CHAPTER 3

Options in Context

Any investment strategy—from plain to exotic—contains specific attributes and can be defined in terms of risk, rates of return, and strategies for changing market conditions. Options are probably the most flexible investment products available. You can use them alone, in combination with other options, or as hedge devices to protect stock positions. Options can help you to exploit market price swings, and you can utilize them in speculative or conservative ways.

The Nature of Risk and Reward

Any assessment of an investment decision has to involve a study of risk and reward. Your conservative approach to investing is based on your sensitivity to risk as a primary means for all your decisions. You are less likely than the typical investor to react to sudden market changes out of panic or greed; your view is long term. Rather than watching index-based and volume trends every day, you track a company’s fundamentals. You base your decisions on earnings reports, capital strength, and operating trends. The stocks you currently hold will be sold if and when you determine that the fundamental strength of the company has changed or if you locate another company whose stock is a better candidate for long-term growth and safety.

When options are involved, the risk equation changes. You are likely not only to alter your investing profile to take options-based risks in some circumstances, but also to use options to protect paper profits without selling or to reduce your basis in stock to create downside protection. The appropriate use of options can increase the conservative nature of your portfolio because some strategies protect existing positions against loss.

Using Volatility as a Risk Measurement

The usual method for defining market risk of stocks involves price volatility. This is a starting point. The more erratic the price trend, the greater the risk and the more difficulty you will have in trying to forecast future price movement. When a stock’s trading range is broad, it further complicates the picture; price volatility is a problem for stock investors because owning shares in a volatile company means valuation is on an unending roller coaster ride.

Price volatility in a stock naturally affects option premium value as well. The greater a stock’s price volatility, the greater the volatility in option premium. The definition of what constitutes a conservative investment varies; it works only when stock has been selected on a conservative basis as a starting point. You may need to accept lower premium levels and lower implied volatility in exchange for safer overall portfolio positions.

The interaction between risk and opportunity is a fact of life. The higher the risk, the higher potential returns; the lower the risk, the lower those returns. Example: You are reviewing available options on McDonald’s (MCD). The market value of stock was at $197.60 at the time, so you are reviewing 195 and 197.50 calls. Clearly, your selection of options will be based on your purchase price for the stock. If you pay $196 for shares, the 195 call is not as attractive as the 197.50 call. Upon exercise, you would experience a $1 capital loss on the 195 call, or a $1.50 gain on the 197.50 call. The selection of an appropriate covered call has to include a critical analysis of your basis in stock, which makes the point that if your original basis in stock is far below either option, you must make comparisons based on exercise with the certainty of profits. A study of the current 14-day options reveals that the 197.50 call is available at 2.11 ($211) and the 195 call is going for 3.70 ($370). Your selection of either one must consider the capital gain, because appropriate strike levels have to be selected based on your original cost of the stock. Exercise of the 95 creates a capital loss of $100 ($196 purchase minus 195 strike) versus premium of $211. Exercise of the 197.50 creates a capital gain of $150 plus option premium of $211 (net profit of $361).

Selling calls in this situation, when the value of stock is on the rise, is a sensible use of options, with profits more likely than losses. The status of MCD is summarized in Figure 3.1. The trend—prices moving higher—is highlighted with a trend line.

Figure 3.1 Selling calls in a rising market

Source: Chart coutesy of StockCharts.com

Using Technical Analysis as a Risk Measurement

An alternative to the analysis of implied volatility is the study of stock charts. In this method, you study the chart of the underlying stock and look for reversal and confirmation signals to time option trades.

The advantage in this method is that seeking two or more exceptionally strong reversal signals may offer a better than average outcome. No one is going to be right 100 percent of the time, but chart analysis can be very effective in identifying strength or weakness in a current price trend. Chart analysis requires confirmation in the form of a second indicator, foreshadowing the same likelihood of reversal in the near future. If you can find three or four indicators, it further strengthens the chances for good timing.

The first disadvantage in technical analysis of stock charts is that this is a complex process. It can be simplified with practice and observation over time, but for anyone who are not familiar with technical analysis the process can be daunting. The second disadvantage is the skepticism many investors have toward technical analysis. Does it really work? It does work in the sense that price strength or weakness tends to show up in the form of specific indicators, but interpreting these accurately is a very subjective process.

Using both fundamental and technical analysis strengthens the overall quality of information. Focusing only on one side or the other has inherent weaknesses. By combining both, your starting point is a prequalified value investment. By selecting stocks on the basis of long-term dividend growth, stable debt ratio, and growing revenue and earnings, you know that the companies you pick are strong in a fundamental sense. The technical tests identify volatility in price trends and if and when reversal signals are located, it will give you a form on insight about price trends not possible with fundamental analysis.

Options Used to Mitigate Stock Investment Risk

With well-selected stocks, the option premium is likely to be “in the zone” of expectation; in other words, the low risk of the conservatively picked stock reflects the same low volatility of the option. You gain the advantage, even when dealing with safe stocks and options, in three ways:

1. You select longer-term option writes. The LEAPS call creates significant profit potential in the covered call strategy. You want to use OTM calls to avoid exercise. When you use LEAPS calls, premium levels often are high enough that the simple yield is more attractive than traditional listed options because of time. The greater the time left until expiration, the higher the time value.
2. The selection of covered writes is limited to stock that has appreciated. It would be contrary to your goals to write covered calls with strike prices close to your original basis in the stock. Some of the best premium returns are found in calls whose current market value is close to the call’s strike price. The covered call write is a means for taking profits and providing downside protection, but without necessarily selling the stock. The strategy solves the dilemma every stockholder faces: Stock has appreciated, and the temptation is to take profits, but you don’t want the capital gain and you don’t want to give up the long-term investment.
3. Exercise is avoided with rolling techniques. You want to repeat the cash profits from writing covered calls on appreciated stock. The best of all worlds is to keep a strong long-term growth stock while generating repetitive option profits. If the short call is exercised, you would gladly accept the high yields, but at the same time, you prefer to avoid exercise. Risk of exercise should not be overlooked; however, as it can occur at any time the short option is open.

Lost Opportunity Risk and Options

Another form of risk to consider is lost opportunity risk. If the stock’s price soars far above the strike price of the covered call, you lose your shares through exercise. Your stock has to be sold at the fixed strike price when that strike price is below the current market value.

Is writing covered calls worth the lost opportunity risk? You will probably have calls exercised periodically, and you will wish you had waited so that you could have benefited from the higher stock price. But your portfolio profits will be higher from writing covered calls on appreciated stock than they will be from simply keeping your long positions without options activity. The lost opportunity is the exception rather than the rule because, by definition, a conservative selection of stocks creates consistent price trends (low volatility) and less likelihood of sudden and unexpected price changes (high volatility). You can further mitigate or even eliminate the risk of exercise using rolling techniques once you have short options.

Perceptions About Options

Properly employed, options can strengthen your portfolio and provide greater protection than just holding well-selected stocks. Because prices tend to move in cycles, short-term and intermediate-term pricing may be erratic, and even the best-chosen stocks go through reversal and consolidation patterns.

As long as long-term fundamental signals continue to show strength, the conservative philosophy is to hold and accumulate stock and wait out the market. This traditional approach observes correctly that short-term pricing is unpredictable as an indicator. Short-term price movement is not useful for long-term prediction. However, it remains possible to (a) protect paper profits and even take those profits without selling shares, (b) exploit market price overreactions, and (c) generate current returns, all without taking on added market risks. The lost opportunity risk associated with committing shares of stock to a fixed strike price should be evaluated along with the rates of return, the value of downside protection, and the yield diversification you achieve with the use of options in a conservative manner.

Strategic Timing and Short-Term Price Changes

Consider the possibilities in options trading when markets are exceptionally volatile. Most of your capital may be tied up in long stock positions that would produce losses if sold when market prices are low. You recognize that this is the time to buy more stock, but you are uncertain, and you do not have capital available to make a bold move even if you wanted to. This is the perfect opportunity—using a limited amount of capital, of course—to buy cheap calls. You know that sharp market drops usually and rebounds quickly. You also recognize the stocks whose fundamental strength supports the probability of a healthy return to the normal trading range. Picking the bargains is not difficult; the decision to put money into the market at these moments is the difficult part.

When your portfolio is depressed, you have three choices. First, you can sell everything and just get out of the market. Second, you can wait out the cycle and hope prices rebound. Third, you can seek a rescue strategy to regain lost value as quickly as possible. This is where options can play a key role. For example, as of the end of 2010, thousands of investors had paper losses in their personal portfolio as well as in their retirement plans. This is a distressing situation; at the time, no one had any idea of how long it would take for the market to recover; some people thought it never would. Uncertainty in the economy, politics, and the market itself, all worked together to increase the fear investors experienced.

Being conservative does not mean that you have the same attitude in all market conditions. Flexibility is an essential tool in your portfolio management arsenal. When opportunities present themselves, it is prudent to take them. If you lack the capital to buy shares, or you are fearful of further price declines, options present the perfect compromise. You can limit your risk by investing only a small amount of capital; and the timing can work to your advantage given the likely price patterns in big-number changes.

This does not suggest that you should speculate in long calls. But every conservative investor has survived through big price swings and seen the results—a big drop followed by a period of uncertainty and then a rapid return to previous levels. This trend can take a few days, weeks, or even months to play out.

Short Positions: Naked or Covered

The concept of speculating on long calls or puts is contrary to the generally understood definition of conservative. There may be moments when you want to use long calls or long puts to take advantage of price changes. It may be appropriate, given the timing, and may even conform to your conservative standards.

Some strategies involving short calls and puts may also conform to your conservative risk profile based on prevailing market conditions and your portfolio positions. The basic covered calls strategy is the most obvious example. When you sell a call, you are taking paper profits and reducing your basis in the stock; you expose yourself to the possibility of losing future price gains in exchange for the certainty of premium income today.

The Uncovered Call: A Violation of the Conservative Theme, Usually

Is it ever justified to sell uncovered calls? In the conservative philosophy, it is not. Uncovered calls are one of the highest risk strategies possible. Chapter 9 contains an example of one situation in which writing uncovered calls can work for a conservative portfolio: the ratio write.

One technique involves topping off a ratio write with one long call. In effect, this eliminates the uncovered portion of the ratio write. For example, if you own 300 shares, full coverage involves selling three calls. If you sell four calls, you have a ratio write. This can also be viewed as the combination of three covered calls and one uncovered call. However, you can further modify this position by purchasing a single call with a higher strike price. In effect, this creates a different kind of combination: a covered call strategy on 300 shares accompanied by a spread (a strategy in which the benefits of one side of the position are offset by the risk in the other). As long as the modified ratio write can be accomplished with a net credit (money coming in rather than going out), the risk is limited. The difference in strike prices between the fourth short call and the long call is a risk if and when the stock moves about the highest short call strike price. Chapter 9 examines this modified strategy in greater detail.

Covered calls are related to ownership of stock, so exercise risk is easily controlled. Short puts are a different matter. In many instances, writing puts makes sense. Because puts cannot be covered in the same way as calls, it is easy to overlook the potential of writing uncovered puts or covering them by combining a short put with later-expiring long puts. The risks of short puts are far more limited than those of short calls, because the potential decline in value is finite. Uncovered puts have the same market risk as covered calls, making them very conservative.

Margin Requirements

There are two areas in which option investors have to live with special rules: taxes and trading restrictions. The tax rules are covered later; a more immediate concern involves the special financial requirements that apply once you move beyond the status of stockholder and begin to make actual option trades.

Margin rules are intended to limit the volume of trading undertaken by investors with limited capital. The Securities and Exchange Commission (SEC) defines a pattern day trader as any individual who makes four or more day trades within five business days. A day trade is opening and closing a position within a single day. Once you make the fourth-day trade within a five-day period, you are required to maintain at least $25,000 equity in your account (in cash and securities). For many options traders, the restriction certainly applies. Unless you can limit activity to three or fewer trades, you will be treated as a pattern day trader.

The problem is not severe by itself, but having that label removed could pose a problem. Your broker may view you and your account as a potential problem and there is no automatic system for every broker to remove the label of pattern day trader. At the very least, you will be required to submit a letter promising not to repeat the trading levels of the past. Your broker may also suspend your account if you violate that promise. Even when pattern day trading does not do great damage to the broker or increases its market risks, being labeled as a pattern day trader can inhibit your ability to trade options freely.

Other Margin Rules

All investors must be concerned with the initial margin (the amount of value required at the time a position is opened) and with maintenance margin requirements (additional margin required if prices change in the securities involved).

Options traders must be aware of these margin rules for options trading. The term “margin” relating to stock trades is far different than its definition for options. As a stock trader, margin is a borrowing mechanism. For example, you can borrow up to 50 percent of the basis in stock. But for options, margin refers to collateral that must be on deposit for certain types of options trades. The strategies involving options may look good on paper but, given margin requirements, limited capital could make combinations of positions impractical.

The margin rules are complex for advanced trading strategies and combinations. To see a complete summary of a typical broker’s margin requirements, check the Chicago Board Options Exchange (CBOE) free download of the “Margin Manual” at https://cboe.com/learncenter/pdf/margin2-00.pdf

Given the limitation on pattern day trading and the capital requirements, it would be difficult for an investor to become active in options without placing substantial capital at risk. With options, the threshold of four trades could be crossed quickly and easily within a few days, at least occasionally; it is the nature of options trading to execute a number of trades in a short period of time because market conditions present immediate opportunities.

Return Calculations: Seeking Valid Comparisons

Margin limitations inhibit investor activity if only a small amount of capital is available. An equally complex problem is the calculation of returns from option activity. In attempting to measure and compare option trades—whether employing timing strategies or the safer and more reliable covered call—you face a problem. How do you measure your profits? Consider the problem of the covered call trade. You have three possible outcomes: exercise, expiration, and closing the position. In the first instance, you combine a capital gain with profits from selling a covered call; in the second, you realize a level of profit, but you still own the stock. You cannot compare possible returns on a like-kind basis. Excluding capital gains on stock is always suggested; however, in picking a strike, you should be aware of your basis in the stock and limit your covered calls to strikes that, if exercised, will produce a net profit and not a net loss.

Return if exercised is calculated as a percentage of the stock’s value, either at the time the strategy is entered into or based on the strike value. Using the strike value makes the most sense because that is the price at which stock will be called away. Your capital gain on stock depends on your basis and should be calculated separately. As long as you purchased the stock at a price below the short call’s strike price, you can ensure a capital gain in the event of exercise.

Limiting this discussion to the option-only return allows you to compare the various option outcomes. While return if exercised (also termed if-called rate of return) appears to be the best possible return on a short strategy, it is not always the case. To make return comparisons valid, you have to view them on an annualized basis. When you consider the possibility of a short call simply expiring worthless (or being closed at a profit), you can repeat the strategy. The ability to sell covered calls repeatedly turns stock into a combined long-term growth instrument and current cash cow. The combined annual income from dividends and call premiums can make nonexercised returns far more advantageous than the exercised rate of return. Including dividends in the calculation of covered call return (termed “total” rate of return) is essential; with all other factors identical, the difference in dividend yield often makes one stock more favorable than another. Dividend yield represents a major portion of overall covered call return.

Table 3.1 Market data for covered calls

Stock name	Symbol	Share price *	Strike	Premium	%	Annualized**
AT&T	T	$30.34	30.50	1.02	3.34%	21.39%
Southern Co.	SO	52.44	52.50	0.94	1.79	11.46
Altria	MO	51.41	52.50	1.29	2.46	15.75

* Closing prices as of April 25, 2019. Source: Charles Schwab & Co.

** To annualize, divide yield by the number of days to expiration and then multiply by 365.

To begin analyzing various options and their potential returns, a side-by-side comparison between stocks is useful, and for each stock, potential outcome (exercise, expiration, or close) is studied. Table 3.1 summarizes the market data for the three companies in the model portfolio. These are based on the 57-day options at the strike immediately above market value of each stock. Even though the same time to expiration is employed, considerable differences will be found for each stock. A careful and thorough comparative analysis of covered call candidates is needed in order to make an informed selection.

Annualizing each outcome produces the yield that would be realized if the position were held open for exactly one year. Using the yields is reported in Table 3.1.

AT&T	3.34% ÷ 57 days x 365 days = 21.39%
Southern Co.	1.79% ÷ 57 days x 365 days = 11.46%
Altria	2.46% ÷ 57 days x 365 days = 15.75%

These examples compare calls OTM. Because all options in this example expire 57 days from the study date, the percentages shown are comparable; but annualized return, while equally comparable, tells the real story and allows you to make comparisons between these three companies.

The return you can expect to earn on any one option depends on the premium’s relationship to the current price and should include dividend yield on the stock. The calculation of option returns also has to consider the ramifications of exercise. Although you do not complicate your analysis by including this factor, it is clear that differences will occur. For example, when the annualized yield is adjusted to include dividends, the picture is changed considerably. Table 3.2 is based on the assumption that annualized return (a holding period of exactly one year) is comparable, and that this should be adjusted to reflect one year of dividend yield as well.

Table 3.2 Annualized return with dividend yield

Stock name	Symbol	Annualized	Dividend yield	Total return
AT&T	T	21.39%	6.64%	28.03
Southern Co.	SO	11.46	4.66	16.12
Altria	MO	15.75	5.95	21.70

* Closing prices as of April 25, 2019. Source: Charles Schwab & Co.

This calculation demonstrates that it is not reliable to simply compare potential returns on covered calls. You also have to consider dividend yield, especially if you are going to select one stock over another as the stock to buy.

Return If Exercised

Although exercise could occur at any time the call is ITM, you cannot accurately compare the yield unless you make this assumption. Return varies based on the time the option is left open.

Stock price can also be deceiving in the side-by-side analysis. All comparisons involving 57-day calls set up annualized returns on a comparative basis. To continue evaluating the portfoliowide returns in these cases, you need to track also the dividend income and growth in the stock’s market value. However, for option-specific returns, the results vary considerably, not only due to different dividend yields but also based on varying times to expiration.

Dividend yield affects overall profitability and may also influence which stocks you would use for the covered call strategy. The most sensible approach is perhaps to calculate both with and without dividend yield and then compare outcomes.

Return If Expired

Comparing return if exercised to return if expired is useful because it shows the result of two possible outcomes. However, it is not accurate to compare the two outcomes to decide which is preferable. The covered call is sensible only if any of the possible outcomes would be justified and acceptable, but consider the problem of trying to compare exercise to expiration. Upon exercise, your stock is called away, then you have a taxable capital gain, and that is going to vary depending on the strike you pick versus your original basis in the stock. In the case of expiration, you continue to own stock. You are free to repeat the covered call strategy after expiration. This means your yield can recur repeatedly as long as exercise never happens, so a true overall comparison is not really possible. Given the potential for repetitive returns from the covered call strategy, the rate of turnover becomes important. The more often you can replace a current covered call with another, the higher your premium income.

It is valid to compare the potential return to the stock’s current value. You must own the stock to enter the covered call strategy as a requirement under your conservative risk profile. Comparing yield to your original cost makes it outdated, because there is no relationship between today’s covered call strike price and your original purchase price. The validity of comparing expiration returns to today’s price rests with the assumption that you would select one or more covered calls based on (a) proximity between strike price of the call and today’s market price, (b) related premium levels, and (c) time until expiration. The major difference between the two potential outcomes (exercise and expiration) is whether you continue to own the stock at the end of the strategy. This is where capital gains and dividend yield become important.

Dividend yield has to be an important component in the selection of stocks for covered call writing, whether you currently own the stock or are considering purchasing shares in the future. You may pursue high-yielding stocks to increase returns, or you may avoid writing covered calls to preserve dividend yield. Another alternative is to write ITM covered calls on high-dividend stocks, while avoiding exposure in ex-dividend month (thus avoiding early exercise). The idea is to exploit time value and either close at a profit or allow the position to expire if the stock price declines (or even to accept exercise when the capital loss is much smaller than the call premium, due to high time value when the position is opened).

Expiration might be the worst-case scenario if it yields the lower return compared with closing or having stock called away. But you have control. You do not need to keep option positions open until expiration. By comparing if-expired returns to the alternative of closing positions today and replacing them with richer premium short calls, consider the following:

• The net yield, on an annualized basis, of closing the call. This is the difference between the original sales premium and the current closing purchase premium, net of transaction expenses, calculated on an annualized basis.
• The comparative yield on a new short call, given longer time to expiration, higher time value premium, and proximity between strike price and current market value.
• The increase, if any, in the strike price level. If the stock’s market value is higher today than when you sold the original call, consider selling calls with higher strike prices. This increases your capital gain in the event of exercise, yet it keeps your position OTM and maintains your conservative standard for covered call writing.

With these variables in mind, the worst case is difficult to quantify. Since the comparison is not valid between stocks, it is not accurate to assign a preference of one outcome over another. All the factors—including exercise, dividend yield, and capital gains—have to be considered as part of your analysis. The original cost of stock, proximity between cost and strike price, and proximity between current value and strike price affect your decision, and those factors are going to vary between stocks.

Long-Term Goals as a Guiding Force

Working within a conservative framework is not always an absolute or easily defined criterion for how to invest or what products to select. Your level of conservatism changes with market circumstances. The various options strategies enable you to take advantage of market high points without disposing of stock you prefer to keep. Degrees of conservatism are possible and may not be fixed. It might be considered conservative to use options at market extremes as long as large amounts of capital are not risked or exercise of short positions produces an undesirable outcome. This is an individual decision, and no universal standard can identify whether it is appropriate.

Current circumstances affect how you invest, and they should. It is not conservative to invest in the same manner in every situation. You need strategies for managing your portfolios in down markets as well as in up markets, and options in their various configurations are powerful tools for protecting your long-term positions and for identifying and taking profit opportunities without compromising your goals.

There is a tendency to classify specific options strategies universally, so taking long positions is always thought to be high risk, and writing covered positions is always viewed as safe. Neither of these is always true. For example, writing covered calls is ill-advised when the stock price is depressed, especially if the current price of an underlying stock is lower than your basis. If you think prices are going to climb in the future to reverse the downtrend, timing of the covered call write would be poor.

Exercise as a Desirable Outcome

One aspect of options often ignored is the desirability of exercise in some circumstances. Exercise is usually avoided as part of an overall strategic approach based on your wanting to enhance current income while doing all you can to keep well-selected, long-term growth stocks. In the covered call strategy, exercise is most likely when the stock’s price is rising, so escaping exercise provides more capital gains in the stock, to be realized later. Avoiding exercise by rolling out of positions is a practical method for managing covered call positions; even if exercise does occur in the future, it is always preferable at a higher strike price. In the following circumstances, you will welcome exercise:

• Writing deep ITM calls, even with tax consequences in mind. If you have a substantial carryover loss to bring forward, you are limited to a maximum of $3,000 per year in capital losses you can claim. When your carryover is far above that level, you will not be concerned about the loss of long-term status you suffer when writing deep ITM covered calls. In fact, in that situation, your covered-call-writing strategy could be designed to invite exercise.
• Selling puts as a form of contingent purchase when the strike price makes sense. If you are willing to buy stock at the short put strike price, minus the premium, exercise is a desirable outcome.
• Accepting exercise when fundamental indicators have changed. You may find yourself in the interesting position of owning stock with a short covered call, also to discover that you no longer want to own the stock. If the call is ITM, you can simply accept exercise in this situation and take your profit. Inviting exercise is one method of dealing with ever-changing market conditions.

As a conservative investor, you continually struggle with the problem of market volatility. Even when you believe stock is worth holding for the long term, how can you ensure that today’s paper profits are not lost in future market price movements? You can use several conservative strategies to accomplish these defensive goals. As Chapter 4 demonstrates, even the technical practice of chart analysis can be incorporated as part of a very conservative system for portfolio management based on options strategies.

Class questions for discussion and/or mini-case studies

Multiple choice

1. Risk can be measured through:

   a. Financial analysis alone.

   b. Technical analysis alone.

   c. Volatility in equities or technical analysis.

   d. Volatility alone.

2. Uncovered calls are considered:

   a. High risk in most situations.

   b. Generally low risk.

   c. The best way to generate cash in a portfolio.

   d. As illegal under current securities law.

3. Annualizing return is accomplished by:

   a. Estimating future income out to a full year’s holding period.

   b. Assuming a one-year holding period in every situation.

   c. Dividing net return by the number of days held, and then multiplying by 365.

   d. Looking back at the past year to calculate annual returns.

Discussion

Locate a stock chart presenting the ideal circumstances for writing covered calls. Explain why the situation is favorable and the range of possible outcomes expected.