- 1999: Volume 8, No. 3 Puts & Calls: The Calm Instead of the Storm

Oscar Wilde once said, "Nothing is so aggravating than calmness." Calmness is, however, what many investors seek. For example, many conservative investors use covered call writing as a means to improve returns on portfolio positions in relatively quiet markets. Dedicated option folk may remember that we examined covered call writing in the last Puts & Calls column (CRB Trader, Mar-Apr 1999). We observed that covered call writers are inherently bullish in the long-term, but hold modestly bullish or neutral near-term outlooks. There are variant positions worthy of examination as well. One uses covered call writing as a base, but increases the investor's bullishness with the addition of a put sale.

Now I can just hear the questions from the crowd: "Why increase bullishness with a put sale? Why not just lose the call sale and hold naked stock?" Volatility, my friends-that's why.

Take the case of ADC Telecommunications (ADCT:NMS). ADC operates in a crowded field supplying voice, video and data systems for telephone, TV, and Internet networks. ADCT shares had spent much of 1999 rising from $35 to $50. But reports of insider selling and new competitor entries depressed prices briefly under $40 in mid-April. ADCT now wavers in the mid-40s. As a result of the recent price break, ADCT's volatility ballooned to near-record levels. (Volatility measures the amount by which a stock has fluctuated or can be expected to fluctuate in a given period of time. It's measured as the annual standard deviation of daily price changes. The July/August issue of CRB Trader will feature a Puts & Calls column on volatility.) Market technicians in early May might have gazed at ADCT's chart to note a price stalemate accompanied by strong support and relatively weak resistance. Suppose you, as one such diviner, project a potential summer rally target in the mid-50s.

On this basis, you could simply buy the stock. But as an astute market observer, you recall that an inverse relationship typically exists between stock prices and volatility. Put another way, bull markets are generally characterised by declines in market volatility while volatility spikes generally attend price breaks. For example, when ADCT was trading at $50 in early April, 20-day historic volatility was about 66 percent. Two weeks later, with the stock at 37-1/2, volatility mushroomed to 90 percent. Mindful of an apparent toppiness in ADCT's volatility, you could instead buy the stock and write a call, say with a $55 strike price. Or, better yet, you could buy the stock, write the $55 call, and write an out-of-the-money put to create a covered strangle. This rather gruesome sounding combination can be an excellent alternative for stock investors in a market where price rises and reduced volatility are anticipated.

Suppose, for example, you construct the strangle depicted in Figure 1. The first thing you'll note is the bullishness of the position. At the outset, the position is the equivalent of an 871-share long position in ADCT stock. This position is innately more bullish than a covered call sale because of the positive delta acquired from the written put. But we'll soon see how the delta of this position can shift radically by expiration. You'll also note that the receipt of two option premiums has reduced the cost basis of the long stock position. We'll later see that this defines your maximum risk in the trade. You'll no doubt note that, as a buyer of ADCT, this translates into a reduction of your cost basis by more than nine percent. If your forecast of diminished volatility is realized such that neither option is assigned, you'll be rewarded with the time decay of two options. You'd be left at the August expiration with outright stock purchased at a "discount" from present market value. On the other hand, market movements outside the strike prices can either result in a doubling of your stock holdings or getting lifted out of your stock altogether. Figure 2 illustrates an expiration scenario for the covered strangle compared with that of a covered write using the August $55 call, and outright long stock. What's immediately evident is that, within the range bounded by the call and put strike prices, the strangle magnifies profits and minimizes losses. But don't go rushing madly to put on this position solely on the basis of its expiration pay- off. Interim volatility surprises and the potential for assignment on the short put leg have to be kept in mind.

Figure 1

ADCT Covered Strangle (May 5, 1999)
	Price per share	Delta
Long 1,000 ADCT Short 10 Aug 55 call Short 10 Aug 35 put	- 44.1/2 + 2.5/16 + 1.7/8	+1,000 -320 +191
Net	- 40 5/16	+871

Figure 2

Profit and Loss Characteristics

Figure 3 illustrates the relative values of the positions at expiration. If you're an experienced covered call writer, you'll immediately recognize the limited profit potential of this position. The position, however, earns both option premiums in a bullish market. So, if the stock's called away in a rally above the call strike price, you'd earn a 36.4 percent simple return on investment (rates of return are calculated on a net cash basis without the inclusion of commission costs):

[Call Strike + Option Premiums]
- Stock Cost
[55 + 4 3/16] - 44 1/2 = 14 11/16

Figure 3

Expiration (August 21, 1999) Values
ADCT	Price Profits/Losses per share
	Covered Strangle	Long Stock	Covered Call
30 35 40 45 50 55 60 65	-15.5/16 -5.5/16 -0.5/16 4.11/16 9.11/16 14.11/16 14.11/16 14.11/16	-14.1/2 - 9.1/2 - 4.1/2 0.1/2 5.1/2 10.1/2 15.1/2 20.1/2	-12.3/16 - 7.3/16 - 2.3/16 2.13/16 7.13/16 12.13/16 12.13/16 12.13/16

The covered 55-call write would have returned only 30.3 percent in the same rally. If the rally took the stock to say, $56, an outright stock purchase would have produced a 25.8 percent simple return. Of course, at that point, you'd still be long stock. You'd have been lifted from your stock position in the covered call and covered strangle scenarios.

Loss characteristics for the covered strangle are similar to those of a covered call, that is, open-ended in a falling market. But, the rate at which losses are engendered is effectively doubled if the stock falls below the put's strike price. At that point the strangle behaves like a 200-share covered write. And here's where the term "covered" seems to fall short. Realistically, only one leg of the strangle is actually covered-the call. The written put is naked. That means provision must be made for assignment or margin. Either a free credit balance at least equal to the put's aggregate exercise price ($35 x 1,000 shares = $35,000) must be available, or the broker's marked-to-market short option margin requirement must be satisfied by account equity. Brokerage firms may require a higher level of account approval to use this strategy, so novice traders may find it more difficult to initiate than a simple covered call.

Expiration Breakeven Point

The covered strangle's breakeven point is derived in the same fashion as that for a covered call. But in this case, both the call and the put premium are used to adjust the stock's cost basis:

Stock Cost - Option Premiums
44 1/2 - (1 7/8 + 2 5/16) = 40 5/16

Like a covered call write, open-ended losses can develop in the position if the stock's below the breakeven level at expiration. And, if the stock's below the put strike price at that time, you could be long twice as many shares as when you initiated the trade.

Delta (Bullishness)

The engine propelling position performance is, of course, delta. Delta changes over time in response to movement in the underlying stock, the passage of time, and shifts in volatility. Figure 4 reinterprets our expiration table to reflect delta values so you'll be able to readily see the positions' relative bullishness. What becomes apparent is that 1,000 shares of stock will always be 1,000 shares of stock. But in combination with options, long stock is effectively transmuted: the stock position can seemingly double or even disappear as one or another of its option companions moves into- or out-of-the-money.

Figure 4

Expiration (August 21, 1999) Delta
ADCT Price	Position Delta (Original values in parentheses)
	(+871) Covered Strangle	(+1,000) Long Stock	(+680) Covered Call
30 35 40 45 50 55 60 65	+2,000 +2,000 +1,000 +1,000 +1,000 0 0 0	+1,000 +1,000 +1,000 +1,000 +1,000 +1,000 +1,000 +1,000	+1,000 +1,000 +1,000 +1,000 +1,000 0 0 0

Theta (Time Decay)

Short options capitalise upon the decay of time value. The strangle's riding two decay curves, allowing a magnified accrual of time premium relative to a simple covered call. Of course, only one-or neither-of the written options can be in-the-money at expiration, so there's an assurance that at least some time premium can be earned if the position's held 'til then. That's a big "if," though. Early assignment can take you out of the business of collecting time premium.

Gamma and Vega (Volatility)

Spikes in market volatility and option implied volatility are deleterious. This should make intuitive sense since there's a direct relationship between option premiums and volatility. If volatility expands, so, too, do option prices. Since you're short options in the strangle, you want to see premiums actually decline. Time decay will take care of that if the values for the options' lives are diminished by market quiescence. Increased volatility, however, means that the stock has a greater likelihood of passing through one or another of the options' strike prices. The market will then demand compensation for this increased risk in the form of higher time premium.

The distinct advantage of the covered strangle is the broad range of prices under which the position produces profits. But interim shifts in volatility can alter the performance characteristics of the strangle dramatically. For example, at the outset, the August 55 call was valued with an implied volatility of 64 percent; the August 35 put was priced at 56 percent. Contemporaneously, ADCT's historic volatility has been:

20-day 100 percent
50-day 82 percent
100-day 77 percent

Figure 5 forecasts the strangle strategy out 55 days under different scenarios, so you'll be able to more easily appreciate the impact of volatility. Clearly, you can see how a lower volatility environment produces better results.

Figure 5

Forecasted Covered Strangle Profit/Loss per Share (June 30, 1999)
ADCT Price	Volatility
	56%	64%	77%	82%	100%
30 35 40 45 50 55 60 65	-16.1/16 -8.1/4 -1.13/16 3.1/4 7.1/16 9.7/8 11.11/16 12.15/16	-16.5/16 -8.11/16 -2.3/8 2.9/16 6.7/16 9.1/16 11 12.5/16	-17 -9.5/8 -3.9/16 1.5/16 5.1/16 7.7/8 9.15/16 11.3/8	-17.5/16 -10 -3.15/16 7/8 4.5/8 7.7/16 9.5/16 10.15/16	-18.5/16 -11.3/8 -5.11/16 -1.1/8 2.1/2 5.7/16 7.5/8 9.1/4

At expiration, of course, volatility won't matter since options will be worth only their respective intrinsic values then. But you have to weather any potential volatility storms to get there. Lower volatility environments simply present a higher probability of arriving at the shore with a profit. To gauge your journey's likelihood of success, let's posit the ideal ADTC price range at expiration to be bounded by the position breakeven point (40 5/16) and the point at which maximum gains are derived (55), the call's strike price. The likelihood of ADTC being within that range at expiry can be quantified as:

Volatility	Probability: 55 ADCT 40 5/16
100% 82% 77% 64% 56%	22.5% 27.2% 28.9% 34.2 38.6

As you can see, the covered strangle can be an ideal vessel for navigating the shoals of a quietly rising market. When considering the strategy, however, just keep in mind the words of an ancient Roman would-be mariner, Publius Syrus: "Anyone can hold the helm when the sea is calm."

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-mail to: bzigler@pacificex.com. 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.