Chapter 18 Option Overwriting

1
Chapter 18Option Overwriting

• Business 4179

2
Key Points

• Writing of covered calls is an extremely
  important strategy that should be understood by
  everyone involved in the market.
• Writing puts is less common but is very
  appropriate for many investors.
• Many portfolio managers prefer index options to
  individual equity options. Margin considerations
  make this activity potentially involved, but also
  potentially very rich.
• Options can also be written to buy stock at a
  price lower than the currently prevailing price,
  or to sell stock at a higher than current price.
  In both cases the difference stems from time
  value of money implications.

3
Question 18 - 1

• Declining prices make put overwriting dangerous.
  Precipitous declines can be disastrous to put
  writers, as some people discovered during the
  crash of 1987.

4
Question 18 - 2

• The tradeoff is simple the lower the striking
  price of a call, the higher its premium, but the
  greater the likelihood of it being exercised. An
  option writer would earn more premium by writing
  the APR 70, but would also have a higher risk of
  exercise.

5
Question 18 - 3

• An in-the-money put stands a greater chance of
  exercise than an out-of-the-money put. The stock
  price must advance further with an in-the-money
  put before it ceases to have intrinsic value.

6
Question 18 - 4

• Covered calls can be used in any portfolio that
  contains common stock. Writing covered calls is
  attractive during periods of declining market
  prices or when market prices are flat.

7
Question 18 - 5

• The portfolio manager need not worry about
  individual equity positions being called away if
  index options are written. Also, the manager
  does not need to keep track of many different
  positions it is much easier to follow a single
  index such as the SP 100.

8
Question 18 - 6

• This would be very reasonable and is often done.
  Both writing calls and buying puts are bearish
  strategies, and there is no reason they cannot be
  done simultaneously.

9
Question 18 - 7

• With covered calls, the maximum loss is known and
  limited. With naked calls, however, potential
  losses are theoretically unlimited. An unlimited
  loss would put the charitable organization out of
  business.

10
Question 18 - 9

• As stated in the text, the term short put is
  somewhat ambiguous. For margin purposes, a put
  is covered if the put writer has a deposit cash
  or cash equivalent whose market value equals 100
  of the strike price.

11
Question 18 - 10

• This makes sense to me.
• If the short put is exercised, the put writer
  must buy shares, conceivably at a loss. But the
  short put position would hedge this loss
  entirely. The shares purchased could immediately
  be delivered against the short position.

12
Question 18 - 11

• With a fiduciary put, the exercise price is
  escrowed. In the event of exercise, the put
  writer already has the funds to buy the stock.
  Non-fiduciary puts do not offer this protection.

13
Question 18 - 12

• You cannot say that writing index puts is always
  preferable to writing individual equity calls.
  Sometimes company-specific events make it
  appropriate to writer individual equity calls,
  sometimes a portfolio is too small to permit the
  writing of even a single covered index call, and
  sometimes regulatory policy precludes the use of
  index options.

14
Question 18 - 14

• If the plan is to buy stock the option writer
  wants a high likelihood that the options will be
  exercised. The more the option is in-the-money,
  the greater the likelihood of exercise. So
  presumably the in-the-money put is preferred.

15
Question 18 - 15

• At expiration someone holds the valuable put.
  Whoever holds it when the music stops is going to
  exercise it. Otherwise they would be throwing
  money away.

16
Problem 18 - 1
42
17
Problem 18 - 2

• Gain on stock 40 ( 77 3/8 - 70) 2,950
• Options expire worthless
• gain 2 2 1/2 100 500
• Total gain 3,450

18
Problem 18 - 3
42
19
Problem 18 - 4
42
20
Problem 18 - 5

• A. You paid 27,000 income received was 3,000,
  and the capital gain was also 3,000. Therefore,
• B.
• This gives a daily R of 0.00263. To annualize,
  multiply by 365
• .00263 365 96.0

21
Problem 18 - 6

• A.
• B. .15 315.66 100 N 4734.9 N
• Plus
• N 1 1/8 100 112.5 N
• Minus
• (320.00 - 315.66) 100 N (434.0) N
• TOTAL 4413.4 N

22
Problem 18 - 6 ...

• C. 59 of cash level 2265 .50 1132

23
Problem 18 - 7

• You received 50 1 1/8 100 5625
• At expiration you must pay
• (320.00 - 334.96) 50 100 74,800

24
Problem 18 - 8
25 3/4
20 3/4
120
125
109 5/8
219 1/4
42
25
Problem 18 - 9

• Presumably the stock will be used for collateral
  in a margin account. Stock counts half the value
  of cash for margin purposes. You can then solve
  for N, the maximum number of contracts that can
  be written.
• N626.0115 100 - (626.01 - 600) 100
  37.50 100 .5 5 million
• N 237 contracts
• 237 contracts 37.50 100 88,750

26
Problem 18 - 10

• The market rose by (660 - 626.01)/626.01 5.43
• The portfolio should rise by 1.15 5.43
  6.24, or
• 124,800
• Gain on the 650 calls 2 100 (27.5 - 10)
  3,500
• Gain on the 600 puts 2 100 (22.5 - 0)
  4,500
• Total 132,800

27
Problem 18 - 11

• N626.01 15 100 - (626.01 - 610) 100
  23.50 100 .5 5 million
• N 246 contracts
• 246 contracts 23.50 100 578,100

28
Problem 18 - 12

• N626.01 15 100 - (680 - 626.01) 100
  7 100 .5 5 million
• N 532 contracts
• 532 contracts 7.00 100 372,400