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Chapter 2. Option Investing: Option Sales Explained

Selling Straddles Against a Portfolio

In option investing, the owner of 100 shares of a stock may be willing either to buy more shares of the stock or to sell out at a premium. In such a situation he can sell a Straddle. A Straddle, as previously defined, is a combination of a Put and a Call, both at the market price of the stock. Let us say that a man sold a Straddle on XYZ at 50 for 90 days, and for it received $500 per 100-share Straddle. By selling the Straddle, he has contracted: (1) to sell 100 shares at 50 any time within 90 days when Called by the holder of the Straddle; (2) to buy 100 shares at 50 any time within 90 days if the holder of the Straddle Puts stock to him. If the Call is exercised, he will have sold his stock at 50 plus the $500 that he received for the option. If the Put is exercised, he will have bought stock at 50, which price is reduced to 45 by the $500 premium. But, you may ask, cannot both the Put and the Call be exercised—first the Call before expiration and then, after the Call has been exercised and still before expiration, the Put? Yes, that can happen. A Straddle consists of a Put and a Call—both separate contracts—and the exercise of one does not void the remaining contract. What would be the result to the writer of the Straddle if both contracts were exercised? Well, in the example cited, the trader started with 100 shares. That stock was called, leaving him with no stock, but subsequently he had 100 shares Put to him, so after he sold 100, he then bought 100, and this brought him back to his original position of 100 shares. Finally, he was ahead by the $500 premium, which he received.

Selling a Spread Option

In option investing, while a Spread is an option that isn't bought or sold too much, an explanation of it nevertheless belongs here so that the reader becomes familiar with all kinds of options.

Suppose that instead of selling a Straddle (both the Put and the Call at 50 for 90 days for $500), Mr. Trader sold a Put at 49 and a Call at 51—that's called a 2-point Spread— and instead of receiving $500, as he would for the Straddle, he receives $400 for the Spread. As a rule, the premium received by the seller of the option or paid by the buyer is reduced by $50 for each point Spread. Thus the Spread of 2 points reduces the premium by one point, or $100. This Spread option, like all other options, is traded by negotiation and is sometimes more difficult to make because the "maker" of the option would prefer to have more "cash in hand" and, therefore, would prefer to sell the Straddle. The only advantage in selling a Spread is this: if, at the expiration of the Spread, the stock which was selling at 50 at the making of the Spread is now selling between 49 and 51, chances are that neither the Put nor Call will be exercised; whereas if a Straddle at 50 has been sold, the chances are greater that at least one side of the Straddle, if not both, will be exercised.

Sale of a Strip

A quite recent addition to the family of Stock Options is a contract called a Strip. In option investing, a Strip is simply a Straddle with an extra Put—in other words, a Put on 200 shares and a Call on 100. The seller of a strip at 50 would contract to buy 200 shares at 50 and/or sell 100 shares at 50. If the sale of a Straddle at 50 would bring the seller $500, then the sale of a Strip would bring about $700. Suppose that a man who had 100 shares of stock selling at 50 were willing to sell a Straddle for $500; that means that he would be willing to sell his stock at 50 plus the $500 premium and/or would be willing to buy 100 shares of additional stock at 50, which would be reduced in cost by the premium of $500 which he received.

In the sale of a Strip on the same stock, if the stock were Called, he would have sold his stock at 50 plus the $700 premium, or at a price equivalent to 57.

On the other hand, if the stock declined and the Puts were exercised, he would have to buy 200 additional shares at 50, which price would be reduced to 461/2 on each 100 by reason of the $700 premium received. Therefore, the question must be asked by the seller of a Strip, "Would I be willing to lose my stock at 57 and/or would I be willing to buy 200 additional shares at 461/2 ?" The increased premium for a Strip gives a higher selling price in case the Call is exercised. If the two Puts are exercised, the $700 premium received reduces the cost of the stock by 31/2 points for each 100-share Put. Whether a Straddle or a Strip should be sold (assuming that it is possible to sell a Strip) depends on the "market feel" of the seller of the contract.

Selling a Strap

In option investing, the reverse of the Strip and, also, a cousin of the Straddle is the Strap. It is a form of option contract that was unknown a dozen years ago. It is merely a combination of a Put on 100 shares and Call on 200 shares. To make a comparison: if a Straddle—one Put and one Call—will bring a premium of $500, and a Strip will bring a premium of $700, a Strap will bring a premium of about $800. If the Calls are exercised, the seller of the Strap will have to sell 200 shares at 50, which price will be increased by the $800 premium to an average sale price of 54. However, if the market declines and the one Put is exercised, the maker of the Strap will have to "take" or buy 100 shares at 50, but this price will be reduced to 42 also by reason of the $800 premium which he received for the sale of the Strap.

Selling Call Options Against Convertible Bonds, Warrants, or Preferred Convertible Stocks

In option investing, there are those who might be called semi-professional or professional traders who own or buy convertible bonds. These bonds are convertible into common stock of the same company and against these bonds the traders sell Call options on the common stock. Below we see an example of how this is done against "converts." The same method can at times be used against warrants and convertible preferred stocks.

General Telephone convertible 4½'s of 1977 sell at approximately 140, or $1,400 for a $1,000 bond at this writing. The stock at the same time sells at 643/8. Each $1,000 bond is convertible into 21.74 shares of the common stock. Therefore, five bonds costing $7,000 give the holder the right to convert into 108.7 shares of common stock.

Suppose that the holder of such bonds sells a Call on 100 shares at 643/8-the market price-for 90 days for $500. One of two results is possible: The Call will not be exercised and the holder of the bonds—the seller of the Call— will benefit by the $500 received for the Call (which will mathematically reduce the cost of the bonds by $500, or 10 points per bond). Or the Call will be exercised, at which time the holder of the bonds will convert into 108.7 shares of stock. He will deliver the 100 shares at the Call price, less dividends, and either hold or sell the odd 8.7 shares. His account will read:

  Bought 5 bonds at 140 Cost    $7,000.00
  Sold 100 shares stock at 643/8   $6,437.50
  Received for Call 100 shares  500.00
  Value of remaining shares (8.7)  
  (minimum value)      560.00
  Because if the stock is Called the stock  
  will be above the Call price    $7,497.50
  Profit      $  497.50

A study of convertible features of securities might disclose other such opportunities.

The Sale of 6-Month-10-Day-Options

The tax law says, in effect, that the premiums received from the sale of an option in option investing must be held in abeyance until the expiration or the exercise of the option. If the contract expires, the premium is ordinary income to the seller of the option. If the option is exercised and it is a Call, the premium is an addition to the proceeds of the sale and, hence, increases the gain, or decreases the loss, on the sale. If the option is exercised and it is a Put, the premium decreases the cost of the stock and, hence, will increase the gain or decrease the loss on the ultimate sale of the stock. The gain or loss on the sale of the stock may be either long term, or short term, depending on the length of time the stock has been held. If a 90-day Call option is sold on a stock after the stock has been held 30 days and the Call is exercised, the time of holding the stock would amount, in all, to approximately 4 months and the gain, if any (including the premium received for the sale of the Call), would be taxed as short-term gain. If the stock in question had been held for over three months when the Call was sold and the Call was exercised at expiration, then the stock in question would have been held for more than 6 months, and any profit, plus the premium received from the sale of the Call, would have been long-term gain. For that reason options are sold for 6 months and 10 days, or longer. It may be that the prospective seller of options does not own the stock for which a Call is bid, but is willing to buy such stock and then sell the Call which is wanted. If a stock is selling at 50 and a 6-month-and-10-day Call contract is bid for, the prospective seller of the Call may buy stock in the market so as to sell the Call. Of course, if the Call is not exercised, the premium received is ordinary income.

But let us explore the tax possibilities if the Call is exercised. Let us assume that a man has bought stock at 50 and has sold a 6-month-and-10-day Call for, let us say, $500. The stock, held for more than 6 months, has gone up to 70 and is Called. The seller has a $500 long-term profit. However, the alert trader may be able to get a sizeable tax benefit. Before the Call is exercised but when the stock has been held for more than 6 months, he may sell his stock in the market and take a long-term profit of $2,000. But he still owes stock at 50 on account of the Call, which he sold. After having sold his stock at 70 to take a long-term gain, he immediately repurchases stock at 70, and this stock he delivers on his Call a few days later, when the Call is exercised. He now has a $2,000 long-term gain and a short-term loss of $2,000, less the premium of $500, which he received for the Call—a $2,000 long-term gain and a $1,500 short-term loss.

While short-term losses may no longer offset long-term gains at the ratio of $1 of short-term capital loss against $2 of long-term gain (as was the law some years ago), there are many situations in which having a long-term gain and a short-term loss is tax-wise.

Just as a buyer of an option can capitalize, tax-wise, on a long-term option, which he bought, so the seller of an option can benefit through proper treatment of options, which he has sold. Of course, in option investing, there is no guarantee that the holder of a long-term Call option will wait till the expiration of his 6 months "plus" before exercising his contract. It may be that a stock could go from 50 to 75 or 80 in half the life of the option, and the holder of the contract, not wanting to lose his profit, may exercise his contract. In such a case the holder of the stock on which the Call was sold may want to buy an additional 100 shares of stock to deliver against the Call and thus maintain his long position in the original stock until it becomes long-term gain.

A summary of the income tax treatment of premiums paid for by the buyer of options and those received by the seller of options has been added as an appendix. This review of tax treatment has been prepared by a leading New York tax-expert and is based on the 1954 tax law as amended and now current.

In conclusion, may I reiterate that I do not contend that all those interested in securities must trade in Put and Call options. I do feel, however, that this part of Wall Street procedure should be understood by all those who trade in securities, since a time may well come when such understanding can be put to good use in their securities transactions. It is my hope that this book on option investing has shed light on the option business, for those who are interested in securities and knew nothing about options, and also for those who had just a little knowledge of the business and wanted to know more about it.

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