- 1999: Volume 8, No. 1 Puts & Calls: Looking for the Exits?

If you're a prudent investor you know that, every once in a while, your winnings have to be scraped off the table. It's simply a matter of good money management. Obviously, selling out of a long stock position is tantamount to an admission that a bull run is over. Perhaps you're now worried about near-term market volatility threatening profits you've accrued in some of your stock picks. Even the most savvy stock pickers often have trouble knowing when to sell. Maybe you, too, could use some help in picking an ultimate liquidation price should the market rise even further.

The recent market for Microsoft (MSFT) serves as a good template. Suppose you bought 2,000 shares in October at $90. By January, MSFT climbed to $150. Anticipating a slow-down in market velocity, perhaps you now want to lower your exposure and start looking for the exits. You notice that near-to-the-money April MSFT calls are priced with an implied volatility of about 41 percent. In other words, using an option pricing model, you see that option market participants are forecasting that MSFT has a 2Ú3 chance of trading within 41 percent of current levels over the coming year. Translating for the three-month life span of the April options, a predicted price range of $119 to $181 per share emerges. Such a volatility forecast offers the prospect of doubling your money by April, which is mighty attractive. But the possibility of giving up half your gains is repugnant. What to do?

One conservative approach necessitates selling half your shares. This will lock in $60 profit now. Left with half your original position, you then can sell a ratio call spread to "substitute" for the stock sold.

A spread is a two-legged trade that entails simultaneously buying and selling similar option contracts. A call spread, obviously, uses call options. The ratio is the comparative number of calls bought versus calls sold. You could build a 2:1 ratio call spread as shown in figure 1.

Figure 1

Buy 10 MSFT April 150 calls @ Sell 20 MSFT April 160 calls @ NET CREDIT

-13 3/8 (each) 9 3/8 (each) 5 3/8 (total)

Now, Here's Where It Gets Interesting

It should be obvious that buying call options is bullish. So, the purchase of 10 at-the-money calls pretty much replaces the bullish posture of the 1,000 MSFT shares sold. Your object is to take money off the table. Buying calls does just that. You're only recommitting $13 3/8 of your $60 profit to do so. But, by selling twice as many out-of-the-money calls simultaneously, you're financing the call purchase and then some. In fact, you're actually creating positive cash flow since $5,375 flows into your account on top of the stock sale proceeds. At this point you may well ask, "Is this substitute position really bullish?" And since you're selling more options that you've purchased, you may also wonder "Is there a margin requirement?"

Well, yes and no. Yes, this position is bullish. In fact, on market advances from the low strike price to the high strike price, it's every bit as bullish as owning 2,000 shares of the stock. And no, there isn't margin required. There's no margin requirement because you own enough MSFT stock and MSFT call options to cover any potential assignment on the 20 calls you've sold.

Look at it this way. The first 10-lot of April $160 calls sold was covered by 1,000 MSFT shares still left in account. You just wrote 10 covered calls. Margin is not required for covered calls. The second 10-lot of April $160 calls was covered by your purchase of 10 April $150 calls. In essence, you just laid a "bull call spread" on top of your covered call write. No margin's required for bull call spreads, since any assignment on the written calls can be answered with the exercise of the long calls at an automatic profit.

As for directional bias, you're still bullish but you've also turned defensive. The trade-off is, until you rid yourself of the spread, you've capped your stock's profit potential. In fact, you've essentially set up a more or less "automatic liquidation" of the remaining stock should the market rise.

Here's the Bottom Line

If MSFT continues to advance from current levels, the $150 calls go in-the-money and act as a substitute for the shares liquidated. Incremental gains accrue dollar-for- dollar, simulating the return pattern of the original 2,000 share stock position, as the market advances between the spread's strike prices.

Ultimately, if MSFT ends up at expiration at $160, the written calls' strike price, you'll be about as profitable as your original 2,000 share MSFT position. But you'd have only been exposed to about half the downside risk.

If MSFT ends up above $160, the short calls will be assigned. But you could then sell a 2,000 share MSFT position (1,000 shares held plus 1,000 shares acquired from exercise of the $150 calls) for the equivalent of $169 3/8 (the sum of the short calls' strike price and premium). You'd then be flat. Profit in the open position is therefore capped at $85 3/8.

If MSFT declines below $150, of course, you'll see some of your open stock profits diminish. But, because of the net credit received initially, the stock would have to drop well below your cost basis to threaten your profits. The aggregate open position breaks even at $84 5/8.

Just look at the potential comparative returns shown in figure 2.

Overall, this is an excellent strategy if you're building your money management skills. This approach reduces downside risk and sets you up as a "scale-up seller" in a rising market. Most of all, it ensures you walk away from the table with more than just crumbs.

Figure 2

IN A FALLING MARKET:
Date +30 days: +60 days: Expiry:	MSFT 130 130 130	L:150 Calls 3 1 3/8 0	S: 160 Calls 1 1/2 1/2 0	Net Profit1 $105,375 $105,750 $105,375	Vs.	2,000 MSFT2 $80,000 $80,000 $80,000
IN A STABLE MARKET:
Date +30 days: +60 days: Expiry:	MSFT 150 150 150	L:150 Calls 10 7/8 5 1/8 0	S: 160 Calls 6 7/8 4 1/4 0	Net Profit1 $122,500 $122,500 $125,375	Vs.	2,000 MSFT2 $120,000 $120,000 $120,000
IN A RISING MARKET:
Date +30 days: +60 days: Expiry:	MSFT 170 170 170	L:150 Calls 24 3/4 22 1/2 20	S: 160 Calls 17 7/8 15 10	Net Profit1 $134,375 $137,875 $145,375	Vs.	2,000 MSFT2 $160,000 $160,000 $160,000

Tables reflect theoretical values derived from a binomial option pricing model using the following assumptions: 41.2 percent volatility, 4.4 percent annual interest rate, and a zero percent dividend yield. Actual option prices can vary significantly from theoretical projections depending on market conditions. These examples do not include the effects of commissions or tax consequences.

1-Profit includes net gain on open stock and option positions together with $60,000 previously realized profit from sale of 1,000 shares of MSFT.

2-Open potential gain if 2,000 shares of MSFT were retained at a cost basis of $90.

Brad Zigler is the Managing Director, Options Marketing, Research & Education at the Pacific Exchange in San Francisco. He can be reached through the Exchange's Web site at www.pacificex.com. Send e-mailto:bzigler@pacificex.com.