of these options have

expired worthless, the option strategy has had no

impact on the overall position. The investor has seen

an additional $5 loss accrue on the original shares, the

same as would have resulted had he simply held on to

his shares.

It should be noted that if the Repair Strategy is

utilized on a stock that continues to decline, it will not

protect the investor from any further decrease in the

price of the underlying stock. If the investor is expect-

ing the price of YZYZ to continue to fall, a strategy

other than the Repair Strategy should be considered.

II. YZYZ is unchanged at $40 at option

expiration in 60 days

If at expiration in 60-days, the price of YZYZ is

unchanged at $40, the situation is very similar to theabove: all of the call options expire worthless, and the

investor is left with his stock position. Once again the

Repair Strategy has neither helped, nor made things

any worse.

III. YZYZ is up to $45 at expiration

in 60 days

If YZYZ has rallied to $45 at expiration, the investors

long calls will then be worth $5. The short $45 calls

will expire worthless. The investor will have a $5

profit on the options, keeping in mind that the

position was initiated for no cost. On the long stock

position, at $45, the unrealized loss will be reduced to

$5. Taking this $5 loss on the stock, and the $5 profit

on the option position, the investor breaks-even on the

overall position.

Notice that what the investor has succeeded in doing is

lowering his break-even point from a stock cost of $50,

to $45. Also note that the Repair Strategy does need

the underlying to at least partially recover in order to

obtain the desired result.

IV. YZYZ is up to $50 at expiration

in 60 days

Should YZYZ rally back to $50 by option expiration,

the investors position will be as follows:

Long stock will break-even

Long 5 of the 40 calls, each now worth $10

Short 10 of the 45 calls, each now worth $5.

The net value of the options equals zero:(5 x 10 x 100) (10 x 5 x 100) = $0.

The value of the options cancel out, the stock is at

break-even, and so the overall position breaks-even.

This is the downside of the Repair Strategy: the best

the investor can do is to break even.

The following table summarizes the investors overall position for various stock prices at expiration. Note thatthe cost of the options is not taken into account since the option position was initiated for no net cost.

Stock at Gain (Loss) Value of 40 Value of 45 Net GainExpiration on Stock Calls Calls* (Loss)

35 (15) 0 0 (15)

40 (10) 0 0 (10)

45 (5) 5 0 0

50 0 10 (2 X -5) 0

55 5 15 (2 X -10) 0

* The value of the short calls is multiplied by 2 since the investor sold 10 calls, versus a long position of 500 shares,and a long position of 5 calls.


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Determining Strike PricesOne consideration when establishing the Repair

Strategy is which option should be purchased, and

which should be sold. Note that in the above

example, the unrealized loss on the stock was 10

dollars and the strike price interval between the

options chosen was $5, half the unrealized loss. If

an investor was holding a stock now trading at 90

with an original cost of 110 (i.e.; a $20 unrealized

loss), she should look to purchase the 90 calls and

sell the 100 calls. If an investor purchases at-the-

money options, then he should look to sell out-of-

the-money options that are approximately at the

half-way mark between the current stock price and

the original acquisition cost.

Can the Repair Strategy be implemented for all

stocks that are trading below the purchase price?

Unfortunately not. The strategy will work for most

stocks that are down 20% from their entry point

(using options that may have 60 to 90 days to

expiration), but will prove inadequate for stocks

down 40% or 50%. In the later cases, investors will

find that selling two out-of-the-money calls will notgenerate enough premium to finance the one at-

the-money call purchased.

Finally, very often, the strategy can be initiated for a

small credit or a small debit. Investors should still

consider the strategy in those cases were they may

have to pay $0.25 or $0.50 for initiating the

position. They may find that the overall benefits of

the strategy are worth a minimal outlay.


8/15

Summary TableUse per share amounts

(1) (2) (3) (4) (5)Stock Price Gain (Loss) Expiration Value Expiration Value Per share Cost of Net at Expiration on Stock of Lower Strike Calls Upper Strike Calls Initiating Position Gain (Loss)

0 000*SL

0**SU

(2 x )

Net Gain (Loss) = 1 + 2 + 3 + 4

* LS = Lower Strike (Calls Purchased)

** US = Upper Strike (Calls Sold)


9/15

Who Should Consider Selling Cash-Secured Puts?

An investor who would like to acquire a position in a particular security,

but is willing to wait for it to trade at his desired purchase price.

Have you given your stockbroker an order to buy a

security at a specified price? If you have, you have

participated in a waiting game. The stock will not

be purchased until it trades at or below your limit

price. Instead of waiting for that to happen, you

could have sold a cash-secured put. A premium (the

price of the option) for selling a put option would

be paid to you for accepting the obligation to buy astock that you want to be a part of your portfolio at

the price you select.

This strategy is used by large portfolio managers as well

as individual investors because it pays them for

assuming the obligation to buy a particular stock. In

other words, certain investors who are considering

buying a stock (or more of a stock they already own)

may want to sell cash-secured puts.

Definition

Selling a cash-secured put involves selling a put and

depositing the money for the purchase of stock at the

brokerage firm (generally, this money is invested in

short-term instruments). The purpose of having the

money in the account is to assure that funds are

available to purchase the stock should the put be

assigned to the account. Generally, the buyer of the

put will exercise the option should the underlying

stock drop below the strike price (the price at which

the seller of the put has agreed to buy the stock). If the

stock does not drop below the strike price by

expiration, the premium will be retained by the seller

and another put may be sold. By selling the put, the

investor receives the premium while waiting for the

stock to decline to the strike or price at which he is

willing to own it.

Therefore, the cash-secured put is a strategy that may

help you accumulate stock at a lower price than where

it is currently trading (net cost = strike price -

premium).

How to Use the Cash-Secured Put

to Buy Stock at a Lower Price

Stock ZYX is a stock that an investor would like to

own. Currently, it is priced at 47-1/8, but he feels it

would be a good buy at 45 and that the stock could

reach that level within the next two months. The

investor can either place a limit order to buy ZYX at

45 or an order to sell ZYX puts with a 45 strike.

Remember, by selling the puts with a 45 strike, he has

the obligation to buy the stock at 45 should the buyer

of the options exercise the right to sell ZYX. The

investor would sell one put for every 100 shares of

stock he was willing to purchase.

.


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Lets compare these two strategies. Commissions and taxes have not been taken into consideration in these examples,

although they can have a significant affect on your returns.

Placing a Limit Buy Order on 500 ZYX at 45 vs. Selling 5 ZYX 2-Month 45

Puts at 1.25 When the Stock is Trading at 47.

At expiration, the stock will either be above 45, in which case the investor will not buy the stock, or below 45,

in which case he can expect to buy the stock at 45. The outcome of each scenario is explained below.

I. ZYX remains above 45 between now and expiration--option not assigned.

Limit Order to Buy 500 ZYX @ 45 Sell 5 ZYX 2-month 45 Puts @ 1.25

thguobsikcotsonthguobsikcotson

526$=stcartnoc5x52.1fomuimerppeeknepollitsredrotimil

By selling a cash-secured put or entering a limit order to purchase the stock, the investor will not be able to

participate in a rise in the price of the underlying. If the puts that were sold expired without being assigned, the

investor could sell another 5 puts if he were still interested in owning 500 shares of ZYX.

II. ZYX is below 45 at expiration--option assigned.

Limit Order to Buy 500 ZYX @ 45 Sell 5 ZYX 2-month 45 Puts @ 1.25

Own (long) 500 shares ZYX @ 45 Own (long) 500 shares ZYX @ 45

less premium for put 1.25

net cost = 43.75

Using a limit order to buy ZYX, the breakeven would be what he paid for the stock. Selling the put lowers the

breakeven which is the strike price less the premium, 45 - 1.25 = 43.75.

Having sold the puts with a 45 strike, should ZYX decline considerably the investor still has the obligation to buy

the stock at 45. However, he does have the cost reduction of the 1.25 premium received for the sale. If a limit order

had been used to purchase the stock at 45, he would begin losing money as soon as ZYX dropped below 45 (thebreakeven).

III. ZYX is at 45 at expiration.

The investor may be in either situation I or II. With a limit order at 45, he may or may not buy the stock. There is

no guarantee that he has bought ZYX at 45 until it trades below his limit price.

If puts were sold, he has the obligation to buy 500 shares of ZYX, and he may be assigned (have the stock put to

him) or the puts may expire worthless. Either way he retains the premium.

Placing a Limit Buy Order on 500 ZYX at 60 vs. Selling 5 ZYX 2-Month 65

Puts at 5.50 When the Stock is Trading at 65

There is another way to use the cash-secured put. For this example we will assume ZYX is trading at 65. Once

again, an investor would like to own ZYX, but not at this level. He thinks that ZYX would be a good buy at 60.

The previous example showed the sale of an out-of-the-money put (put strike price below current stock price)

which required the stock dropping to the strike price of the put before the stock would be purchased. An alternative

approach is to sell an at-the-money put (put strike price and current stock price are equal) or an in-the-money put

(put strike price above current stock price) in which the premium from the put assures a target net purchase price


11/15

for the stock. By selling an in-the-money put it is more likely that the put will be assigned and the stock will be

purchased. The owner of an in-the-money put is likely to exercise his right to sell the stock above its current value,

therefore, the seller of the put will be obligated to buy the stock.

Lets compare the limit order to the at-the-money put sale.

I. ZYX rises above 65 between now and expiration, and there is no assignment.

Limit Order to Buy 500 ZYX @ 60 Sell 5 ZYX 2-month 65 puts @ 5.50thguobkcotsonthguobkcotson

fomuimerppeeknepollitsredrotimil

5.50 x 5 contracts = $2,750

II. ZYX drops below 65, but remains above 60 by expiration--option assigned.

Limit Order to Buy 500 ZYX @ 60 Sell 5 ZYX 2-month 65 puts @ 5.50

56@XYZserahs005)gnol(nwothguobkcotson

limit order still open less premium for put 5.50

net cost = 59.50

Selling the cash-secured put at a strike price of 65 for 5-5/8 allowed the investor to buy ZYX below the 60 limit at

a net cost of 59.50, even though ZYX never traded there. If he had used a buy order at 60, he would not own any

stock.

III. ZYX drops below 60 by expiration--option assigned.

Limit Order to Buy 500 ZYX @ 60 Sell 5 ZYX 2-month 65 puts @ 5-5/8

56@serahs005)gnol(nwo06@serahs005)gnol(nwo

less premium for put 5-5/8

net cost = 59-3/8

Even if ZYX dropped through his 60 limit, the cash-secured puts supplied some downside protection. Since the

net cost is 59-3/8, so is the breakeven. Had ZYX been purchased with a limit order at 60, the investor would nothave any downside protection, and would begin to lose as soon as it dropped below the limit order cost.

IV. ZYX at 60 at expiration.

If a limit order was used to buy the stock, he may or may not own it. However, had the put been sold he might be

put the stock and own ZYX at a price of 59.50 (65 strike price - 5.50 premium).

Summary

Selling a cash-secured putis a strategy that allows you to be paid a premium for the obligation to buy a particular

stock. Currently, there are short-term options listed on more than 1400 stocks and more than 350 of those stocks

also have LEAPS, Long-term Equity AnticiPation SecuritiesTM, which are simply long-term stock and indexoptions. The premium received for selling a put gives you some downside protection by lowering your breakeven

while placing no limit on how high the stock can be subsequently sold. This strategy may also give you the

opportunity to purchase a security for a lower cost than it is currently trading. In other words, someone interested

in investing in stock may want to consider selling a cash-secured put as a means of buying that stock.


12/15

Who Should Use Equity Collars?

An investor who is looking to limit the downside risk of an equity at little or no cost.

An investor who is willing to forego upside potential in return for obtaining this

downside protection.

Equity collars are used by investors whose primary concern is the downside risk of a stock position.

They are willing to place a cap on upside potential in order to limit their down side risk at little, and

sometimes no cost. Collars may be of special interest to those investors who have one equity position

that accounts for a large proportion of their net worth, and who may not be able to reduce the size of

this position. For these investors, low cost protection may take a precedence over maintaining upside

potential.

DefinitionAn equity collar consists of the simultaneous

purchase of a put option, and the writing of a call

option. Both options are out-of-the-money, and

usually have the same expiration date. Most often a

collar is established against an existing equity

position, with one put purchased and one call

written for every 100 shares held. It is also possible

to establish a collar at the same time that an equity

position is purchased.

How to Use an Equity CollarCollars are used mostly by investors who have

accumulated a large position in a given stock

(through an employee stock purchase plan, for

example) and who are primarily concerned about

the downside risk of their holdings. These investors

may be reluctant to sell their stock for a variety of

reasons: the tax liability could be substantial, or

selling your employers stock may be sending the

wrong kind of signal to management or other

shareholders. These investors are also willing to give

up some of the stocks upside potential in order to

obtain the desired downside protection at little or

no cost.

As an example, consider an investor who has accu-

mulated 1,000 shares of XYX stock, now trading at

$44.75 This investor may be familiar with the

purchase of protective puts but may also be reluc-

tant to spend the amount necessary to buy put

options. This could be especially true if the desired

protection is for a relatively long period of time. If

a 10-month 40 put option on XYX could be

purchased for $4.75, for example, the investor

might be unwilling to pay such a high premium.


13/15

In order to lower the net cost of the protection, the

investor could purchase 10 of the 10-month 40

puts, and, at the same time, sell 10 of the 10-

month 55 calls for $4.50. The cost of the put

options is offset, for the most part, by the premium

received from writing the call options. If the collar

could be established for no net premium, then it

would be what is commonly known as a zero-cost

collar. Commissions are not taken into consideration

in the analysis that follows, however, commissions

can have a significant effect on expected returns.

Purchasing the 10-month40-55 Collar for a Net Premiumof $0.25 per Share

I. XYX is below $40 at expiration

If XYX is trading below $40 at expiration, the

investor will have the right to exercise the put

options and sell the shares at the strike price of $40.

This represents the worst case scenario, and the

investor will have to absorb a loss of $4.75 per share

(the difference between the stock price of $44.75

when the position initiated and the selling price of

$40) and a loss of $0.25 per share which represents

the cost of the collar. The total downside risk,

therefore, is $5.00 per share.

Note: If, prior to expiration, the investor decides to

keep the shares, the put could be sold. The pro-

ceeds from the sale of the put would partially offset

the accrued loss on the stock.

II. XYX is above $55 at expiration

If XYX is trading above $55 at expiration, it is

likely that the written 55 calls will be assigned.

Consequently, the investor will be forced to sell the

XYX shares at the strike price of $55. Remember

that when call options are written against a long

stock position, an obligation to deliver those shares

at the options strike price is being assumed. If the

buyer of these calls decides to exercise, then the

writer must deliver the shares.

In establishing a collar, the obligation to deliver

shares was assumed so that the call premium could

be used to partially offset the cost of the put

option. The stock being called away at $55, in this

example, represents the investors best case scenario.

A $10.25 gain (the exercise price of $55 minus the

original price of the stock, $44.75) will be realized

less the $0.25 cost of the collar. The upside,

therefore, is limited to $10 per share.

III. XYX is trading between $40 and $55

at expiration

If the price of XYX is anywhere between $40 and

$55 at expiration, both the put and call options

will be out-of-the-money and will expire worthless.

The investor will keep the XYX shares, and the

only cost will have been that of establishing thecollar, $0.25 per share in this example. During this

period, the investor will have retained ownership of

the shares, with the ability to vote and to receive

dividends, if either applied.


14/15

Commission, dividends, margins, taxes and other transaction charges have not been included. However, they will affect the outcome of optiontransactions and should be considered. The strategy discussed above is for illustrative and educational purposes only and should not be construedas an endorsement, recommendation or solicitation to buy or sell any particular security. Options involve risk and are not suitable for allinvestors. For information on the uses and risks of options, you can obtain a copy of Characteristics and Risksof Standardized Options from TheOptions Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, IL 60606, 1-888-OPTIONS.

5/09

FREE interactive strategies are available at www.cboe.com


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