- 1999: Volume 8, No. 6 Puts & Calls: Strangling's Not Always a Capital Offense

We're all familiar with "love-hate" relationships, but how many of us have "buy-sell" feelings for our stocks?

You might very well harbor such sentiments when your stock becomes range-bound. Consider for a moment, however, that the stock's support and resistance lines can provide opportunities to juggle your portfolio positions, or to make a little loose change. Let's suppose you own 1,000 shares of XYZ, a stock you've traded for years. Sitting at $52 now, the stock's price rise has stalled. Lately, shares have rallied and retreated from the $62 level several times and bounced off $43 as well. Since you like the company's long-term prospects, you're willing to add another 200 shares to your holdings if a buying opportunity crops up. You're just as likely, however, to sell 200 shares from your portfolio on the next rally to take some near-term profits off the table.

To set yourself up as a potential buyer/seller, you could place both a $45 buy limit order and a $60 sell limit order with your broker. Unfortunately, these orders play second fiddle, priority-wise, to market orders. Limit orders can only be filled at, or better than, the limit price. Market orders can get ahead of your limit order in the execution queue and take precedence, denying you a fill, even if your limit is touched

You could not only overcome the priority problem, but also set up more potentially attractive executions by writing both XYZ calls and puts struck at your limits. Using six-month options, you might set up this transaction:

Sell 2 XYZ 60 calls Sell 2 XYZ 45 puts	2 1/4 per share + 2 per share
Total premium	4 1/4 per share

By writing two calls, you're obliged to sell 200 XYZ shares from your portfolio at $60 upon assignment. The likelihood of assignment on the calls, of course, increases as XYZ rallies above the strike price. If assigned, you'd really be selling stock at an effective sale price between 62 1/4 and 64 1/4, since you're pocketing option premiums as well. You can keep the entirety of the assigned call's premium, but what you realize of the out-of-the-money puts' premium depends upon the cost to cover (buy back) the options. For example, if the puts now could be bought for 1/2, XYZ's effective sale price becomes 63 3/4:

Strike price proceeds Call profit Put profit	60 + 2 1/4 + 1 1/2
Effective sale price	63 3/4

You may opt to leave the puts open and await expiration. If the puts expire unexercised, you'll max out with an effective stock sale price of 64 1/4. The risk associated with holding the puts open becomes readily apparent in a sudden downturn if you end up being assigned. Then you'd be forced to buy the very shares you previously sold. More about that later.

What If the Stock Declined Instead?

If the puts move onto the money, you could end up with stock being put to you at the $45 strike price. But then you'll have at least the put premium and some, if not all, of the call premium in hand to defray the stock's acquisition cost. An assignment at expiration, for example, yields an effective purchase price of 40 3/4:

Strike price cost Put profit Call profit	45 - 2 - 2 1/4
Effective purchase price	40 3/4

An early put assignment could increase the stock's purchase price if you choose to buy back the written calls. Say it costs you 3/4 to unwind the calls. You'll end up effectively paying 41 1/2 for the stock, since your call profit, the offset to the stock's cost, would drop to 1 1/2.

In a market where XYZ lolls between the options' strike prices, the risk of assignment is greatly diminished. And if expiry rolls around without a rally above 60 or a dip below 45, you'll end up keeping two option premiums together with your original 1,000 share XYZ position. That'd be the equivalent of earning a three percent annualized dividend on your entire portfolio.

Note that the written calls are covered by stock held in portfolio, so no margin is required for this leg. The puts, however, are a different matter. Since writing puts makes you a contingent buyer of stock, margin requirements can only be ducked by having a free credit balance at least equal to the options' aggregate exercise price. Simply put, you gotta have enough unencumbered dough to buy the underlying stock if the puts are exercised by the buyer. That would mean $9,000 ($45 x 100 shares x 2 puts) in this case. Even if the puts are thus "cash-secured," the option trade (rather gruesomely nick-named a short "strangle" in option parlance) will still have to be done in a margin account. Having in account both the underlying stock and the cash to secure the puts earns this position the moniker of a "covered strangle."

Let's assume your per share cost base for the 1,000 share XYZ position is $30. We'll review the essentials of strangling the $43 - $62 trading range.

Outlook: While bullish on your portfolio position in the long-term, you want to capitalize upon a projected near-term trading range to produce a simulated dividend yield. Additionally, you wish to establish a disciplined approach to shedding portfolio exposure on rallies and augmenting portfolio positions on dips.

Strategy Implementation: You write two puts and two calls with strike prices lying near the stock's current support ($43) and resistance ($62) levels-the puts' ($45) at support, the calls' ($60) at resistance.

Profit Potential: At expiry, the strangle's cash gain potential is limited to the two premiums received, or $850. If the stock stays flat at $52, the simulated dividend yield would amount to 3.26 percent. Since "excess" long stock is held in portfolio, overall open-ended profit potential is maintained.

Expiration Breakeven Point: The naked strangle's downside breakeven point is the lower (put) strike price minus the two premiums received, or 40 3/4; the upside breakeven point is the higher (call) strike price plus the two premiums received, or 64 1/4. However, since the strangle's overlaid on a long stock position of 1,000 shares, the portfolio's still got a net bullish bias with an expiration breakeven point of about 31 3/4.

Risk Potential: As a stand-alone, a naked short strangle's risk is unlimited-most particularly in a dramatically rising market. When the strangle is overlaid on a position in the underlying stock, however, the upside risk is limited to having the covered shares called away. Instead, the portfolio's risk is more greatly magnified in a falling market as additional shares are added if the puts are assigned. As indicated by the increase in the net breakeven point, the portfolio assumes the long stock risk exposure of a 1,200 share position if the option expires at an underlying stock level under $45.

Margin: A margin account is required to trade a covered strangle. Maintenance of a free credit balance at least equal to the puts' aggregate exercise price will obviate meeting mark-to-market margin requirements, though. The minimum margin requirement otherwise will be the greater of:

20 percent of the underlying stock's current market value
+ Current put premium
- Put out-of-the-money amount, or
10 percent of the underlying stock's current market value
+ Current put premium

A Swedish monarch once said, "I myself find it much less difficult to strangle a man than to fear him." Applying that sort of hard-nosed reasoning to markets may make portfolio management a less worrisome venture too.

Brad Zigler is 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.