Notice:
  The views and information expressed in this document reflect the opinions and experience of the author Robert C. Pelletier.  Neither CSI nor the author undertake or intend to provide tax advice or trading advice in any market or endorse any outside individual or firm.  All recommendations are provided for their informational value only.  Readers should consult competent financial advisors or outside counsel before making any software purchase or investment decision.  CSI does not stand behind or endorse the products of any outside firms.

Copyright (c) 2001 Commodity Systems Inc. (CSI).  All rights are reserved.

Holiday Schedule Using Options to Take the Sting Out of a Down Market

    CSI will be closed for voice communication on Monday, September 3 for the U.S. Labor Day Holiday. The CSI host computer will be accessible as usual, and data from those exchanges that remain open will be available at their normal times.

Using Options to Take the Sting Out of a Down Market

    Over the past year, stock traders and 401K investors have experienced what most futures traders simply take for granted:  Markets can move down as easily as they may move up, and profits may be earned in both directions. Although Single-Stock Futures will soon make it easier for traders to take advantage of these fluctuations by entering into short positions in equities, alternative investment vehicles already exist. Even without Single-Stock Futures, savvy traders can assume a bearish market posture without taking on unreasonable risk by using the options markets.

    To meet the needs of our customers who trade options, we recently decided to expand our options coverage to include the U.S. equity options traded at the Chicago Board Options Exchange (CBOE). As you may be aware, CSI currently provides daily updates and historical data on futures and index options traded in the U.S. and the U.K., but we have offered stock options in the past. We are excited about the forthcoming renewed database category of stock options and hope that you will find it beneficial. 

    Options are, indeed, a bit more complicated to trade than equities. They have a well-deserved reputation as high-risk tradables, but they also offer significant opportunities for profit and financial security. Below is a sampling of some of the alternatives for trading options in a manner that can minimize the substantial risk levels inherent in the typical options trading process.

Earning Interest on Your Account

    One of the safest option positions you can take is to sell a covered call. In fact, the act of writing covered calls is considered by some to be safer than owning the stock without the covered call. This option strategy involves writing a call against your own existing shares, which may be captured from you by the option buyer at the prescribed strike price. The stock you own is collateral for the "covered" call. The premium you receive for writing the covered call could easily give you a 3 to 25% return or more per trade as you repeatedly wait out your option's termination date.

    One desirable outcome of selling a covered call would be for the stock to remain in the same general price range without moving appreciably above the chosen strike price during the forward period of the option. The purchaser of your option would not want to buy your shares above the current market price, so the option would not be exercised and you would retain ownership of your shares. The premium paid to you for the option (less commission) is your profit. This is one way that you can use options to gain a respectable return on your securities in a relatively flat market -- without taking on unreasonable risk. 

    To further illustrate the above, suppose your private account holds 100 shares of Intel that may currently be trading at, say, $30 per share.  You could write a call against those 100 shares by accepting the premium of, say, $1.50 per share for a two-month forward out-of-the-money strike price of $32.50.  If the stock price stays below $32.50 plus transaction costs, the option will expire valueless, and you'll pocket the $150 premium (less commission). Your return of $1.50 on the $30 investment in two months translates to an annualized return of 30 percent (6 times 1.50/$30). Of course, commissions would be deducted from your gross profit. Such returns are readily available, albeit with some significant other risks.

    What if the price of Intel stock goes up to around $33? The buyer of the option would most likely exercise it and buy your stock at the strike price of $32.50.  If he does exercise the option, you would net $2.50 per share (the strike price less the share price at the time the premium is taken) plus the $1.50 premium (less commissions). You still come out ahead of where you would have been had you simply held the stock and sold it at $33.

    The above scenario addresses the situation where a covered call is written with the objective of earning a return against the stock.  Another possible use for the covered call is to combine it with a stop position to protect against losses and even see gains in a down market. This strategy involves placing a stop below your market entry position and selling a covered call above the current market price. If, hypothetically, Intel's prices were to slip significantly and the stop were to be hit, there would normally be a loss in the given market position. However, since the stock price would be lower, the call option that you wrote could be bought back at a lower price, helping to reduce the cost of the stop loss. When you factor in the gain made from selling the initial call and the reduced loss from your stop-out, this technique can possibly make you money even in a down market.

    As testament to the safety of trading covered calls, the U.S. government allows IRA plan administrators to use covered call writing in IRA management programs.  The general theory is, if the government sanctions covered call writing, then the risk can't be that unreasonable.  Unfortunately, perils seem to persist in almost any financial program.

    Except for the stop-loss case, covered calls may invite at least two unfortunate scenarios. The first is the situation where a stock's implied volatility might increase rapidly.  For example, an uncertain current development could threaten a company's value. In such a situation, the stock's price will likely shift to reflect the expected outcome, but if there is much doubt about the final outcome, the price may not change much.  The option premiums, however, all increase in value, as there is a greater chance that the price may go dramatically up or down in the near future. Although the stock's value may not show much of a change, volatility would increase because of the added uncertainty and your short position could turn sharply against you.  In this situation, you must either wait it out and possibly lose your stock at a loss, or you can buy back your options at a loss.  If you buy back your options, then you can close out your stock position.

    The second regrettable situation is caused when the stock upon which the covered call was written is purchased by the option holder and the seller is subject to a large capital gains tax.  This is a serious concern that might be remedied by buying the same stock for delivery under a one-day title transaction before the three-day option settlement period has elapsed.  In this event, if the redundant purchase can be accomplished in ample time, the capital gains tax would be avoided because the newly purchased shares would be delivered in lieu of the writer's original shares that would have been subjected to capital gains treatment.

Using Options to Act as a Stop to Protect Against Excessive Loss 

    In another scenario, a trader may consider using a put option to protect against the market erosion of a given long position in an existing security position.  When used this way, a put option can become insurance against a market decline. This is an approach that is also quite risky, and is therefore not readily accepted by brokers who are concerned with customer experience and suitability in such a volatile marketplace. Brokers are disinclined to allow customers to trade securities that may have considerable potential risk such as with puts and calls.  Covered calls are far more acceptable to risk-adverse brokers who do not want to be challenged for accepting business from non-seasoned novice traders.

    By now you may have come to see the double entendre of the word "premium" to describe the price of an option. On one hand, it is the extra value paid for the privilege of buying or selling the stock at an agreed-upon price. On the other hand, it may be considered like the "premium" payment on an insurance policy. An option is, in effect, an insurance premium against excessive risk for a period of time. Paying for some relatively cheap insurance (the option premium), could help bail you out of an otherwise sizeable loss.

    The above strategies are examples of ways that options might be used to help preserve and enhance your investment capital. The risks associated with "naked" option positions that can easily leave the trader with a valueless investment, represent another side of options trading that cannot be overlooked. We urge anyone interested in trading options to study the markets carefully and discuss trades with a trusted professional before risking your hard-earned money. 

    Check the Business and Investing section of your library or local bookstore for literature on options trading. I recommend DeMark on Trading Options, McGraw Hill, 1999 as a good starting point. The online booksellers  (Amazon.com, Borders.com, BooksAMillion.com, to name a few) offer a wide variety of additional choices. A wealth of option trading information is also available from websites. Suggested sources include the CBOE's website (cboe.com), Equity Analytics, Ltd. (e-analytics.com/optbasic-htm) and Life Security Corp (get122.com/). 

    We hope that our enhanced options database will help in your studies. The anticipated release date is somewhere near the end of the year. We'll keep you posted. 
 

Important Notice: Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of "Characteristics and Risks of Standardized Options." Copies of this document are available from your broker or the Chicago Board Options Exchange, 400 S. LaSalle Street, Chicago, IL 60605. No statement in the CSI Technical Journal or in the CBOE documents should be construed as a recommendation to buy or sell a security or as investment advice.