- 1999: Volume 8, No. 2 Puts & Calls: Decisions, Decisions!

Author's Note: Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. The examples presented do not take into consideration commissions, tax considerations or other transaction costs which may significantly affect the economic consequences of a given strategy. Options involve risk and are not for everyone.

Compaq (NYSE:CPQ) has been good to you this past year. In spite of its recent swoon, the stock still generated a 22 percent return from March 1998 to March 1999.

So what's to worry about? Well, pundits have been decrying market breadth lately. Complaints are rising that double-digit gains are not sustainable in the face of such a narrow-based market impetus.

So, do you keep the stock? Bail out? Even (shudder) go short? In order to make a sensible decision, you'll first need to make a careful assessment of your current financial and psychological situation, your market outlook and your investment goals. Strategy selection should then focus on only those positions that are consistent with all of these benchmarks.

Situation

This part is relatively easy. Presently, you're long stock. But what are you inclined to do with those shares? Do you need to raise cash, so you're inclined to sell? Or do you want to keep the stock?

Perhaps the middle ground more aptly describes you. Maybe you'd ordinarily keep the stock, but on a sufficient price rise you'd be a willing seller. Let's posit this as your situation. You hold 100 shares and you're inclined to hold the shares in the hopes of meeting or bettering last year's return, even if you must sell them in order to profit. Let's also suppose you're disinclined to add new money to the market.

Keep in mind that you do earn a dividend with CPQ. It's a rather paltry one, though. You're not going to realize your objective on the basis of dividend receipt alone.

Market Outlook

This is the tricky part. Here you must rely on research, either performed by yourself or bought from other sources. Whatever resource you rely upon, make sure that the outlook is quantifiable. It's one thing to say that stock is headed upwards. But when? And to what degree? No market outlook should be considered valid without a well defined price and time target. Let's suppose fundamental research points to a price target of 38 to 39 within the next 12 months. Near-term, however, the technical charts point to a month's worth of base building.

Goals

What do you want to accomplish with your investment? A replication of last year's return? Or do you want the opportunity to outperform your previous record? Let's say your objective is to better last year's performance on an annualized basis.

Strategy

An option-savvy investor reviewing the foregoing-currently long stock, a near-term flat market forecast with a bullish underlayment, and no new money to put at risk-might immediately seize on covered call writing as the logical choice. This strategy entails laying out-of-the-money call sales on top of the stock currently held in order to earn the option's time decay. But which one to sell?

The first consideration is the expiration date. Since your forecast calls for about three to four weeks of quiescence, only options expiring within that time-frame makes sense (see figure one).

Figure 1

April CPQ Calls - 24 days to expiration
CPQ Last 31 1/2
Strike Price 32 1/2 35 37 1/2	Bid 1 5/16 9/16 1/4	Ask 1 7/16 5/8 5/16	Delta .45 .25 .13

The call struck at 37 1/2 offers such a slight premium as to take it out of the running. Its premium may not even cover discounted transaction costs. Your decision must now rest on weighing the comparative merits of the remaining two series.

Since you'll need to measure investment returns from present levels in order to compare with the previous year's performance, we'll assume the current price of CPQ to be your cost basis in the following examples. A few other formulae will be useful in comparing the positions. (See figure 2 for definitions.)

Figure 2

Breakeven (adjusted cost basis) = Stock cost basis - premium Maximum gain = (Strike price + premium) - original stock cost basis Maximum potential loss = adjusted cost basis

Covered (35 call) write

Writing the 35-struck call makes for a position still decidedly bullish as measured by the resultant net delta. Certainly, that's more bullishness than seems warranted by your technical analysis. Still, remaining "uncovered" would be an even more bullish position to maintain. If volatility were to hold at the level currently implied by the option premium, CPQ has a 77 percent probability of ending up below the strike price. That's a pretty good likelihood of success. And the picayune 9/16 premium accordingly reflects the market's modest risk perception. Using the same volatility assumption, there's a 56 percent likelihood of CPQ winding up above the covered call's breakeven point. In sum, the odds CPQ will end up somewhere in the middle-below 35 and above 30 15/16-by expiration are about 32 percent (see figure three).

Figure 3

Covered (35 call) write - 24 days to expiration
Position Short 1 CPQ Apr 35 C Long 100 CPQ Net	Cash flow + 9/16 -31 1/2 -30 15/16	Delta - .25 +1.00 + .75
Expiration breakeven - 30 15/16 Maximum potential gain - 4 1/16 (( 35) Maximum potential loss - 30 15/16

Covered (32 1/2 call) write

Employment of the lower-struck call certainly creates greater cash flow as well as a delta stance more closely aligned with your near-term forecast. The higher premium also yields a bit more downside protection. But with volatility at current levels, CPQ has only a 59 percent probability of ending up below the strike price. That's unquestionably a slimmer edge than what was offered by the 35-struck call. On the other hand, there's a 62 percent chance of CPQ ending up above the 30 3/16 breakeven point. Altogether, the odds CPQ will end up in the "golden middle"-below 32 1/2 and above 30 3/16-by expiration are only about 20 percent (see figure four).

Figure 4

Covered (32 call) write - 24 days to expiration
Position Short 1 CPQ Apr 32 C Long 100 CPQ Net	Cash flow + 15/16 -31 1/2 -30 3/16	Delta - .45 +1.00 + .55
Expiration breakeven - 30 3/16 Maximum potential gain - 2 5/16 (( 32 1/2) Maximum potential loss - 30 3/16

Comparative Analysis

Did this analysis make your decision-making any easier? Perhaps, but it may be hard to see at first. If you look at the decision in terms of "expected value," however, the fog soon dissipates. An expected value is simply the payout anticipated as the result of multiplying an outcome (e.g., a gain) by its probability of occurrence. You'd then look at the possibility of earning the calls' time premium from CPQ settling into the "golden middle" this way (see figure five).

Figure 5

Covered call write - 24 days to expiration
Position 32 C 35 C	Premium 1.94 .56	x x x	Probability .20 .32	= = =	Expected value .39 .18

This would be more accurate, of course, if you used the net premium (after transaction costs). All else held equal, however, the lower-struck call seems to provide twice as much relative value as the higher-struck call.

Another way to look at this situation is to compare the return on investment obtainable from each covered write. Here you'd want to compare the returns along three different dimensions: the returns when CPQ remains flat, the return generated if the call were exercised at expiration, and if a minimum investment return is required, the price CPQ needs to attain to generate the requisite gain. Let's suppose, for example, you need to achieve at least twice CPQ's last year return on an annualized basis, or 44 percent, before you'll invest (see figure six).

Figure 6

Covered call write - 24 days to expiration
	Standstill Return		Target Return	Exercise Return
Strike Price 32 35	Simple 4.4% 1.9%	Annualized 67.0% 28.6%	(44%) Price 31 1/8 31 7/8	Simple 7.5% 13.0%	Annualized 114.1% 197.2%

It's apparent from this analysis that only the lower-struck call meets your return criterion. But take into consideration that you must have definite confidence in the likelihood of CPQ holding pat at current levels for this to be a realistic expectation. Keep in mind also that the annualized return from this strategy is predicated upon your ability to reinvest at a constant rate (4.4 percent), or to continuously overwrite, over the coming year. That's not consistent with your forecast of CPQ's potential price advance since overwriting only works in relatively flat markets.

Software certainly makes your decision-making a lot easier. To perform the expected value analysis, for example, you'll need a "probability analyzer." If you'd like to find out how to get your hands on one, e-mail me. At least that should be a decision easily made.

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. Sned e-mailto:bzigler@pacificex.com.