Chapter 18

Option Overwriting

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What’s a good way to raise the blood pressure of an
Investor Relations Manager? Answer: Talk about
the pros and cons of stock options.

- Eilene H. Kirrane

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 Outline
 Introduction
 Using options to generate income
 Combined hedging/income generation
strategies
 Multiple portfolio managers

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 Introduction
 Option overwriting refers to creating and
selling stock options in conjunction with a
stock portfolio

 Motives for overwriting:

• To generate additional portfolio income
• To purchase or sell stock at a better-than-
market price

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 Using Options to
Generate Income
 Writing calls to generate income
 Writing puts to generate income
 Writing index options
 A comparative example

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 Writing Calls to
Generate Income
 Writing covered calls
 Writing naked calls

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 Writing Covered Calls
 Writing covered calls:
• Occurs when the investor writes options against
stock he already owns
• Is the most common use of stock options by
both individual and institutional investors
• Has a profit or loss determined by the long
position and the short position

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Writing Covered Calls (cont’d)
 Covered call writing is very popular with
foundations, pension funds, and other
portfolios that need to produce periodic
cash flows

 In relatively stable or slightly declining

markets, covered call writing can enhance
investment returns
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Writing Covered Calls (cont’d)
Example

Nile.com stock currently trades for $116 per share. Call

options with a striking price of $120 and a $6 premium are
available for Nile.com.

Construct a worksheet and a profit and loss diagram to

determine the profit or loss associated with writing a
covered call for Nile.com. Assume the investor purchases
the stock for $116. Use a range for the stock price at
option expiration from $0 to $150.
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Writing Covered Calls (cont’d)
Example (cont’d)

Solution: A possible worksheet is shown below:

Stock Price at Option Expiration
0 50 100 116 120 125 150
Long stock -116 -66 -16 0 +4 +9 +34
Short call +6 +6 +6 +6 +6 +1 -24
Total -110 -60 -10 +6 +10 +10 +10
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Writing Covered Calls (cont’d)
Example (cont’d)
Maximum gain

$10
$0
$120

-$110
Maximum loss
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 Writing Naked Calls
 Writing naked calls:
• Involves writing an option without owning the
underlying stock
• Has a potentially unlimited loss
– Especially if the writer must buy the shares in the
market
• Is used by institutional heavyweights to make
money for their firm

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 Writing Naked Calls (cont’d)
 Naked call writing is not often used by
individual investors
• Brokerage houses may enforce high minimum
account balances

 Fiduciaries should be extremely careful

about writing naked calls for a client

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 Writing Puts to
Generate Income
 Fiduciary puts
 Put overwriting

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 Fiduciary Puts
 A fiduciary put is a covered (short) put
• The writer of a fiduciary put must depot the
striking price of the option in an interest-
bearing account or hold the necessary cash
equivalents

 The commission costs of fiduciary puts may

be lower than writing covered calls
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 Fiduciary Puts (cont’d)
Example

February put options on Nile.com are available with an

exercise price of $120 and an option premium of $7.25.

Construct a profit and loss diagram for a fiduciary put,

showing the maximum gain and maximum loss.

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 Fiduciary Puts (cont’d)
Example (cont’d)
Maximum gain

$7.25
$0
$120

-$112.75
Maximum loss
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 Put Overwriting
 Put overwriting:
• Involves owning shares of stock and writing
put options against them
• Is a bullish strategy
– Both owning shares and writing puts are bullish
strategies
• May be appropriate for portfolio managers who
don’t want to write calls for fear of opportunity
losses
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 Put Overwriting (cont’d)
Example

An investor buys Nile.com stock for $116 per share.

Simultaneously, the investor writes a Nile.com FEB 115
put with an option premium of $4.25 per share.

Construct a worksheet and a profit and loss diagram to

determine the profit or loss associated with put
overwriting. Use a range for the stock price at option
expiration from $0 to $150.

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 Put Overwriting (cont’d)
Example (cont’d)

Solution: A possible worksheet is shown below:

Stock Price at Option Expiration
0 75 115 116 150
Long stock -116 -41 -1 0 +34
Short put -110.75 -35.75 +4.25 +4.25 +4.25
Total -226.75 -76.75 +3.25 +4.25 +38.35
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 Put Overwriting (cont’d)
Example (cont’d)
Maximum gain
is unlimited

$0
$115

-$226.75
Maximum loss
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 Writing Index Options
 Introduction
 Margin considerations in writing index call
options
 Using a cash account
 Using a margin account
 The risk of index calls
 What is best?
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 Introduction
 Index options:
• Are one of the most successful innovations of
all time

• Include the S&P 100 and S&P 500 index

options

• Have little unsystematic risk

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 Margin Considerations in
Writing Index Call Options
 Using a margin account does not
necessarily involve borrowing

 Charitable funds or fiduciary accounts use

margin accounts to provide the fund
manager with added flexibility

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 Using A Cash Account
 A portfolio manager can use a cash account to
write index options:
• If a custodian bank issues an OCC index option escrow
receipt to the broker
• If the bank certifies that it holds collateral sufficient to
cover the writing of index calls and
• If the writer can provide the necessary collateral by the
deposit of cash, cash equivalents, marginable stock, or
any combination of these

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 Using A Margin Account
 The required funds in a margin account to write
index calls:
• Equal the market value of the options plus 15% of the
index value times the index multiplier less any out-of-
the-money amount and

• Are subject to a minimum amount equal to the market

value of the options plus 10% of the market value of
the index times the index multiplier

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 Forms of Margin
(Margin Equivalents)

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 The Risk of Index Calls
 The risk of writing index calls is that the
index will rise above the chosen exercise
price

 The lower the striking price:

• The more income the portfolio receives
• The higher is the likelihood that the option ends
up in the money

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 The Risk of
Index Calls (cont’d)
 Cash settlement procedures for in-the-
money index options:
• Involve the transfer of cash rather than
securities

• The writer owes the call holder the intrinsic

value of the call at option expiration

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 The Risk of
Index Calls (cont’d)
Example

A portfolio manager wrote 90 FEB 690 OEX calls. On the

expiration date, the S&P 100 index is at 693.00.

What is the amount the portfolio manager must pay to the

holder of the OEX options?

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 The Risk of
Index Calls (cont’d)
Example

Solution: The manager must pay $27,000:

(693.00 – 690.00) x $100 x 90 contracts = $27,000

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 What Is Best?
 Advantages of writing index options over
writing calls on portfolio components:
• They require only a single option position
• They vastly reduce aggregate commission costs
• They carry much less unsystematic risk
• There is less disruption of the portfolio when
calls expire in-the-money and are exercised

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 A Comparative Example
 Setup
 Covered equity call writing
 Covered index call writing
 Writing fiduciary puts
 Put overwriting
 Risk/return comparisons

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 Setup
 Consider three market scenarios:
• An advance of 5%
• No change
• A decline of 5%

 We are managing a portfolio of five stocks

(see next slide)
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35
 Covered Equity Call Writing
 Individual call options are written against
each of the five securities in the portfolio

 The following slide shows the manager’s

selection of options and the resulting
performance

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37
 Covered Equity
Call Writing (cont’d)
 Observations:
• The portfolio makes money in each of the
scenarios
• The portfolio makes the most money when the
market advances
– The portfolio would lose all five securities
• ARC and IP are called away when the market
remains unchanged
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 Covered Index Call Writing
 Covered index calls are written

 The following slide shows the manager’s

selection and performance

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40
 Covered Index
Call Writing (cont’d)
 Observations:
• The greatest gain occurs when the market
advances 5%

• The manager does not have to sell any stocks

because of cash settlement

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 Writing Fiduciary Puts
 Index put options are written in anticipation
of the underlying stock rising in value

 The following slide shows the selection of

puts and the resulting performance

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43
 Put Overwriting
 Put overwriting is the most aggressive
strategy

 The following slide shows the selection of

puts and the resulting performance

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45
 Risk/Return Comparisons
 Put overwriting has the largest potential
losses and gains

 Writing covered equity calls is not always

superior to writing covered index calls

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 Risk/Return
Comparisons (cont’d)

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 Combined Hedging/Income
Generation Strategies
 Writing calls to improve on the market
 Writing puts to acquire stock
 Writing covered calls for downside
protection

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 Writing Calls to
Improve on the Market
 Appropriate for someone who wants to sell
shares of a stock but has no immediate need
for the money
 Income can be increased by writing deep-
in-the money calls
• The writer attempts to improve on the market
• The expectation is that the calls will be
exercised
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 Writing Calls to Improve on
the Market (cont’d)
Example

Nile.com stock currently sells for $116 per share. An

institution holds 1,000 shares and would like to sell the
stock. JAN 100 calls on Nile.com are available for $18 per
share.

If the stock price on the expiration is $120, what would be

the cash receipts to the institution if it writes 10 calls and
sells the stock in January? What would be the cash
receipts if it sold the stock today?
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 Writing Calls to Improve on
the Market (cont’d)
Example (cont’d)

Solution: If the institution sells the shares immediately, it

would receive $116,000 (1,000 shares x $116).

If it wrote 10 calls, it would receive $118,000 in January:

Option premium:
$18 x 100 x 10 = $18,000

Stock sale when options are exercised:

$100 x 1,000 shares = $100,000
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Writing Puts to Acquire Stock
 Involves writing in-the-money put options

 A manager can improve on the market by

purchasing the stock when the put options
are exercised

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 Writing Puts to
Acquire Stock (cont’d)
Example

You want to buy 500 shares of Western Oil, which

currently trades at $66.75 per share. January 70 puts sells
for $5.

What is the cost of acquiring the shares now? What is the

cost of acquiring the shares if you write 5 WO JAN 70
puts and the options are in-the-money on the expiration
day?
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 Writing Puts to
Acquire Stock (cont’d)
Example

Solution: Outright purchase of the shares now would cost

$33,375 (500 shares x $66.75).

If you write 5 puts, you would pay $32,500 for the shares:
Option premium received:
5 x 100 x $5 = $2,500
Amount paid for shares when options are exercised:
5 x 100 x $70 = $35,000
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 Writing Covered Calls
for Downside Protection
 Appropriate for an investor who:
• Owns shares of stock
• Suspects the market will turn down in the near future
• Does not want to sell the shares at the moment

 Provides some downside protection, but

alternatives are:
• Buying puts
• Using portfolio insurance

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 Multiple Portfolio Managers
 Separate responsibilities
 Distinction between option overwriting and
portfolio splitting
 Integrating options and equity management

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 Separate Responsibilities
 Assume:
• A stock portfolio is assembled by a manager for
a client
• The stock portfolio is used by a different
manager for writing covered options

 Management of the stock portfolio is the

most important concern
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 Option Overwriting
Versus Portfolio Splitting
 Portfolio splitting means managing a
portfolio in accordance with more than one
objective
• E.g., half is growth of income, half is capital
appreciation
 Option overwriting seeks to generate
additional profits for the fund through the
receipt of option premiums
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 Integrating Options
and Equity Management
 Hedging company-specific risk
 Unity of command

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 Hedging
Company-Specific Risk
 To hedge a company-specific risk of a
particular firm in a portfolio use individual
equity options
 To hedge industry risk, employ options on
an industry index
 To hedge the entire portfolio, use index
options

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 Unity of Command
 Index options increase the feasibility of
using a single portfolio manager for both
equity and option positions
• Index options do not require the transfer of
securities
• The time requirement to overwrite with index
options is minimal
• The manager who has the flexibility of index
options can exercise more creativity
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