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Chapter 2. Strategic Option Trading Examined

Selling Call Options Against a Portfolio

It is interesting when considering strategic option trading an example I saw. I remember lecturing in Chicago some years ago, and after this talk, during a question-and-answer period, one of my audience said, "I have bought options, but I never knew I could sell them." Well, for every trade—whether in options or clothing or real estate—there must be both a buyer and a seller. It is usually very interesting to my audiences to learn where options come from, who makes them, and why. I'll try to explain the selling of options, the advantages to the seller, the disadvantages, and the pitfalls, for I said at the outset that I would show the good side and the bad.

Options are sold by individuals, funds, trusts and insurance companies, and—as I like to say—by anyone who has what I call "a continuous portfolio of common stocks." One who sells options must be percentage-minded—the man who buys a stock at 50 and expects to get 150 for it is not a prospective seller of options, but the man who is satisfied to take a premium of, say, $300 and for that give a Call on his stock for 90 days, and then repeat that procedure over and over again, is percentage-minded and could do well. It is my contention that the selling of options against a portfolio is no more speculative than is the owning of such common stocks.

Consider, as you look at strategic option trading, a man (or an institution) who owns 1,000 shares of a stock selling at 50. He sells a Call, good for 90 days, at 50, for which he receives $300 per 100 share Call. This $300 he receives as soon as he sells the option. Let's see what happens if the stock goes up, and also what happens if the stock goes down.

If the stock goes down and is below the Call price when the option expires, the Call will not be exercised. The seller of the Call will still have his stock and will have profited by the $300 which he received for the Option. If he can sell such an option four times a year (and there are four 90-day periods in a year), he will make $1,200 in premiums, or almost 25 per cent per annum on the $5,000 investment.

Let's look at the other side: the stock advances and the stock is selling above the Call price when, or before, the option expires. The stock is "Called" and the seller of the option must deliver stock at 50, less any dividends. He then has:

  Sold 100 shares at 50  $5,000
  Received $300 for Call    300
  Total Received        $5,300

I am sure that after Mr. Trader has had his stock Called and Has $5,300 to re-invest, he can think of another stock which he would be willing to buy. Strategic option trading accomodates the roving eye. Let's say that this stock is also selling around 50, and he buys 100 shares and then sells a Call against it. The stock will either go up or down. If it goes up, he has his $300 premium again for the second Call and he loses his stock. If it goes down, the Call won't be exercised. He has the $300 premium and is at liberty to sell a Call again on the same stock if he cares to do so.

It is just as simple as that and quite automatic. One shouldn't sell a Call at one time and for one expiration date on all of his stock, but should try to sell a Call on part today, at today's price, and a Call on part of his holdings at a later date at the current market price in an attempt to have staggered prices and options expiring on different dates, like this:

  Sold call 200 at 50, expiring June 20 Premium    $600
  Sold call 200 at 52 expiring July 7 Premium     600
  Sold call 300 at 54 expiring July 18 Premium     900

I believe that there are two pitfalls to avoid in the selling of options: (1) Never sell a Call option unless you own the stock, and (2) Never sell a Put option without the wherewithal to pay for the stock in case it is Put to you. Otherwise, the risk in selling options is no greater, in my opinion —arrived at through years of experience—than the risk in owning like common stocks. For instance, if one had sold Calls freely in the beginning of 1958 without owning the stocks, he could have been Called for stock at 50 when it was selling at 80. If one had sold Puts in the summer of 1957 without having sufficient cash to pay for the stock when it was Put to him, he might have had stock Put to him at 50 when it was selling at 30. The return to be had by selling options almost on an investment basis is interesting enough without looking for additional income and additional grief by trying to gain additional premiums.

Before going into the selling of Put options, Straddles, Spreads, Strips and Straps— as you look at strategic option trading a word about margins. The New York Stock Exchange has set minimum initial margin requirements for the sale of options by customers of its member firms. However, these member firms may increase these requirements according to house policy. The minimum initial margin for the selling of a Put option is 25 per cent of the Put option price, unless the account is "short" the stock, which is already adequately margined. The minimum initial margin requirement for the sale of a Call option is 30 per cent of the stock on which the Call is written, unless the Call is written on stock already "long," in which case the "long" stock is already adequately margined. The minimum initial margin requirement for the sale of a combination Put and Call (Spread or Straddle) where there is no stock position, is the larger of the two requirements for the separate Put or Call, or 30 per cent.

It must be emphasized that these are minimum initial requirements and that they may be increased by the member firm where the customer has his account but they cannot be below these initial requirements as fixed by the rules of the New York Stock Exchange. Before attempting to sell options, arrangements should be made with your stock-exchange broker for the guarantee of such contracts. Your stock-exchange broker will also advise you what the margin requirements are.

When an option is exercised, however, thereby creating a stock position, the position must be fully margined according to stock-exchange requirements.

The Sale of Put Options

An individual (or a company) has $100,000, which he would invest in common stocks. He could buy these stocks in the market or he could sell Put options in an attempt to acquire the stocks a few points below the current market price or to earn premiums from the sale of Put options against the money that he is willing to invest. He must consider this as he looks at strategic option trading.

For an example: With a stock selling at 50, a man (or a company) sells a Put option at 50 for 90 days, receiving a premium of $300 for each 100-share Put contract. For the $300-premium, which he receives at the time that he "makes" the Put contract, he agrees to buy 100 shares at 50 before expiration of the option if the holder of the option cares to deliver it to him. The maker of the Put has no choice—he must receive and pay for the stock if it is Put to him. The option is with the holder of the contract. If, before or at the expiration of the option the holder of the contract cares to deliver the stock, the maker of the option must buy 100 shares at 50, which price is reduced by the $300 he received for the option, making the cost to him 47. If the stock is above the Put price, the holder of the Put option will not deliver stock and the writer or maker of the option has benefited by the $300 received for the contract. Here, too, it must be remembered that if it is possible to sell four such Put options in a year (there are four 90-day periods in a year), the annual return will be $1,200 on a possible investment of $5,000.

The operation can be worked on a number of shares of stock or stocks up to the point where the total amount to be paid for the stocks (if the holders of the Puts exercise them), less the premiums received, equals the amount of cash held for investment. To illustrate:

Suppose that Mr. A. and Mr. B. would each like to acquire 1,000 shares of different stocks selling at 50. Mr. A. buys 1,000 shares:

  100 A at 50   $5,000
  100 B at 50   5,000
  100 C at 50   5,000
  100 D at 50   5,000
  100 E at 50   5,000
  100 F at 50   5,000
  100 G at 50   5,000
  100 H at 50   5,000
  100 I at 50   5,000
  100 J at 50   5,000
  Total Cost       $50,000

Mr. B. sells a Put option on each stock at 50 for 90 days for $300 premium for each 100-share Put. He has received $3,000. At the expiration of the options, no Puts are exercised, and he has earned $3,000 on his possible investment of $50,000 of cash he is holding for investment, at an annual rate of about 24 per cent.

If the Put options are exercised, he will have an account such as this:

  Bought 100 A on a/c of Put $5,000
  Bought 100 A on a/c of Put 5,000
  Bought 100 A on a/c of Put 5,000
  Bought 100 A on a/c of Put 5,000
  Bought 100 A on a/c of Put 5,000
  Bought 100 A on a/c of Put 5,000
  Bought 100 A on a/c of Put 5,000
  Bought 100 A on a/c of Put 5,000
  Bought 100 A on a/c of Put 5,000
  Bought 100 A on a/c of Put 5,000
  Total Cost $50,000
  Less Premiums Received    3,000
  Net Cost $47,000

Mr. A's list cost him $50,000, while Mr. B. has acquired the same stocks at a cost of $47,000. It isn't likely that the situation would work out this all-or-none way; probably some Puts would be exercised, some not. But the principle, as far as strategic option trading is concerned, is clear.

So much for selling a Put or Call option. A man sells a Put option if he is willing to have the stock delivered to him. He may be short the stock and willing to cover, or he may have no position in the stock but have funds to pay for the stock and be willing, for a premium, to acquire the stock at a price which may be above the market price for it at the time the Put option is exercised by the holder.

Conversely, if a man owns stock which he would be willing to sell, he sells Call options,and the premium which he receives enhances the selling price if the Call is exercised; if it is not exercised, the premium adds to the income on the stock which he holds.

Buy 100 Shares and Sell Straddle or Buy 200 Shares

Consider the difference, as you continue to look at strategic option trading, between these two methods: Mr. A. is bullish on XYZ and buys 200 shares at the market, which is 70. Mr. B. is also bullish and buys 100 shares at 70, and at the same time sells a Straddle at 70 for 90 days for $700. At or before the time the option expires, one of three things will happen:

(1) At the expiration of the contract (neither side having been exercised prior to that date), the market price for the stock is just about the Straddle price. This rarely happens, but it can and sometimes does.

Neither the Put nor the Call is exercised and Mr. B. has gained the $700 premium.

(2) The stock is selling below 70, the Put price, and Mr. B. will have 100 shares delivered to him on the Put option, which will make his position as follows:

  Bought 100 shares in market at 70   $7,000
  Had 100 shares Put at 70      7,000
  Net Cost       $14,000
  Less premium received       700
  Net Cost of 200 Shares       $13,300
  or 66½ for each 100 shares  

(3) The stock is above the Call price (70) and Mr. B. will have his 100 shares called from him at 70. His account will look like this:

  Sold 100 shares (through Call) at 70 $7,000
  Sold Straddle 100 shares—premium    700
    $7,700
  Bought 100 shares in market at 70 $7,000
  Profit        $ 700

The first situation needs no discussion as it rarely happens. If it does, however, Mr. B. is at liberty to sell another Straddle, having profited by the premium of $700 on an actual investment of $7,000 and a possible investment of $7,000 on the outstanding Put option—or at the rate of 20 per cent per annum.

In the second situation the market is down, but Mr. B. has his 200 shares at a cost of $13,300, whereas Mr. A. has his 200 shares at a cost of $14,000.

In the third situation, we know that Mr. B. made $700.

What Mr. A. made is problematical; it depends on what he did with his stock. If he sold his stock in the market below 73½, he did not do as well as Mr. B.; if he sold it above 73½, he did better than Mr. B. Mr. B.'s method of operation is quite mechanical—each 100 shares of stock he holds is a unit on which he tries to earn as many premiums a year as he can. Each $7,000 he had available for investment is also considered a unit which can earn him a premium, and on this, too, he tries to earn as many premiums as he can each year. Mr. B.'s only problem is to stay in and sell options on stocks which he would be willing to have in his investment portfolio if the Puts are exercised - this is simpler situation in strategic option trading and better for it.

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