APPENDIX A USING OPTIONS TO REDUCE RISK

Options are derivative contracts that have no value on their own. They derive their worth from the value of some other asset. They are used to reduce risk and are the most sophisticated, intricate, and arcane of the financial instruments.

If used improperly, options can be among the riskiest of investments. In the early 1990s some institutions that obviously lacked a full understanding of the risks and consequences of the inappropriate application of derivatives became high-profile casualties of improper usage. An electric saw can be a valuable tool in skilled hands or a dangerous one in the hands of a careless individual. Orange County lost an estimated $2 billion and Long Term Capital, $4 billion from the bungled use of derivatives. The accompanying negative publicity gave these tools of risk management a tainted reputation.¹

UNDERSTANDING PUTS AND CALLS

The call option is an agreement that gives the investor the right but not the obligation to purchase a security at a specified price within a specified period of time. Conversely, a put option gives the investor the right to sell a security at a specified price for a specified time.

You can buy or sell both put and call options. These kinds of instruments can make your head spin because of the many possible variations and combinations of option contracts. There are some simple and conservative ways to use puts and calls. Some of these strategies are as follows:

• Sell covered calls
• Purchase a protective put
• Sell uncovered puts
• Purchase calls

Sell Covered Calls

Let’s say Karen owns 1,000 shares of Intel, which is currently trading at $28 per share. She would be absolutely thrilled if it went to $35 in the next five months. This would amount to a 25 percent increase. As a matter of fact, she is willing to give someone else the right to buy her stock between now and five months from now at $35. She’ll give away all appreciation above $35 to the other party. For giving this up she receives an immediate payment called an option premium. Let’s assume she will receive $1,250, or $1.25 per share. She keeps this money regardless of what happens with the stock price. If Intel is above $35 in five months, it will be sold at $35. If it’s below $35, she keeps the stock (as well as the option premium) and can write another round of covered calls if she wishes. This is a conservative strategy for stock investors and is called covered call writing.

What if she sold the call options but didn’t own the underlying stock in Intel? This is a very high-risk strategy. She would receive the $1.25 per share option premium, but her losses are theoretically unlimited. Let’s say she does this and Intel is at $60 five months from now. She has the obligation to deliver Intel stock at a price of $35 per share. She received $1,250 from the option premium but lost $25,000 by having to buy Intel at its current price of $60 to cover the shares that were sold for $35. Obviously, the conservative investor would consider this an unreasonable strategy.

Purchase a Protective Put

Let’s assume that Karen still owns Intel, and it is at $28 per share. She is worried about the economy. Some economists are 205forecasting robust results, while others see a severe recession. She feels that Intel will do well in a rebound and could even double in price in the next year. But if the economy falters, she fears that Intel could go all the way down to $10 per share. She wouldn’t want to suffer that kind of drop.

She is willing to pay $3 per share, or $3,000, if someone else guarantees that he will purchase her Intel shares at $25 for the next twelve months, if she wants to sell. Of course, she would only do this if the share price was less than $25 at the end of the twelve months. Let’s say Intel goes down to $10 per share. She exercises her options to sell at $25. Karen nets $25 less the option premium of $3, or $22 per share. She still lost money, but $22,000 is better than $10,000. Essentially, she bought portfolio insurance with a deductible. The higher the deductible (losses you are willing to absorb), the lower the premium. Now if the stock doubled to $56 per share, her account would be valued at $53,000 ($56 - $3 option premium). The put option gives you a predetermined maximum loss and unlimited gains.

If you don’t own Intel and just buy a put option, you are speculating that the price will come down. If it doesn’t come down, you lose 100 percent of your investment. The loss in this case is limited to the amount of your investment.

Sell Uncovered Puts

Now let’s say that Karen doesn’t own Intel, and it is currently at $28. This is a stock she would like to purchase, but only if it gets down to $25 per share. She could put a buy limit order in at $25, meaning that if Intel were to go down to $25, her order to purchase 1,000 shares would go through at that price. Instead she sells put options on Intel that obligate her to purchase at $25 if it is at or below that price twelve months from now. She immediately receives an option premium of $3 per share for taking on this obligation. She keeps this regardless of what happens to the stock price of Intel. If the option is exercised, she buys at $25 per share, but she received $3 for the 206option premium so her net investment is really $22. If the stock price stays above $25, she won’t get to buy Intel but keeps the $3,000 option premium.

You can see that this could be a risky strategy because if the stock goes down a lot, you are on the hook for buying at the exercise price. In the event the stock price goes to zero, your maximum loss is the cost of the stock at exercise, less the option premium.

Purchase Calls

Karen thinks Intel is going to soar but doesn’t want to sink $28,000 into the stock in case she is wrong. She buys ten call option contracts (each contract represents 100 shares of stock) that give her the right to purchase Intel at $35 per share for a five-month period. The cost is $1,250. By purchasing the option she is limiting her maximum loss to the option premium. So if Intel goes down to $5 or $10 per share, her loss is $1,250 and no more. She simply chooses not to exercise the option. However, if Intel gets to $56, she would exercise her option to purchase at $35 and have a gain of $21,000 less the $1,250 cost of the contracts, or $19,750. She could also sell her option before it expires and make a profit. You can see that there is huge leverage here if the stock goes up, while the downside is limited to the amount invested.

All of this may sound very complicated, but many people are unsuspecting buyers of options. Anyone who has ever purchased a home and taken out a mortgage with a no-penalty prepayment provision actually owns an option. In this case the homeowner-borrower has the option to determine the conditions of repayment. If mortgage rates drop, the homeowner can refinance and take out a mortgage with a lower rate of interest, leaving the lender with a loss of a high-interest loan replaced by a low-interest loan. This option is pretty much standard with most loans today. The borrower is actually paying207 for this option by paying a slightly higher interest rate for the no-prepayment provision clause.

Options can be a useful device for protecting the value of a stock portfolio from devastating losses. However, the investor should be cautious and work with a financial professional who thoroughly understands all the intricacies of how they function.