PERSONAL FINANCIAL PLANNING

June 2000

A RISK-MANAGEMENT APPROACH TO INVESTING IN OPTIONS

By Nicholas G. Apostolou and D. Larry Crumbley

Options are perceived as very risky investments. Many investors fail to understand their value as risk management tools. Investors can adopt certain strategies to reduce volatility and risk. These tactics are increasingly used by more sophisticated investors and their advisors.

As derivative instruments, options are derived from the stocks, bonds, and indexes on which they are based. Price moves in options closely parallel the cash markets where stocks and bonds are traded. In reality, those trading in options also are trading in the underlying securities.

The listed option is now a practical investment vehicle for institutions and individuals seeking financial profit or protection. In 1999, the Chicago Board Options Exchange (CBOE) listed more than 1,200 options on the stock of domestic and foreign companies, 41 index options, 171 equity LEAPs (long-term equity options expiring in two to five years), and 11 index LEAPs.

Risk Management Tool

Options were originally conceived as a way to transfer risk from one party to another and smooth out price fluctuations. Subsequently, speculation itself became an important factor in options trading markets. Speculators make the options markets more liquid by taking positions that facilitate trading.

Options allow speculators to bear risk and hedgers to transfer risk. Hedgers are individuals and firms that make purchases and sales in options solely to establish a predetermined price level. A speculator assumes the price risk that a hedger is seeking to eliminate. A hedge is a transaction designed to minimize an existing or anticipated risk.

A stock option is a contract that gives a holder the right, but not the obligation, to buy or sell shares of the underlying security at a specified price on or before a given date after which the option expires. Therefore, options contracts specify three conditions:

* Description of the property to be delivered,
* Price of the property, and
* Specific period during which the right can be exercised.

Options traders use standardized terms, including the strike (exercise) price and the expiration time. Standardization enables buyers and writers (sellers) of options to close out their positions by offsetting sales and purchases. Selling an option with the same terms as the one purchased, or buying with the same terms as the one sold, lets an investor liquidate a position.

Although options traded on organized options exchanges are similar in many respects to common stocks, there are some important differences:

* There is no fixed number of options. The number of available options depends on the number of buyers and sellers.
* There are no formal certificates as evidence of ownership. Statements prepared by the investor's brokerage firm indicate ownership of options.
* An option is a wasting asset. If it is not sold or exercised prior to its expiration date, the option becomes worthless and the holder loses the full amount paid for the option.

Call Options

A call option gives its holder the right to buy a specified number of shares of the underlying stock at a strike price between the date of purchase and the option's expiration date. A single call option gives the holder the right to buy 100 shares. For example, an investor who bought a Zeus October 30 call option would have the right, but not the obligation, to buy 100 shares of Zeus common stock at a cost of $30 per share at any time before the end of October. The right to purchase common stock at a fixed price becomes more valuable as the price of the underlying common stock increases.

Example: Sally buys a Zeus 30 call option when the stock is at $30 and pays a premium of $2 (which means that the option will cost $200). An option contract is based upon 100 shares. If Zeus stock climbs to $35 before expiration and the premium rises to $6, Sally has two choices in disposing of the option:

* She can exercise the option and buy the underlying Zeus common stock for the total cost of $3,200 ($30 * 100 + the $200 premium). She can then sell the shares for $3,500, yielding a net profit of $300.

* She can sell the options contract for $600, earning a profit of $400 ($600 ­ $200 premium). Here, Sally yields a profit of 200% ($400 / $200), while the profit on an outright purchase given the same price would be only 150% ($300 / $200).

For tax purposes, the premium on the purchase of a call is a nondeductible capital expenditure. If the call is exercised, the premium is added to the buyer's basis of the purchased stock and added to the seller's amount realized. Any gain or loss of a nondealer is long-term or short-term, depending upon the holding period of the stock involved. If a holder fails to exercise an option, for purposes of the loss, the option is deemed sold or exchanged on the day it expires. Any gain to the grantor or loss to the purchaser is treated as short-term.

An option does not have to be exercised to secure a profit. The more advantageous action--exercising or selling a profitable option--is determined by whether an investor wants to own the common stock or underlying security. In deciding to exercise the option or to sell the option, an investor considers premium levels, commissions, and taxes. Unless the investor wants the stock, it is generally better to capture the profit by selling the option itself.

However, stock prices do not always move in the direction anticipated. Using the previous example, assume that Zeus common stock fell to $25 and the option premium dropped to $.75 ($75 total). Sally could sell the option to partially offset the $200 premium, and the loss would be $125. If she did not take action and the option expired worthless, the loss would be the total amount of the premium paid ($200), which is less than Sally would have lost had she purchased 100 shares outright [an outright purchase would have produced a loss of $500 ($3,000 ­ $2,500)].

Put Options

A put option gives the holder the right to sell a specified number of shares of the underlying common stock at a predetermined price (strike price) on or before the expiration date of the contract. Buying a Zeus October 30 put gives an investor the right to sell 100 shares of Zeus stock at $30 per share any time before the option expires in October.

Example: Sam buys a Zeus October 30 put at a premium of $2 ($200) when the price of the underlying common shares is $30 per share. If Zeus stock falls to $25 before October and the premium rises to $6, Sam has two choices in disposing of these in-the-money (the strike price is greater than the market price) put options:

* He can purchase 100 shares of Zeus stock at $25 per share and exercise the put options to sell Zeus at $30 per share, yielding a profit of $300 ($500 profit on the common stock minus the $200 option premium).

* He can sell the put option contract, yielding a profit of $400 ($600 premium received minus the $200 premium paid).

If an investor exercises a put, for tax purposes the cost reduces the amount realized on the sale of the underlying stock. The seller's cost basis in the stock is reduced by the amount received for the put. An investor does not have to exercise an option to realize a profit. Sales of options usually involve lower transactions costs than exercising options. Generally, a better strategy is to sell an option rather than to exercise it.

Short Sales vs. Put Options

An investor who anticipates declining stock prices can purchase put options or sell the stock short. A short sale is the sale of a common stock that is not owned with the intention of repurchasing it later at a lower price. The investor borrows the stock from another investor through a broker and sells it in the market. Usually, a broker has other clients who own the security and are willing to loan shares.

In a short sale, the proceeds of the sale are credited to the customer's account, but the broker requires the posting of collateral. Most short selling is done through margin accounts, which require a certain percentage of the stock's price (currently 50%) to be in the account.

The objectives of the short seller are the same as those of the put option purchaser: They both want to make a profit from anticipated declines in stock prices. The put buyer faces a maximum loss defined by the amount of the premium. A short seller, however, has no limit on the loss that can be sustained and also faces margin requirements and additional restrictions. On the other hand, the option's limited life span constrains the put buyer. An investor can be correct in anticipating a future price change but still lose money because the price change did not occur within the limited period of the life of the option.

Delta

Delta measures the change in an option's price (premium) relative to the change in the underlying price of the stock. Call option deltas are positive and put option deltas are negative because call options have a positive relationship and put options a negative relationship with the underlying stock's price. Call option deltas usually range in value from 0 to 1. A call delta of 0.50 indicates that a one-point increase in the stock should be accompanied by a wQ -point increase in the call premium. For a put with a delta of ­0.25, a one-point increase in the stock should produce a rQ -point drop in the put premium. A higher delta indicates that a call option price will have a greater reaction to a rise or fall in the price of a stock. Conversely, the lower the delta, the more responsive put premiums are to changes in the price of a stock.

At-the-money call and put options have deltas of approximately + wQ and­ wQ , respectively. Deep-in-the-money call options (underlying stock is more than 5 points above the strike price) have deltas of approximately +1, and deep-in-the-money put options (underlying stock is more than 5 points below the strike price) have deltas of approximately ­1. When option positions are deep-out-of-the-money, their deltas approach zero.

Computing deltas forces investors to confront the risk they are assuming in trading options, and options investors should assess their risks daily. Observing an option's premium in relationship to changes in the price of stock often can spotlight distortions in time value (amount by which the premium exceeds intrinsic value).

An options investor can use delta to manage risk. The delta tells the investor who owns options the number of shares required to construct a position that will protect the investor from the effects of price movements in the underlying stock. The combination of options and stock to create such a position is called a delta-neutral. The total value of the position will remain stable despite changes in the prices of the individual components.

Covered Call Writing

Investors can use two strategies involving stock options to offset risk:

* Covered call writing
* Protective puts.

The strategy of choice for an investor depends upon the extent of the expected stock or stock market decline. Many investors view options as highly speculative, risky investments. However, there are conservative options strategies, such as covered call writing.

Investors write covered calls for two reasons:

* Additional income on the underlying common stock can be realized by earning premium income.
* Covered calls provide a measure of downside protection (limited to the amount of the premium) against small declines in the price of the stock.

Investors usually consider covered call writing to be a more conservative strategy than the outright purchase of common stock because the downside risk is reduced by the premium received for selling the call.

The covered call writer either buys common stock and simultaneously sells an equivalent number of call options against the shares purchased (commonly called a buy-write) or sells calls against common stock that is already owned. Any investor can profit from this strategy. Its characteristics can be summarized as follows:

* The option sale provides immediate cash flow.
* Losses are reduced by the premium in the event of a downward movement in the price of the common stock.
* The investor receives a positive return even if the underlying common stock is called away (exercised).

A covered call writer owns the underlying common stock but is willing to forgo price increases in excess of the option stock price in return for the premium.

A writer should be prepared to deliver the common stock shares, if assigned, at any time during the life of the option. An assignment is the receipt of an exercise notice against a seller that provides an obligation to sell the underlying security at the specified strike price. An assignment is executed on a random basis or in accordance with procedures established by the Options Clearing Corporation and brokerage firms. To avoid losing the stock, an investor may cancel the obligation at any time by executing a closing transaction, which entails buying options with identical terms.

A good conservative strategy is to sell out-of-the-money calls (strike price greater than current price) with about two months until expiration. The investor should avoid the current expiration month because option prices decline as they get closer to expiration. Investors should also avoid far out-of-the-money calls because the sale will produce minimal proceeds.

Uncovered Call Writing

Uncovered (naked) call writing differs from covered call writing because the investor does not own the shares of the common stock represented by the option. Furthermore, unlike the more conservative strategy of covered call writing, the potential loss of uncovered call writing is unlimited. An investor who writes an uncovered call option is trying to earn a return without investing in the underlying shares of stock. An uncovered call writer must deposit and maintain enough margin (cash or securities on deposit) with the broker to guarantee that the stock can be purchased for delivery if the call is exercised.

Writing uncovered calls can be profitable during periods of declining or stable prices, but investors should be aware of the significant risks involved. If the market price of the underlying common stock sharply increases, the call could be exercised. To satisfy the delivery obligation, the writer would have to acquire stock in the market for substantially more than the strike price of the option, which could result in a net loss. Therefore, only investors that have studied the options market closely and are financially able to afford the risk should undertake uncovered call writing.

Protective Puts

A protective put is the simultaneous purchase of a stock and a corresponding put option or the purchase of a put related to a stock the investor already owns. Whereas covered call writing provides a partial hedge against a decline in stock prices, protective puts can provide almost complete protection. If the stock value declines, the price of the put increases, especially when the put is in-the-money.

A protective put results in unlimited profit potential. The price of protection against loss while retaining the upside potential is the amount of the put option's premium. The investor pays a premium (the cost of the put) to insure against a loss in the stock position. Because the put option is a right to sell at a predetermined price, the purchase of the put predetermines the maximum risk of the stock. This limit on risk occurs because a put entitles the investor to sell the underlying shares at the exercise price of the put at any time through the expiration of the option, regardless whether the price of the common stock declines. The investor continues to receive any dividends paid during the period on stock owned. For common stocks that pay substantial dividends, this dividend revenue can substantially reduce the cost of purchasing puts.

The cost of protection can be measured in terms of annualized percent of investment. For example, consider a six-month Zeus put with a premium of $4 when the stock is trading at $50. The premium of $4 represents 8% of the $50 cost of Zeus. Because the 8% premium protects the investor for only six months, the annualized cost of protection is 16%. The 16% annual cost is the price the investor is willing to pay to benefit from any advance in the stock of Zeus, while limiting the risk of loss.

The protective put strategy is most effective when an investor feels the price of the stock is vulnerable on the downside. In employing this strategy, the investor probably should stick to the put with a strike price closest to the existing price of the common stock. In addition, it is advisable to purchase a put with at least three months remaining to permit the stock sufficient time to rise.

Writing Put Options

The seller (or writer) of a put option is obligated to purchase the underlying stock (normally 100 shares per put option) at the strike price upon receipt of an exercise notice. In return for assuming this risk, the investor is paid a premium at the time the put is written. As a put writer, the investor must be prepared to buy the underlying stock at any time during the life of the option. Investors can write covered or uncovered put options.

Covered Put Writing. A put writer is considered to be covered when

1) a corresponding short position exists or
2) cash deposits or cash equivalents equal to the exercise value of the option are held with a broker. The investor borrows the stock from another investor through a broker and sells it in the market. Subsequently, the investor repurchases the stock and returns it to the broker. To ensure that the short position is covered, the broker requires collateral to be posted.

A covered put writer's profit potential is limited to the premium received and the difference between the strike price of the put and the original price of the stock shorted. The potential loss is substantial: the price of the stock may increase significantly above the original price of the stock shorted. In this case, the short position will generate losses offset only by the premium received. The covered put writing strategy is not used frequently because uncovered put writing offers the same risk and rewards with generally higher premiums.

Uncovered Put Writing. A put writer is considered to be uncovered if

1) there is no corresponding short stock position or
2) no cash deposits or cash equivalents equal to the exercise value of the put exist. An investor unwilling to purchase stock at the current price might write put options, hoping to acquire the stock at a lower price and, meanwhile, receive premium income. If the put is exercised, the cost of the common stock will be the exercise price less the premium.

Just the Basics

There are many other uses of stock options to generate additional income and hedge against market changes. The preceding discussion is intended to present an overview of some of the simpler approaches to using options. *