Options Trading for the Conservative Investor PDF (2nd Edition)

From the Library of Lee Bogdanoff Download at WoweBook.Com OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com This page intentionally left blank From the Library of Lee Bogdanoff Download at WoweBook.Com OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR INCREASING PROFITS WITHOUT INCREASING YOUR RISK Michael C. Thomsett From the Library of Lee Bogdanoff Download at WoweBook.Com Vice President, Publisher: Tim Moore Associate Publisher and Director of Marketing: Amy Neidlinger Executive Editor: Jim Boyd Editorial Assistant: Pamela Boland Operations Manager: Gina Kanouse Senior Marketing Manager: Julie Phifer Publicity Manager: Laura Czaja Assistant Marketing Manager: Megan Colvin Cover Designer: Alan Clements Managing Editor: Kristy Hart Project Editors: Julie Anderson and Jovana San Nicolas-Shirley Copy Editor: Karen Gill Proofreader: Dan Knott Indexer: Michael C. Thomsett Senior Compositor: Gloria Schurick Manufacturing Buyer: Dan Uhrig © 2010 by Pearson Education, Inc. Publishing as FT Press Upper Saddle River, New Jersey 07458 This book is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, or other professional services or advice by publishing this book. Each individual situation is unique. Thus, if legal or financial advice or other expert assistance is required in a specific situation, the services of a competent professional should be sought to ensure that the situation has been evaluated carefully and appropriately. The author and the publisher disclaim any liability, loss, or risk resulting directly or indirectly, from the use or application of any of the contents of this book. FT Press offers excellent discounts on this book when ordered in quantity for bulk purchases or special sales. For more information, please contact U.S. Corporate and Government Sales, 1-800-382-3419, [email protected]. For sales outside the U.S., please contact International Sales at [email protected]. Company and product names mentioned herein are the trademarks or registered trademarks of their respective owners. All rights reserved. No part of this book may be reproduced, in any form or by any means, without permission in writing from the publisher. Printed in the United States of America First Printing January 2010 ISBN-10: 0-13-704200-0 ISBN-13: 978-0-13-704200-5 Pearson Education LTD. Pearson Education Australia PTY, Limited. Pearson Education Singapore, Pte. Ltd. Pearson Education North Asia, Ltd. Pearson Education Canada, Ltd. Pearson Educación de Mexico, S.A. de C.V. Pearson Education—Japan Pearson Education Malaysia, Pte. Ltd. Library of Congress Cataloging-in-Publication Data Thomsett, Michael C. Options trading for the conservative investor : increasing profits without increasing your risk / Michael C. Thomsett. — 2nd ed. p. cm. Includes bibliographical references and index. ISBN 978-0-13-704200-5 (hardback : alk. paper) 1. Stock options. 2. Options (Finance) 3. Investments. 4. Risk management. I. Title. HG6042.T462 2010 332.63’2283—dc22 2009036159 From the Library of Lee Bogdanoff Download at WoweBook.Com CONTENTS ACKNOWLEDGMENTS............xi ABOUT THE AUTHOR............xii PREFACE.......................xiii CHAPTER 1: SETTING THE GROUND RULES....1 The Ground Rules...............2 A Model Portfolio...............4 CHAPTER 2: OPTION BASICS..................7 The Workings of Option Contracts.....................8 Long and Short................13 Calls and Call Strategies.........17 Puts and Put Strategies..........22 Listed Options and LEAPS Options......................28 Coordinating Strategies with Portfolio Goals................32 Option and Stock Volatility: The Central Element of Risk....35 v From the Library of Lee Bogdanoff Download at WoweBook.Com Trading Costs in the Option Analysis......................46 Tax Rules for Options: An Overview..................47 The Importance of Professional Advice and Tax Planning........48 CHAPTER 3: OPTIONS IN CONTEXT...........51 The Nature of Risk and Reward...52 Perceptions about Options.......60 Short Positions: Naked or Covered......................63 Margin Requirements and Trading Restrictions...........68 Return Calculations: Seeking Valid Comparisons.............70 Long-Term Goals as a Guiding Force.................80 Exercise as a Desirable Outcome..82 CHAPTER 4: MANAGING PROFITS AND LOSSES.....................85 Your Conservative Dilemma......87 Managing Profits with Options...89 Overcoming the Profit-Taking Problem.....................92 vi OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com Managing the Inertia Problem....99 Taxes and Profits..............102 CHAPTER 5: OPTIONS AS CASH GENERATORS..................107 The Covered Call Concept......108 Examples: Ten Stocks and Covered Calls................110 Smart Conservative Ground Rules.......................115 A Conservative Approach.......121 Tax Ramifications of Covered Calls................125 Rolling Forward and Up: Exercise Avoidance............130 The Exercise Acceptance Strategy.....................131 CHAPTER 6: ALTERNATIVES TO STOCK PURCHASE....................133 Leverage and Options..........134 The Long-Call Contingent- Purchase Strategy.............137 The Covered Long Call.........140 Short Puts and Contingent Purchase....................144 Contents vii From the Library of Lee Bogdanoff Download at WoweBook.Com Rescue Strategy Using Calls.....148 Rescue Strategy Using Puts......154 Covered Calls for Contingent Sale..............155 CHAPTER 7: OPTION STRATEGIES IN DOWN MARKETS......................157 Thinking Outside the Market Box..................158 The Long Put: The Overlooked Option.......161 Short Puts: A Variety of Strategies....................165 Comparing Rates of Return for Dissimilar Strike Prices........170 Using Calls in Down Markets....172 Evaluating Your Stock Positions..175 Stock Positions and Risk Evaluation...................180 Options and Downside Risk.....182 Option Planning with Loss Carryover...............185 CHAPTER 8: COMBINATION CONSERVATIVE TECHNIQUES..................189 Spread Techniques.............190 viii OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com Straddle Techniques............192 Long or Short Positions.........194 Theory Versus Practice.........196 Tax Problems with Combination Strategies....................199 The Ultimate High-Return Strategy.....................200 Examples of the Strategy in Practice.....................202 Outcome Scenarios............211 The Augmented Strategy: A Short Straddle..............213 Rescue Strategies..............218 CHAPTER 9: STOCK SELECTION AND THE OPTION CONTRACT...........221 Remembering Your Conservative Profile as a Priority............223 Dangers and Pitfalls in Using Options.....................224 Temptation to Select Most Volatile Stocks...............226 Creating Sensible Conservative Standards...................228 Maintaining Fundamental Clarity......................232 Contents ix From the Library of Lee Bogdanoff Download at WoweBook.Com The Importance of Taxes in the Option Equation.............235 Option Volatility to Judge Stocks.................236 APPENDIX: OPTION TRADING STRATEGIES..239 GLOSSARY.....................243 INDEX.........................249 x OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com ACKNOWLEDGMENTS any thanks to Michael Panzner, Rudy Morando, Harry Domash, M and Steve Kursh, all of whom added to this project with their suggestions. Also, I am most grateful to my editor, Jim Boyd, for his steady hand and guidance. Acknowledgments xi From the Library of Lee Bogdanoff Download at WoweBook.Com ABOUT THE AUTHOR Michael C. Thomsett has published more than 70 books on investing and business topics, including Stock Profits: Getting to the Core (FT Press, 2004) and many other books concerning options and stock mar- ket investing. His best-selling book Getting Started in Options (John Wiley & Sons, 2009) is in its 8th edition and has sold more than 250,000 copies. He has written many other books published by John Wiley & Sons, Amacom Books, and Dearborn. Thomsett lives in Nashville, Tennessee. xii OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com PREFACE The Elusive Goal: Low Risk and High Yield here is good news about the market. Recent stock market trends T have been troubling for just about everyone invested in stocks. The traditional approach of buy-and-hold and the trusted technique of value investing based on a study of the fundamentals seemed to fall apart beginning in 2008. Does this mean that buy-and-hold is dead? Not at all. The cyclical nature of the market simply went through a strong bear cycle, but the strength of the American stock market has shown time and again that downward movements are temporary and are always followed by record-breaking upward-moving markets. In the meantime, however, you may have seen most of your retirement savings and personal portfolio disappear. The staggering losses in even the best-known value investments brought into question the basic “safe” philosophy of the market. To protect yourself in this kind of volatile and uncertain environment, you need strategies to hedge loss- es; create extra sources of income; and most of all, reduce risk while increasing net yield. Is it even possible to match low risk with high yield in the volatile mar- kets that have dominated recent years? Most experts question the idea that risk-averse investors can outperform the market averages. However, this book challenges the conventional wisdom by demon- strating how conservative investors can exploit a narrow band of poten- tial strategies, dramatically increase yields, and, at the same time, manage risks within their self-defined risk limitations. To some conservative investors, options are too exotic and too risky. If a range of strategies is too much trouble or contains too many pitfalls, it is not worth pursuing. But a basic premise in this book is that a con- servative investor is not necessarily someone who does not want to expand beyond a well-understood and short list of investment possibil- ities. Being a conservative investor does not necessarily mean that you Preface xiii From the Library of Lee Bogdanoff Download at WoweBook.Com are unwilling to examine new ideas, expand your portfolio, or take acceptable risks. It just means that you are not interested in speculation or in exposing yourself to the possibilities of high risk. Investors tend to be aware of the potential for high returns without also acknowledging that such strategies are usually accompanied by unavoidable high risks. This is where the inexperienced suffer losses in the market. The lack of experience that attracts the novice to specula- tion in options and other high-risk strategies has caused much grief in the market. When you look back at the dot-com years, you see that many first-time investors made quick paper profits, only to lose it all in a sudden reversal of fortunes. But conservative investors know that put- ting all capital in a single industry is ill advised, especially if companies are chosen that have never reported a net profit, whose stock has risen more than $200 per share in a few months, or whose actual core busi- ness is only vaguely defined. Given these observations, conservative investors naturally seek meth- ods for using their capital that achieve some specific goals, including the following: Preserving spending power after both inflation and taxes Avoiding unacceptable market, liquidity, and diversification risks Protecting profits without loss of invested positions, hedging the portfolio against the possibility of loss These goals are typical for conservative investors and actually serve moderate investors just as well. They involve strategies for avoiding loss. As a conservative investor, you are not averse to risk in any and every form; essentially, you are averse to unexpected surprises. This is perhaps the most important distinguishing characteristic between you and other investors. The majority of novice investors are surprised when they lose money in the market, but, in retrospect, should they have been surprised? In most situations, novices operate on certain assumptions concerning potential profits but are unaware of the relat- ed risk or the degree of risk exposure. Otherwise, their investment deci- sions probably would have been different. xiv OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com With this in mind, this book offers a more realistic definition of conser- vative investors: those who are experienced enough to be aware of both yield and risk and who make decisions based on that level of awareness. Conservative investors are not as likely as other investors to be taken by surprise when they lose money in the market. Another aspect of this expanded definition distinguishes between risk profile and the willing- ness to use creative and alternative strategies. Conservative investors are not close-minded and do not reject exotic instruments like options merely because of their reputation as high-risk. Instead, well-informed conservative investors are likely to examine claims about high-yield potential with an open mind. You may be skeptical and, at the same time, willing to listen to the suggestion that the combination is at least possible. A limited number of strategies do, in fact, offer the potential for various conservative applications to meet the three goals common to conservative investors: preserving capital, avoiding unacceptable risk, and protecting paper profits. For example, this book includes 12 overall strategies (see the Appendix, “Option Trading Strategies”), qualified in terms of risk levels. This book does not suggest that you have to become an expert in a broad range of complex or exotic options strategies. Instead, it propos- es a rather limited number of strategies appropriate for conservative investors. This approach respects the risk limitations in the conserva- tive strategy while showing how experienced stock market investors can expand their yield levels significantly, protect existing positions, and come through market down cycles intact. Preface xv From the Library of Lee Bogdanoff Download at WoweBook.Com This page intentionally left blank From the Library of Lee Bogdanoff Download at WoweBook.Com 1 SETTING THE GROUND RULES In any discussion of an investment strategy, you begin with a series of assumptions. Your assumptions tie in to your conservative profile: You have prequalified the stock of a limited number of companies; you believe these stocks will rise in value over time; fundamentals are essential in stock selection; you would be happy to buy more shares; and a finite number of companies meet your standards. We have identified ten companies that make up a “model portfolio” to illustrate the options strategies in this book. These serve as examples of companies meeting a few basic criteria for picking companies and their stocks, as candidates for conservative options trading. 1 From the Library of Lee Bogdanoff Download at WoweBook.Com T his book explains how conservative investors can employ options strategies to (a) enhance current income without increasing market risks; (b) protect long positions through options used for insurance; and (c) create a form of contingency to survive in volatile market conditions. The Ground Rules Because you are a conservative investor, the arguments in this book are based on a series of underlying assumptions. Always keep these ground rules in mind, because they relate to your risk profile and to your invest- ing philosophy. Five underlying assumptions are used in this book. 1. You will limit options activities to stocks you have prequalified. This is a necessary starting point as long as your portfolio—and the stocks you use for options strategies—includes stocks you believe in as long-term-hold stocks, and you consider these stocks permanent parts of your portfolio (as long as the funda- mentals remain strong). This is an important attribute because it is not conservative to buy stocks solely to use for options strategies. A conservative approach to options must include the premise that your activities will be limited to the strongest pos- sible stocks you can find. 2. You believe that your stocks will rise in value. A conservative investor naturally expects stocks to rise in value; otherwise, why keep them? But this seemingly obvious point has relevance in the underlying assumptions of this book. Many of the discus- sions of strategies are premised on a belief that over the long term, the subject stock’s market value will rise. Many options strategies work best when stocks do not rise, so for example, covered call writing (a very conservative strategy) is most prof- itable when stock values remain steady or even fall slightly. This 2 OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com means that you may need to time a strategy to produce profits resulting from short-term stability in prices, hoping for longer- term growth. So a second underlying assumption is in line with the conservative approach. This means you want to accumulate shares of value investments; you expect prices to rise over time; and you will change a hold to a sell when the fundamentals change. However, at the same time, some options strategies are designed to take advantage of short-term price volatility. When marketwide volatility affects short-term prices in your stocks, you have an opportunity to pick up discounted shares, take profits (without having to sell stock), or average down your overall basis. Of course, the proposal that you should average down is conservative only if the basic stock selection assump- tions remain valid. You will want to employ such a strategy only for stocks in which you have a strong belief as long-term value investments. 3. You accept the premise that fundamental analysis of stocks is an essential first step in the process of examining option opportunities. Options have no fundamental attributes. These are intangible contractual instruments, and they have no value on their own; thus, you can only judge the tangible value of stock as a means for selecting appropriate options strategies. Many first-time options traders make the mistake of overlook- ing this basic reality. They select options (and stocks) based on the immediate return potential, but they ignore the real market risks of the underlying stocks. This violates the conservative tenet that stocks should be chosen for their fundamental strength and growth potential. 4. In the event of a temporary downward movement in a stock’s price, you would be happy to buy more shares. Some investors may be unwilling to pick up more shares of a particular stock, even when the opportunity to buy discounted shares is present- ed. In this book, several strategies are introduced proposing that additional shares may be purchased (or exposed to contin- gent purchase) using options. If this is not the case in a particu- lar situation, those suggestions should be passed over. You may have a strict formula for diversification or asset allocation that Chapter 1 Setting the Ground Rules 3 From the Library of Lee Bogdanoff Download at WoweBook.Com you use to limit risks in any particular stocks, for example, so strategies aimed at increasing your holdings in one stock may contradict your portfolio management standards in such an instance. Strategies proposing that you set up situations in which more shares may be picked up work only if that sugges- tion conforms to your overall portfolio plan. 5. You believe that an adequate number of available stocks meet your criteria. Some investors become convinced that their short list of stocks is the only list available to them. Thus, if they were to sell shares of stock from their portfolio, they would be unable to reinvest profits in equally acceptable stocks. If you do not believe this, you are probably aware that dozens of stocks meet your fundamental criteria, in terms of price level, PE ratio, volatility, dividend payment history, and a range of other analytical tests. Accordingly, if a particular stock is sold from your portfolio, a number of other stocks that you could and would purchase upon sale of stocks you currently own also conform to your criteria. Incidentally, this practice makes sense whether you trade options or not. The fundamentals can change for any company, so if a hold stock changes to a sell, you need to reinvest funds. As a matter of basic port- folio management, every investor needs a secondary list of stocks that would be used to replace sold stocks from the current portfolio. The need for maintaining this list relates to options trading because some strategies result in selling shares of stock. In those cases, you want to reinvest capital in a new issue on your list of qualified stocks. A Model Portfolio In the examples used in the following chapters, these five underlying assumptions demonstrate how options work within the conservative framework. These criteria are applied to a model portfolio of ten stocks, which are used in various combinations throughout. This helps to tie together the various examples and range of possible outcomes. This model portfolio is by no means a recommendation of stocks you should own. It was selected to include stocks with some common 4 OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com attributes. Many have increased dividends every year for the past ten years and reported low volatility in trading. Others have exhibited ris- ing market value in recent years. All these stocks have available both listed options and long-term options (LEAPS), enabling you to look at a variety of scenarios for each conservative strategy. Employing a single portfolio throughout the book is helpful in another way. Not every strategy works well for each stock in the model portfo- lio, so you can walk through the selection process to demonstrate how a particular strategic decision is made. Although your portfolio may contain a number of excellent value investments, some strategies sim- ply do not work at all times or in all cases. You can compare the differ- ent potentials for strategies across a range of stocks by following the model portfolio throughout the explanations in each chapter. The values of each stock, current bid, and asked value of every option used in this book are based on the closing prices reported by the Chicago Board of Exchange (CBOE) on April 18, 2009. Table 1-1 sum- marizes this model portfolio. Table 1-1 Model Portfolio Stock Name Trading Symbol Closing Price * Caterpillar CAT 32.29 IBM IBM 101.27 Johnson & Johnson JNJ 53.05 Coca-Cola KO 45.02 McDonald’s MCD 56.09 3M MMM 53.81 Altria MO 16.99 United Parcel Service UPS 54.65 Wal-Mart WMT 50.20 Exxon Mobil XOM 66.75 * Closing prices as of April 18, 2009 Chapter 1 Setting the Ground Rules 5 From the Library of Lee Bogdanoff Download at WoweBook.Com Is this a “conservative” portfolio? That is a matter of opinion—and one that depends on the timing of purchase, long-term goals, and your per- sonal opinion about the fundamentals for each corporation. These ten stocks provide a cross section of stocks that illustrate where strategies work well and where they do not work at all. The actual definition of a conservative portfolio is (and should be) always evolving based on changes in the market, in a stock’s market price and volatility, and, of course, in emerging information concerning fundamental strength or weakness of a particular company. Is this information out of date? The data gathered on the closing date— April 18, 2009—is old, but it would be impossible to perpetually update 10 stocks and still meet the publication date of this book. However, all the information is relative. The values of options for a particular stock will probably be consistent from one period to the next—assuming the proximity between closing price and option strike price is about the same, and that months to go until expiration are the same as well. Although these relationships can and do vary based on ever-changing perceptions about a particular company, the data is valid for the pur- pose of illustrating strategies. The use of some measurement in time is necessary, and all these stocks were selected and summarized on the same date. Given all these qualifications, these closing prices (and the option values used in this book) are fair and reasonable. As of that same date, April 18, 2009, there were about 2,500 stocks that had options available to trade—a lot of choices for conservative investors. 6 OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com 2 OPTION BASICS The biggest hurdle in the options market is terminology. This chapter explains the basic concepts and defines option terms; introduces call and put strategies; explains how long and short positions work in both types of option contracts; and provides an overview of the options market. 7 From the Library of Lee Bogdanoff Download at WoweBook.Com T ypically, books about options start by showing how you can lever- age a small amount of capital to make fantastic profits, often in the triple digits. Such books tend to quickly become overly technical and complex, so that you end up with two problems. First, you are exposed to the proposition that you can get rich by speculating in options; second, the discussion becomes obscure as the details emerge. This is not an approach that works for conservative investors. One basic assumption in this book is that, as a conservative investor, you want to know exactly how options might or might not work in your portfolio, and you want the information to be presented clearly and logically. Because this involves a fairly narrow range of possible strategies—only those appropriate in a conservative portfolio—a lot of the more exotic potential of options is avoided. Even the most experienced investor struggles with terminology and the meaning of key concepts, so this chapter covers the important matters that you need to master, including explanations of calls and puts in either long or short positions; how option contracts work; expiration of options; strike prices; and time, extrinsic, and intrinsic value. In dis- cussing the range of possible strategies, the purpose is not to recom- mend any particular approach but to explore and review all the possibilities. As a conservative investor, you will find only a small portion of these strategies to be of interest; but you can also benefit from know- ing about all the potential uses of calls and puts. The Workings of Option Contracts In this section, you find a review of the option contract rules. The mechanics of expiration, strike price, and time, extrinsic, and intrinsic value affect all decisions related to how you should or should not employ 8 OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com options and how risks increase or decrease as you employ a particular strategy. Option Attributes to Determine Value Collectively, the attributes of the option contract determine its value. This value relates not only to how high or low the value is today, but also to how the option gains or loses value as a strategic tool in your stock portfolio. Option contracts refer to 100 shares, so each contract allows the buyer to control 100 shares of the underlying stock. Every option relates specifically to that one stock and cannot be transferred. The pre- mium is the cost (to the buyer) or value (to the seller) of the option con- tract. This cost/value is expressed as the value per 100 shares, usually without dollar signs. For example, if an option’s current premium is 6, it is worth $600, and if the current premium is 4.75, it is worth $475. Some strategies make options useful for protecting paper profits, maxi- mizing short-term income with little or no market risk, or hedging other positions. If the option premium is too high (for long-position strate- gies) or too low (for short-position strategies), a particular option strat- egy cannot be justified. Expiration limits the lifetime of the option. The potential profit period for the option speculator is the flip side of the advantage the short seller enjoys. Just as a short seller of stock sells and has an open position, the short seller is an options trader who initiates a position by selling the option. The short option position can be closed in one of three ways. First, it may expire worthless, in which case the entire premium received by the seller is profit. Second, it may be closed by buying back at any time, with the difference between the initial sales price and final purchase price representing profit or loss. Third, it may be exercised by the buyer, and the short seller may be obligated to complete the exercise transaction. When a call is exercised, the seller is required to deliver 100 shares of stock at the strike price. When a put is exercised, the seller is required to take delivery of 100 shares at the strike price—shares are “assigned” to the seller. Chapter 2 Option Basics 9 From the Library of Lee Bogdanoff Download at WoweBook.Com Intrinsic, Extrinsic, and Time Value Premium An option premium has three components: intrinsic value, extrinsic value, and time value. The intrinsic value is equal to the number of points that an option is in the money (ITM). This concept is explained in greater detail later in this chapter; for now, it is important to understand the meaning of intrinsic value related to the stock price. The strike price is the price at which an option can be exercised; for example, if a call option has a strike price of 45, it provides the buyer the right (but not the requirement) to buy 100 shares at $45 per share. The money rules for this example are as follows. 1. If a 45 call is held on stock currently valued at $47 per share, the option is 2 points ITM. 2. If the stock is valued at $45 per share, there is no intrinsic value. This condition—when strike price and stock market value are identical—is called at the money (ATM). 3. If the stock is valued below the strike price, there is no intrinsic value. For example, if the strike price is 45 and the stock is sell- ing at $44 per share, the condition is 1 point out of the money (OTM). The opposite direction applies to puts. In-the-money intrinsic value refers to the number of points the stock is below the strike price of the option. For example, if the strike price of a put is 40 and the stock is cur- rently selling at $37 per share, the put option contains 3 points of intrin- sic value. If the stock is lower than the call’s strike price or higher than the put’s strike price, there is no intrinsic value. Time value and extrinsic value are the portions of the option premium above and beyond intrinsic value. The longer the time to expiration date, the higher the time value. This value decays over time in a predictable manner, accelerating as expiration nears. Extrinsic value is the key to identifying option strategy opportunities; it is the volatility premium of the options beyond both intrinsic and time value premium. There is also a relationship between extrinsic value and the proximity between strike price of the option and current value of the underlying stock. A study of option values demonstrates how this relationship works. 10 OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com Long-Term Options and Their Advantages The LEAPS (Long-term Equity AnticiPation Security) option is a long- term contract. In comparison, the standard listed option lasts only about 9 months maximum. When various strategies are viewed comparing LEAPS options to listed options, that longer expiration makes a lot of dif- ference to both long and short strategies. There is a far higher time value in a long-term LEAPS option, which may exist for up to 30 months. In the stock market, that is a long time, and everyone knows that many changes can occur over 30 months. So, if you purchase options, you must expect to pay more for the longer life of the LEAPS option, because you also buy far greater time. For the short seller, the longer period translates to higher income, because as a seller, you receive the premium when you open the short position. For that higher premium income, you also have to accept a longer exposure period. However, although the dollar amount of the premium is greater, the annualized return for selling short is nor- mally less than for shorter-term options. The expiration and, more specifically, the time between opening an option position and the expiration date, determines the extrinsic value and affects the decisions made by speculators on the long side and investors on the short side. Strike Price of Options The strike price is the second feature that determines the option’s value. The strike price is fixed and, in the event of exercise, determines the cost or benefit to every option position, whether long or short. The proxim- ity of current market value to the strike price of the option also deter- mines the current premium value and the potential for future gain or loss, as well as the likelihood of exercise. For example, if a call’s strike price is 30 (meaning it would be exercised at $30 per share) and the cur- rent market value of the stock is $34, the call is 4 points ITM. It is quite likely that this option will be exercised in this condition, especially as expiration approaches. If the stock’s price declines to $28 per share, the call would be 2 points OTM; and if the price stops at the strike price of $30 per share, it is ATM. Chapter 2 Option Basics 11 From the Library of Lee Bogdanoff Download at WoweBook.Com These definitions are opposite for puts. When the market value of a put is lower than the strike price, the put is ITM; and when the stock’s value is higher, it is OTM. These definitions are important because the actual time value, extrinsic value, and intrinsic value are affected by the rela- tionship of the stock’s market price to the option’s strike price. This rela- tionship also determines the short side’s exposure to exercise. The actual timing of exercise is uncertain; it can occur any time the option is ITM. When an option is ITM, changes in the option’s premium track stock price movement point for point, so changes in the option’s value are more dramatic when a stock’s market value changes in the in-the-money range. Extrinsic value premium is the intangible portion of the premium value. Extrinsic value varies depending on the volatility of the underlying stock. In comparison, time value inevitably declines as expiration approaches. For the option buyer, time is the enemy. Even when the long option is ITM, time value declines as expiration approaches. So, if a speculator pays a lot for time value, it takes substantial price movement to offset that intangible feature. For example, a buyer pays 7 points ($700) for a call that consists entirely of time value premium. By the point of expiration, if the stock has moved 7 points above the strike price, that call is worth only $700, because all the time value will have evaporated. In this situa- tion, the buyer breaks even. (Actually, the buyer loses money due to the trading expense on both sides of the transaction.) The Time Advantage for Short Sellers For the option seller, time is an advantage. The higher the time value pre- mium when the short position is opened, the greater that advantage. Referring to the previous example, if you were to sell a call with 7 points of time value, you could close the position at a profit as long as the pre- mium value was lower than the original 7 points. For example, if the stock were 5 points higher than the strike price near expiration, you could close the position and avoid exercise—and make a $200 profit ($700 received when the short position was opened, minus $500 paid to close the position—not considering trading fees). 12 OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com The intrinsic value of the option premium is equal to the number of points the option is ITM. For example, if your 40 option is held on stock currently valued at $43 per share, the option contains 3 points of intrin- sic value. If that call is currently valued at 5 ($500), it consists of $300 intrinsic value and $200 time and extrinsic value. As another example, if your put has a strike price of 30 and the stock is now valued at 29, the put has 1 point—$100—of intrinsic value because the stock’s value is 1 point below the put’s strike price. If the current value of the put is 4 points, it consists of $100 intrinsic value and $300 time and extrinsic value. Long and Short The decision to go long (buy options) or short (sell options) involves analyzing opposite sides of the risk spectrum. The interesting feature of options is that strategies cover the entire range of risk, often with only a subtle change. Long options are disadvantageous in the sense that time works against the buyer; time value disappears as expiration approaches. Given the certainty that time value evaporates by expiration, it is difficult to overcome that obstacle and produce profits consistently. The less time until expiration, the more difficult it is to profit from buying options; and the longer the time until expiration, the more the speculator has to pay to pick up those contracts. Long options can insure paper profits, but the more popular application of long options is to leverage capital and spec- ulate. There are circumstances in which you, even as a conservative investor, will want to go long in options. For example, following a large price decline in the market in a short time span, prices of strong stocks are likely to rebound; but not being sure where the market bottom is, you may tend to be the most fearful when the greatest opportunities are pres- ent. In these cases, buying calls allows you to control shares of stock, limit potential losses, and expose yourself to impressive gains—as long as prices rebound in a timely manner. This is a speculative move, but even the most conservative investor may see market declines as buying opportunities, especially if a small amount of capital is at risk. This does not mean that going long with options is conservative or even advisable. But every investor holding a portfolio for the long term knows Chapter 2 Option Basics 13 From the Library of Lee Bogdanoff Download at WoweBook.Com how market cycles work. Options present occasional opportunities to take advantage of price swings. When overall market prices fall suddenly, conventional wisdom identifies the occurrence as a buying opportunity; realistically, such price movements make investors fearful, and it is unlikely that many people will willingly place more capital at risk—espe- cially because the paper position of the portfolio is at a loss. So, buying options can represent a limited risk for potentially rewarding profits— an opportunity to buy more shares of stocks you continue to think of as long-term hold issues. Taking Profits without Selling Stock The same argument applies when stock prices rise quickly. Sudden price run-ups are of concern to you as a long-term conservative investor. The dilemma is that you do not want to sell shares and take profits because you want to hold the stock as a long-term investment; at the same time, you expect a price correction. In this situation, you can use long puts to offset price decline. You create a choice using long puts. First, if and when the price decline occurs, you can sell puts at a profit; the short-term profit from puts offsets the price decline in stock. The second choice is to exercise the puts and dispose of the stock at the strike price (which would be higher than current market value). You would take this path if your opinion of the company were to change, so that your hold position moved to a sell position along with the decline in stock value. You are likely to stick with the conservative path: As long as you want to hold the stock for the long term, you are willing to ignore short-term price volatility. Even so, few investors can ignore dramatic price move- ment in their portfolio. When prices plummet or soar—especially as part of a marketwide trend as witnessed in 2008 and not for any funda- mental reasons—the change in price levels may be only temporary. The tendency for some investors is to panic and sell at the low or to buy at a price peak. In other words, rather than following the wisdom “buy low, sell high,” investors often react to short-term trends and “buy high, sell low.” It helps to ignore short-term trends and to resist the human ten- dencies toward panic or greed; and as a conservative investor, you are more likely to equip yourself with a cooler head during volatile times. 14 OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com Even so, you can retain your conservative standards and, at the same time, use options to exploit the market roller coaster. There are risks involved, but the alternative is to take no action but a wait-and-see approach. Options can help you deal with price volatility on the upside or the downside for fairly low risk and without losing sight of your long- term investment goals. The question of speculative versus conservative is not easily addressed. Yes, using options to play market prices is speculative; but at times, you can take advantage of that volatility without selling off shares from your portfolio. The same observation applies on the short side of options, where risks are far different and market strategies can vary. Buyer and Seller Positions Compared When you short options, you do not have the rights that buyers enjoy. Buyers pay for the right to decide if and when to exercise or whether to sell their long positions. When you are short, you receive payment when you open the position, but someone else decides whether to exercise. Time value works to your advantage in the short position, so you can control the risks while creating a short-term income stream. Risk levels depend on the specific strategy you employ. The highest risk use of options is the uncovered call. When you sell a call, you receive a premium, but you also accept a potentially unlimited risk. If the stock’s market value were to rise many points and the call were exercised, you would have to pay the difference between the strike price and current market value at the time of exercise. For example, let’s say you sold a call with a strike price of 40 and you received a premium of 8 ($800). That reduces your risk exposure to as much as $48 per share (strike price of 40 plus 8 points you received for selling the call)—but without considered trading costs. However, what if the stock’s market value rises to $74 per share before expiration, and the call is exercised? In that event, you must deliver shares and pay $3,400 upon notice of assign- ment ($74 per share current market value, minus $40 per share strike price). Your loss would be $2,600 ($3,400 payment minus $800 you received for selling the call). Chapter 2 Option Basics 15 From the Library of Lee Bogdanoff Download at WoweBook.Com The uncovered call is the highest risk strategy; in comparison, the cov- ered call is the lowest risk strategy. If you own 100 shares, you can deliver those shares to satisfy exercise, no matter what the market price is. Upon exercise, you keep the premium you were paid. The greatest argument against covered call writing is the chance of lost appreciation. In the pre- vious example, had you merely held onto your 100 shares, their value would have increased to $74 per share. Because you wrote a 40 call, you would be required to sell them for $40 per share. As a counter to this argument, a couple of points have to be remembered. First, the frequency of large price increases should be studied in comparison to the certainty of option premium you earn for selling calls. Second, as long as exercise creates a profit in the call as well as capital gain in the stock, you earn a profit. For example, let’s say your original basis in the stock was $32 per share and the stock is currently valued at $38 per share. You sell a 40 call and receive a premium of 8 ($800). Upon exercise, your profit is $600 capital gain on the stock plus $800 profit on the short call (plus any div- idends you received during the holding period). That is an overall 43.75 percent return ($1,400 ÷ $3,200). Including stock profits with option profits is not entirely accurate because the two are separate transactions. However, in picking a strike price for covered call writing, you need to evaluate the outcome in the event of exercise. Your selection of one strike over another certainty affects your total profit on the exercised covered call. The capital gain created when a covered call is exercised may produce impressive levels of profit as long as the basis in stock was far lower. However, for the purpose of comparing option returns under different outcome scenarios, capital gains are not normally included as part of the analysis. If you owned stock and simply sold it without writing options, you would earn the capital gains, so stock and option profits in covered call examples are not tied together as part of the comparison. In the previous scenario, the option-only return, you received $800 for sell- ing a call when the stock was at $38 per share. This is a 21.1 percent return ($800 ÷ $3,800). To make this comparable to other option returns, you also need to annualize this return, meaning the yield is recalculated as if the position remained open for exactly one full year. 16 OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com Understanding Short Seller Risks The short call may be high risk or highly conservative. In comparison, the short put has varying risk levels depending on the purpose of going short, your willingness to accept exercise, and the amount of premium paid to you at the time you open the short position. The decision to employ options in either long or short positions defines risk profile; the definition of conservative is rarely fixed or inflexible. It is more likely to define an overall level of attitude about specific strate- gies while acknowledging that strategies may be appropriate in different circumstances. It is all a matter of timing a decision based on the current status of the market, your portfolio, and your personal decision to take action or to wait out volatile market conditions. Calls and Call Strategies As a starting point in any discussion of option strategies, two matters have to be remembered. If you buy a call or a put option, you have the right to take certain actions in the future, but you do not have an obliga- tion. Second, if you sell a call or a put, the premium you receive as part of an opening transaction is yours to keep, whether the option is later closed, expires, or is exercised. These two points are crucial in develop- ing an understanding of how options trading works. Options are contracts that grant specific rights to the buyer and impose specific obligations on the seller. If you think of options as intangible contractual rights (rather than as tangible items such as shares of stock, for example), the entire discussion of how to use options is easier. It may be worrisome for you as a conservative investor to consider trading in an intangible product, but when you relate it to other types of investments, you can appreciate both the logic and the need for options. For example, in a real estate lease option, you have two parts: a lease specifying monthly rent and other terms, and an option. The option fixes the price of the property. If you decide to exercise that option before it expires, you can buy the property at the specified contractual price even if property values are significantly higher. Chapter 2 Option Basics 17 From the Library of Lee Bogdanoff Download at WoweBook.Com Stock market options are the same, but they involve stock instead of real estate. Every option refers to 100 shares of stock, and options come in two types: calls and puts. When you buy a call, you acquire the right to buy 100 shares of stock at a specific price (the strike price) before the option expires. All options have fixed expiration dates, so the time element of options is a crucial feature to consider when comparing option values. For the buyer, a relatively small risk of capital potentially fixes the price of 100 shares of stock for several months. If and when that buyer decides to buy the stock, the call can be exercised to acquire 100 shares at a price below current market value. That is the essence of the call. Is the Strategy Appropriate? For your conservative portfolio, buying calls is not an appropriate fit in most applications. Buying calls is the best known and most popular option strategy, but it is usually a purely speculative move. If you are convinced that a stock’s market value is sure to rise before the expiration of an option, you can buy calls as an alternative to outright purchase of shares. This strategy would be appropriate in the following circum- stances. You are concerned with short-term price volatility, and you do not want to commit funds to buy shares, but you still want to fix the price of stock at the option’s strike price value. You want to buy shares, but you do not have funds available at the moment, so buying a relatively cheap call is a sensible alter- native (given the chance that you could lose the money). You are aware of the risk of loss, and you want to proceed with buying a call anyway. So, as with any general rule, there are exceptions. You retain your status as a conservative investor even though circumstances may arise in which you would want to buy a call. It is not a conservative strategy, but all investment decisions should be driven by circumstances and not by hard- and-fast rules. Although the general rules you set for yourself guide your portfolio decisions, special circumstances and momentary opportunities or limitations can bring about exceptions. 18 OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com Option Terms and Their Meaning Every call contains a series of terms. These are the type of option, the strike price, the underlying stock, and the expiration date. The type of option is either a call or a put. The two have to be distin- guished because they are opposites. If you placed a buy order for an option without specifying whether it was a call or a put, that order could not be filled. All the terms have to be specified in an order. The strike price is the price of stock that may be acquired if and when the option is exercised. This strike price remains unchanged until the option expires, except in cases of stock splits. You have the choice, as a buyer, of either selling the option to close the position or exercising the option. Upon exercise of a call, you buy shares at the strike price. You “call away” the 100 shares of stock from the seller. If you exercise a put, you have the right to sell 100 shares, or to “put shares of stock” to the buyer and dis- pose of stock at a fixed price. The underlying stock is the company on which the option is traded. The company cannot be changed; it is as fixed as the strike price. Options are not available on all stocks, but they can be found for the majority of large-cap stocks listed on American stock exchanges. The expiration date is a fixed date in the future specifying when the option expires. This term is critical because after the expiration date, the option no longer exists. As a buyer, you know that the time value pre- mium evaporates if your option is not exercised or sold before the expi- ration date. These four terms collectively define and distinguish every option. None of the terms can be modified or exchanged after you open an option, and the terms determine the option’s value (the premium you pay when you open the option). If you accept the beginning argument—that buying options is not nor- mally appropriate for you as a conservative investor, but special situations can bring about an exception to that rule—it is always possible that going long could be a useful strategy. It makes sense to keep the long position in reserve as one of many possible ideas. It’s a mistake to simply reject a possible strategy because it is not a good fit with your overall investing Chapter 2 Option Basics 19 From the Library of Lee Bogdanoff Download at WoweBook.Com theme. However, remember that, for the most part, you will not be will- ing to speculate by buying options. The Cost of Trading Augmenting the complexity of buying is the trading expense involved. This applies to both sides of the transaction. You are charged a fee when you open the position and another fee when you close it. In any calcula- tion of risk and potential profit or loss, the cost of trading therefore must be included. If you deal with single-option contracts, you limit your exposure to loss. But at the same time, the per-option cost of trading is quite high. With this in mind, option traders often execute transactions using multiple option contracts. This reduces the cost of trading and results in a lower per-option cost. But remembering that buying options is a high-risk venture, using multiple contracts just to reduce per-option trading costs does not reduce overall risk; it increases it, because you must put more capital at risk. For the option buyer, trading costs make the proposition even less likely to turn out profitably. As a call buyer, the odds are against you. A second possibility is far more interesting and potentially more profitable: selling calls. If you are famil- iar with selling short, using stock, you know that the sequence of events is opposite from when you go long. You have to borrow shares of stock to sell, and opening the short position exposes you to the possibility of loss. If the stock’s market value rises, you lose money. So, short sellers expect the price of stock to fall. Eventually, they close the position by entering a closing purchase transaction. Short sellers have to make enough profit to offset the cost of borrowing stock, trading fees, and the point spread between original selling price and final purchase price. Selling stock is high risk without a doubt. If the stock’s value rises, you lose money, and short sellers are continually exposed to that market risk. Two observations about going short on calls: First, the transaction is far cheaper and easier than shorting stock; second, the strategy can be either high risk or conservative. 20 OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com In, At, or Out of the Money Selling a call is easier than selling short shares of stock, because you do not have to borrow calls to go short. You simply enter a sell order, and the premium (the value of the call) is placed into your account the follow- ing day. When you sell a call in this manner, you are in the same market posture as the short seller of stock, but at less risk. You are hoping that the price of stock will fall so that your short call will lose value. That means you will be able to either close the position profitably with a clos- ing purchase transaction or wait for the call to expire worthless. As long as the market value of the underlying stock remains at the strike price (ATM) or below the strike price of the call (OTM), exercise will not occur. When the stock’s market value is higher than the call’s strike price (ITM), you are at risk of exercise. The proximity of the stock’s current market value to the strike price is summarized in Figure 2-1. in the money at the money strike price of the call out of the money Figure 2-1 Strike price and stock price In the figure, observe that the option’s strike price remains level, but the status of the option relies on stock price movement. This illustrates how a call functions. Whenever the stock’s price is higher than the call’s strike Chapter 2 Option Basics 21 From the Library of Lee Bogdanoff Download at WoweBook.Com price, the call is ITM, and whenever the stock’s price is below strike price, the call is OTM. The same logic applies to a put, but the terms are reversed. Referring again to Figure 2-1, if the stock’s price were higher than the strike price of the put, it would be OTM, and if the stock’s price moved below the strike price, the put would be ITM. The relationship between strike price and stock price is critical for any- one who opens a short position in options. The short-call position can be one of the highest risk positions you can assume. However, it can also be one of the most conservative positions. This riddle is explained by whether or not you own 100 shares of stock when you sell a call. If you go short with calls and you do not own the stock, risks are theoretically unlimited because the market value of stock can rise indefinitely. This uncovered call strategy is clearly inappropriate for your conservative portfolio. However, when you own 100 shares, those shares are available in the event the call is exercised; so in the right circumstances, call sell- ing is highly profitable and conservative. Chapter 3, “Options in Con- text,” compares short calls in these contradictory risk profiles, and Chapter 5, “Options as Cash Generators,” provides in-depth explana- tions of covered call-writing strategies, the ultimate conservative use of options. Puts and Put Strategies The put is the opposite of the call. If you buy a put, you acquire the right (but not the obligation) to sell 100 shares of the underlying stock. If you exercise a put, you sell 100 shares at that strike price, even if the current market value of stock is far below that level. Like the call, the put expires at a specific date in the future. As a put buyer, three outcomes are possible. 1. The put is sold. You can sell the put at any time prior to expira- tion. For example, if the underlying stock’s market value falls below the strike price, the value of your long put increases, and the put can be sold at a profit. Because time value declines over the holding period, it is a highly speculative strategy to buy puts 22 OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com purely for short-term profits. It is unlikely that you can earn profits by consistently buying long puts without some other rea- soning behind that decision. For example, if you believe that stocks in your portfolio are overbought and you want to protect paper profits, long puts can be used as a form of insurance to protect your stock positions. 2. The put expires worthless. If you take no action before the expi- ration date, the long put becomes worthless, and the entire pre- mium you paid would be a loss. When you buy puts, you profit only if and when the market value of the underlying stock declines; if the value remains at or above the strike price, your put does not appreciate. Even if the stock does fall a few points, the put loses time value as expiration approaches; so to profit, you need the stock to decline enough points to offset your origi- nal cost and to replace time value with intrinsic value, all before expiration date. 3. You exercise the put. If the stock’s current market value is far lower than the put’s strike price, you have the right to sell 100 shares at the higher strike price. If you own shares of stock and you bought the put for downside protection, exercise can work as a sensible exit strategy. For example, you may have purchased shares originally when the stock looked like a viable long-term hold, but the financial picture has since changed. If you own one put per 100 shares, exercising the put and selling shares enables you to keep paper profits while escaping from the long position in stock. The Overlooked Value of Puts The put’s strategic potential is easily overlooked by investors and specu- lators. More attention is paid to calls. There are good reasons for this. Short calls can be covered by ownership of 100 shares of stock per call, but puts cannot be covered in the same way. The put is more exotic and alien to the mindset of many investors. Most people are used to betting on the potential for stocks to rise in value, but they are not as willing to consider the possibility of price declines. This is ironic considering the Chapter 2 Option Basics 23 From the Library of Lee Bogdanoff Download at WoweBook.Com unavoidable cyclical nature of investing. Prices rise, but they also fall, so using puts as well as calls to speculate on price movement or to protect paper profits presents a number of interesting strategic possibilities. In markets like 2008, when 28 out of 30 Dow Industrial stocks lost value, puts would have offered far greater value than calls as speculative trades. Where do puts fit for the conservative investor? Several possible appli- cations of puts are worth considering on both the long and short sides. The best known is the use of long puts for insurance. If you buy one put for every 100 shares of stock, you protect your paper profits; in the event of a decline in the stock’s market value, the put’s premium value increases. So, once the stock’s price goes below the put’s strike price, loss of stock value is replaced dollar for dollar in higher put premium value. This protection of paper profits—a form of insurance—is a conservative strategy. You pay a premium for the put because you fear that stock prices have risen too quickly, but you do not want to take profits in the stock. You can use puts in this situation to keep the stock while protecting prof- its and, perhaps, even taking profits without needing to sell stock. This insurance does not have to be expensive. Just as you can select insurance based on varying levels of deductible and copayment dollar values, you can select puts based on their cost and level of protection. For example, if you want to protect all your paper profits, you buy puts with strike prices close to current market value; that means you pay a premium with a high level of time value. If you are willing to carry some of the risk, you could buy puts at lower strike prices; these would be far cheaper but would provide less protection. For example, if you originally purchased 100 shares of stock at $42 per share, and today’s market price is $52, you have 10 points of paper profits. If you buy a 50 put, you protect 8 of those 10 points, but the put is expensive. If you buy a 45 put, you cover only 3 points of paper profits, but the put is far cheaper. The Insurance Cost of Puts The put has a limited life, so your protection extends only to expiration date. Using puts for insurance therefore requires periodic replacement of the put. Again, this compares to insurance like health, homeowners, or life policies, where periodic premium payments are required. As with all 24 OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com insurance, the value of paying a premium depends on the premium cost and the protection it provides. Buying puts can provide benefits beyond mere speculation. Selling puts—going short—presents an entirely different risk profile than the long strategy, but it is not necessarily high risk. Shorting puts may, in fact, be a viable strategy in your conservative portfolio. A short call can be covered simply by owning 100 shares of stock. That relationship eliminates the market risk and converts a high-risk strategy to a conservative one. But short puts can be covered only by also buying long puts that expire later. There is an important difference, however, between short calls and short puts. Although an uncovered call presents tremendous risks, the uncovered short put has only a limited risk. The stock can only fall to zero value in the worst case, so the potential risk is finite. On a practical level, a stock’s likely market value has a floor some- where higher than zero, and this level is subjective. You can define the price floor as technical support level, book value per share, or based on recent trading patterns. The point is that the real risk is the difference in points between the put’s strike price and the lowest likely trading price per share. Most people consider the technical support level to be that price. If you accept that a specific price-support level is also a lowest likely trading price, you can likewise accept the risk of going short with puts. That risk is further discounted by the value of the put premium you will be paid when you short the put. When you also consider that time value is involved, that net risk can be quite minor. Remember, buying puts is a long shot for the speculator due to time value premium. But for the seller, time value is a benefit; the further the time value falls, the higher your profit in shorting the put. You may review recent trading ranges of the stock to judge the safety or risk of selling puts. Conservative Guidelines: Selling Puts Is selling puts a conservative strategy? It can be in some circumstances. You have to assume several elements to conclude that short puts are appropriate in your conservative portfolio. Chapter 2 Option Basics 25 From the Library of Lee Bogdanoff Download at WoweBook.Com The strike price is a fair price for the stock. Whenever you short a put, you have to accept the possibility that the put will be exer- cised. You have to accept the strike price as a price you are will- ing to pay for the stock. The premium you receive justifies the exposure. When you sell options, you are paid the premium. That premium and the length of time you remain exposed to possible exercise have to justify the decision. The risk range is minimal. When you consider the spread between the put’s strike price and your estimated support price for the stock, minus the put premium, how many points remain? This is the most reliable method for judging whether to sell puts. Ultimately, you would like to acquire shares of the stock. Whenever you sell puts, you should also be willing to acquire shares in the company. If you really don’t want to own the stock, you should not sell puts. You have been watching a company for several months, and you like the fundamentals. The stock is currently valued at $62 per share. You decide that if the stock’s value declines to $55, you will buy 100 shares. As an alternative, you also consider selling puts. You analyze the values and conclude that it would be a smart move. The lowest likely trading price, in your opin- ion, is about $46, or 9 points lower than your target acquisition price of $55 per share. The 55 put is currently valued at 6 ($600). Here is the risk profile of these price relationships: Strike price of the put $55 Less: Support level estimate $46 Gross risk margin $ 9 Less: put premium $ 6 Net risk per share $ 3 26 OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com Should you sell the 55 put? If the stock’s value were to fall below $55 per share, the put would be exercised. Your risk exposure is really at the $49-per-share level (strike price of 55 minus 6 points of premium). The entire premium consists of time value, and your net risk is 3 points. The longer the short put remains open, the more the time value deteriorates. Given the minimal risk, this is a sensible strategy in a conservative port- folio. Were the margins higher, the risk of acquiring stock at potentially inflated values would not make sense. Puts as a Form of Contingent Purchase Short puts can be thought of as a form of contingent purchase. When you compare the risk of selling puts to the risk of buying shares outright, it makes sense. Consider the alternative given in the previous example. If you bought shares today, your cost would be $62 per share. If the stock’s market value falls, you lose one dollar per share for each point of loss. If the stock falls to $49 per share, your long stock loss is $1,700. Compared to the alternative, selling a put, the risk of buying 100 shares is far greater. In this situation, you are better off selling the 55 put. Your net cost, after considering the premium you receive for selling the put, would be $49 per share, equal to the market value at that time. This type of analysis—reviewing one decision against another— demonstrates how realistic comparisons can help to define your risk lev- els. If you begin with the assumption that selling puts short is high risk, you can never get beyond that conclusion. It is true that in some circumstances, shorting puts is extremely high risk. For example, if you short puts on stock you do not want to own, that contradicts your conservative standards. The analysis of any option-based strategy should include a preliminary but thorough analysis of the underlying stock and its fundamental strength or weakness as well as a study of its price volatil- ity. If you shop for the richest option premium levels, you end up short- ing puts on the highest-risk stocks, which you do not want to do. The previous example demonstrates, however, that in the right circumstances, using puts as a form of contingent purchase is a wise decision. Chapter 2 Option Basics 27 From the Library of Lee Bogdanoff Download at WoweBook.Com Listed Options and LEAPS Options Traditionally, risk assessment for options is based on a short lifespan— 8 months or less for listed options. The ever-growing popularity of LEAPS—long-term options that last as long as 30 months—changes the analysis. Even for the long position, the risk of ever-declining time value takes on a different context when looking 2 or 2 1⁄2 years ahead. The availability of long-term options makes long positions more viable in many more situations. Longer-term options contain far greater time value, of course, because time value is just that: the value of time. So, compared to a 6- or 8-month time span, a 24- to 30-month option has far greater potential—for both long and short positions. For example, it is practical to use LEAPS to leverage capital while retain- ing the choice of buying shares in the future and, at the same time, reduc- ing the cost of buying options. Chapter 6, “Alternatives to Stock Purchase,” explains how contingent purchase strategies work. Using Long Calls in Volatile Markets Let’s assume that you have your eyes on several stocks, and you believe that all offer potential for growth over time. The problem is that the market has been volatile lately, and you’re not sure whether the timing is good for picking up shares. For example, if you liked a particular stock in 2008 but you saw how poorly the market was acting, buying stock was a dangerous move. In these circumstances, LEAPS can provide a safe alternative. The not-uncommon situation of a volatile market makes it difficult even for conservative investors to time their decisions. The fun- damentals work, and long-term prospects are strong; even so, you are not sure about the short-term prospects for a stock. Influencing your deci- sion, annual cyclical change, outside economic forces, and market or sec- tor trends affect the timing of your decision. In this environment, it could make sense to buy LEAPS calls instead of stock. As an initial risk analy- sis, you cannot lose more than the premium cost of the LEAPS call, so the initial market risk is lower. At the same time, in going long with calls, you 28 OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com would acquire the right (but not the obligation) to buy 100 shares of the underlying stock at any time before expiration. If the LEAPS call has 30 months to go, a lot can happen between now and then. The risk is that the stock’s market value will not rise, or even if it does, it may not rise enough to offset the cost of time value and to appreciate adequately to justify your investment. The solution allows you to reduce the cost of buying the LEAPS call by selling calls on the same stock. As long as those short calls expire before the long call, and as long as the short call’s strike prices are higher than the strike price of the long call, there is no market risk. This is a form of covering the short call. For example, you buy a 50 call expiring in 30 months, and then you sell a 55 call expiring in 21 months. If the stock’s market value rises and the short 55 call is exercised, you can satisfy the exercise with your long call, mak- ing $500 on the transaction (selling at 55, buying at 50). Or, if the short call expires, it can be replaced with another. A likely scenario in this “cov- ered option” position is that the short call’s time value will decline; it can be closed at a profit and replaced with another call. As long as you remember the rule—higher strike prices, earlier expiration—and the number of short positions does not exceed the number of long posi- tions open at the same time, you can write as many covered short posi- tions as you like, limited only by margin limits set by Federal law and your broker. It is even possible, based on ideal price movement of the underlying stock, that your premium income from selling short calls can repay the entire cost of the long-term long LEAPS position. There are no guarantees, but it is possible. The basic long-short LEAPS strategy is summarized in Figure 2-2. In the figure, you see that this strategy has two legs. First, you purchase a long call with a 50 strike price, and later, you sell a 55 call. To avoid an uncovered short position, the 55 call must expire at the same time as the long call, or before. If the short call outlasts the long call, you face a period in which that short call will be uncovered. Chapter 2 Option Basics 29 From the Library of Lee Bogdanoff Download at WoweBook.Com Sell 55 call, 21-month expiration Buy 50 call, 30-month expiration Figure 2-2 Long- and short-call strategy This example shows that the ideal price movement in the underlying stock involves a minimum number of points. You want to acquire value in the long position so that you can exercise the long call later; at the same time, you do not want to see the short position rising in value because you want it to expire worthless (or you want to be able to close it out at a profit in the future). Remember, the goal in this strategy is twofold. First, you want to have the ability to exercise the long call and buy 100 shares of stock at the strike price. Second, you want to reduce the cost of the long position with a “covered” short position at a higher strike price. The quotation marks are placed around the word covered because this strategy is not the same as covering a short call with 100 shares of stock. The coverage refers to offsetting positions: one long and the other short. If the short position is exercised, you can use the long position to fulfill the obligation. This enables you to mitigate risk in terms of both cost and potential exercise. The “contingent purchase” with “covered option” strategy is not complex, and it may be a smart fit for conservative portfolios. This question is explored in depth in Chapter 6. The point is that LEAPS options expand the strategic possibilities while also making it possible to reduce many forms of risk. 30 OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com Using LEAPS Puts in a Covered Capacity Long LEAPS puts can work in the same way. For example, you may pur- chase LEAPS puts for insurance on existing long stock positions and reduce your insurance cost by selling puts that expire sooner than the long put and have lower strike prices. This basic strategy—combining long puts and covering them with short puts—is summarized in Figure 2-3. Buy 60 put, 30-month expiration Sell 55 put, 21-month expiration Figure 2-3 Long- and short-put strategy This figure is the reverse of the contingent purchase previously shown. The difference is that puts are used instead of calls. This strategy assumes that the underlying stock’s value is trending downward or trading in a narrow price range. The purpose in covering the put is to reduce the risk of exercise and resulting loss, and at the same time, to reduce the cost of buying the long put. This strategy has a limited risk. If the stock’s price rises above the original strike price, the loss is limited to the net cost between the long and short put positions; and if the stock’s price falls below the short put’s strike price, exercise can be offset by the long put. (This means that instead of being required to buy 100 shares of stock, you would simply exercise your long put, so that you would pick up 5 points of profit, the difference between the long 60 put and the short 55 put.) Chapter 2 Option Basics 31 From the Library of Lee Bogdanoff Download at WoweBook.Com These strategies—covering long options with shorter-term short positions—work best when your estimate of likely price movement in the stock is correct. This, of course, is true for any market strategy you employ. The call strategy works best when the market price of the under- lying stock rises over time, and the put strategy is preferable when the price declines. The wisdom of using either strategy is based on your abil- ity to read intermediate-term volatility trends accurately. The strategies make long positions in options more practical than the purely specula- tive approach, but profitability is not ensured. The overall purpose of the long option strategy is to maximize the opportunity while identifying worst-case outcomes and setting up the strategies so that you will not lose or so that losses are minimal. In the case of calls, you may want to exercise the call to acquire stock far below market value; in the case of puts, you can insure existing long stock positions while mitigating the cost of carrying that insurance. Coordinating Strategies with Portfolio Goals Your ultimate purpose in using options should be to augment or protect your conservative goals. If your goals are best served by simply buying stock and not using options for any purpose, that is the policy that should overrule all other possibilities. However, some option strategies are com- pelling enough that they cannot be rejected without further study. The conservative strategies worth considering must be coordinated with a broader overall strategy. The following basic conservative option strate- gies are explained in greater detail in Chapters 4, 5, and 6. Using long puts to insure long stock positions. Your conserva- tive position in stocks, held for the long term, should not be affected by short-term price uncertainties. If you accept the pre- cepts of both the Dow Theory and the random-walk hypothesis, you realize that short-term price movement is not reliable as an indicator of longer-term trends. As a conservative investor, you have probably based your portfolio decisions on fundamental indicators, and you monitor financial reports as they are released to spot emerging and changing trends. In theory, you can simply 32 OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com ignore short-term price movement without concern for tempo- rary market volatility; many supporters of value investing sug- gest this approach. In practice, though, marketwide price gyrations are unsettling; they raise questions even among con- servative investors. The 2008 market was a perfect example of extreme volatility and a strong bear market, bringing into ques- tion even the most conservative approach to investing. (See Chapter 4, “Managing Profits and Losses.”) The strategically timed purchase of puts can work as a timing mechanism at what you consider to be market tops. You want to continue holding stock as a long-term investment, so you are not inclined to take profits; but you are also concerned about losing paper profits in the short term, even though that concern is con- tradicted by your long-term investment goals. Buying puts makes sense for two reasons. First, if you are correct and the stock is overpriced at the moment, the long put will be profitable and those profits will offset the unavoidable price correction. Second, the fundamental indicators for the stock may change at the same time that the price gyration is occurring; in fact, the unexpected volatility may foreshadow weakness in the fundamentals. The change could also affect your opinion of the stock as a safe long- term investment, in which case you may want to dispose of shares. If the stock’s market value is depressed by the time you decide to dispose of shares, you will have to sell at a loss off the high. However, if you bought puts for insurance at or near the price peak, you now have a choice. You can sell the put and realize a short-term profit while holding onto shares, or you can exercise the put and dispose of stock at the higher strike price. In this manner, you achieve two goals. First, you preserve your paper profits by selling at or near the price peak (the fixed put strike price). Second, you dispose of shares when your opinion of the company has changed. In this example, the use of puts for insurance was perfectly in line with your conservative goals. You can never assume that conservative means you pick a portfolio and stay with it, no mat- ter how the fundamentals change. On the contrary, you are probably continually monitoring financial strength, and you Chapter 2 Option Basics 33 From the Library of Lee Bogdanoff Download at WoweBook.Com make changes in your portfolio to ensure that your fundamental standards are matched in the mix of stock you hold. Changes in price may precede a change in financial strength or operating results, so price changes may be reliable indicators for using puts to insure paper profits. Covered call writing against long stock positions. The best- known conservative options strategy is the traditional covered call. In this strategy, you write one call for every 100 shares owned. It is appropriate when the call, if exercised, would pro- duce a capital gain in the stock that you would be happy to real- ize. In other words, if you are not willing to have stock exercised, you should not write the covered call. Assuming that you would accept exercise as one possible outcome, you can use techniques such as rolling out of one call and into another to maximize income. The properly selected covered call strategy produces consistent current income. In exchange for writing covered calls, you risk losing out on increased market value; when stock prices rise above strike price and calls are exercised, your shares can be called away. However, when you compare that risk to the regular and dependable creation of current income in a conservative market risk profile, it is apparent that covered call writing will beat market averages without increasing market risks. Covered call writing also discounts your basis in stock, so your profit cushion is further protected. (See Chapter 5.) The traditional covered call strategy makes sense and fits well with your conservative risk profile when all the required ele- ments are present: You will accept exercise if it occurs; exercise will produce a good return on your investment; and overall, the strategy will produce short-term profits while enabling you to retain your long-term portfolio. In those instances where stock is called away, you can replace it with a different stock or use long calls for contingent purchase planning. (See the next bullet.) Options for contingent purchase plans. Of the three basic con- servative option strategies, contingent purchase plans are the most complex. The various methods you can employ are good matches in a conservative portfolio as long as the overall stan- dards are maintained and given priority. One common trap for 34 OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR From the Library of Lee Bogdanoff Download at WoweBook.Com options traders is to become intrigued with the potential prof- itability of a particular strategy and to lose sight of the more important portfolio goals. A contingent purchase is conservative because it provides alternatives to buying stock at a fixed price or, when price trends do not continue, to limiting losses with the use of long options. Those losses are limited in two ways. First, you can never lose more than the long premium you pay. Second, when employing LEAPS call or put options, you can cover the long-call position with short sales as long as the short calls expire earlier and are higher-strike calls or lower-strike put contracts. A contingent purchase is equally interesting when using short puts in place of long calls, and the most advanced strategy involves selling covered calls and uncovered puts at the same time. In Chapter 6, a detailed example of this more complex strategy demonstrates why this is a conservative strategy and how it con- sistently produces extra current income in your portfolio. Option and Stock Volatility: The Central Element of Risk The whole question of risk is central to the options decision and to main- taining the conservative structure and theme in your portfolio. The selec- tion of options can be directly related to price volatility as one measurement of risk— perhaps the most important. When you pick stocks, you decide whether to follow fundamental or

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