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How To Invest In Stocks With Options

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Gary Trennepohl

Jim Bittman

Oklahoma State University The Options Institute

Applied Options Strategies

(2)

Session Outline

Typical Fund Objectives

Strategies for “special situations”

Six Investor Strategies

(3)

Using Options to Meet Investment Objectives

Objectives:

– Increase exposure to equities without

increasing risk

– Buy equities during the next year at lower

prices

– Generate income

(4)

Suitable Option Investment Strategies 1

Invest cash 5%-20% below current market level and generate income

– Sell cash-secured put

– Sell out-of-the-money put spread

(5)

Suitable Option Investment Strategies 2

Increase market exposure, limit risk and conserve cash

– Ratio call spread overlay

– Long a synthetic or split-strike synthetic

Target buy/sell prices and generate income

(6)

Special Situations Defined

Portfolio rebalancing driven by Unanticipated market moves

Anticipated/unanticipated cash flows Market timing events

Price entry/exit decisions

Options give investors more strategy alternatives to manage these

(7)

Prices for Case Studies

November 1 S&P 500 @ 1,425 Strike Mar Mar

Price Calls Puts 1,350 130 65 1,400 95 85 1,450 70 105 1,500 45 130

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3 Strategies that:

Invest Below the Current Market Level

and Bring in Cash Income

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Case 1 –

Ready to Buy If Down 8%-10%

Market View: You are willing to commit

funds to the S&P near 1,300 Objective: Bring in cash income and buy

the market near 1,300 Strategy: Sell cash-secured put

Sell SPX Mar 1400 Puts @ 85 T-Bills: $140,000 per put

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SPX Level Sale Price Value at Exp. P /(L) 1500 1450 1400 1350 1300

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85

85

85

85

85

+85

+85

+85

0

0

0

50

100

+35

Short 1 1400 Put @ 85.00

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Short 1 1400 Put @ 85.00

+100  + 50  0      ][       ][        ][        ][      - 50  -100  1350 1400 1450 Put expires Keep premium = 6% ann rate Invest in S&P Effective price = 1,315

+85

1,315 1425 1300

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Case 1 – Sell Put – Outcomes

Market

Up: Puts expire; keep premium,

equal to 6% annual rate

Steady: Same as up

Down: Buy the S&P at 1,315 (8% below

current level of 1,425)

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Case 2 – Ready to Buy if Risk is Limited

Market View: You are willing to buy near

current levels if risk is limited Objective: Commit funds with limited risk

and bring in cash income Strategy: Sell put spread

Buy SPX Mar 1350 Put @ - 65 Dr Sell SPX Mar 1450 Put @ + 105 Cr

Net Credit 40 T-Bills: $145,000 per put

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Buy 1350 Put @ 65.00 Sell 1450 Put @ 105.00 Stock Price +1350 Put at 65.00 –1450 Put at 105.00 P /(L) 1500 1450 1400 1350 1300

(65)

(65)

+40

+40

+105

+105

(65)

+55

(10)

(65)

+ 5

(60)

(15)

(45)

(60)

(15)

Case 2 – Sell Put Spread

 +    0        ][       ][        ][        ][     -    1,450 1400 1350

Put expires

Keep 40

Max loss

+40

1410

1425

60

Invest

in S&P

at 1410

40/1410

365/150 = 6.9% (ann. rate)

1,500

(16)

Case 2 – Sell Put Spread – Outcomes

Market

> 1,450: Puts expire; keep premium

of 40 index points (7%)

1,350-1,450: Buy S&P at level of 1,410

(

1.1% below current level)

< 1,350: Max loss of 60 index points

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Market View: The market will decline 10-15% Objective: Bring in cash income and buy

the market down 10%-15%.

Strategy: Cash-secured ratio put spread

Buy 1 SPX Mar 1400 Put @ 85 (85) dr

Sell 2 SPX Mar 1350 Puts@ 65 ea. 130 cr

T-Bills $135,000 Net Credit 45 cr

Case 3 – Ready to Buy 10%-15%

Lower

+1 –2

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S&P Level +1 1400 P at 85 –2 1350 P at 65 ea. P /(L) 1450 1400 1350 1300 1250 Buy 1 1400 Put @ 85.00 Sell 2 1350 Puts @ 65.00 ea

(85)

(85)

+45

+45

+130

+130

(35)

+130

+95

+15

+30

+45

+65

(70)

( 5)

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 +    0        ][        ][        ][     -    1425

Case 3 – Cash-Secured Ratio Put Spread

1400 1350 1300

Puts expire

Keep 45

Buy at a

level of

+45

1,255

Long

put

settles

+95

(20)

Case 3 – Ratio Put Spread – Outcomes

Market

> 1,400: Puts expire; keep premium

of 45 index points

(3.2% in 150 days)

1,350-1,400: Long put settles in cash for

additional income

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2 Strategies that:

Increase Market Exposure,

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Case 4 – Increase Exposure Without Risk

Market View: The market will rise modestly Objective: Add upside exposure without

increasing downside risk. Strategy: Ratio Call Spread Overlay

Own SPY (or S&P stocks) @ 1,425

Buy 1 SPX Mar 1,450 Call @ 70 (70) Dr Sell 2 SPX Mar 1,500 Calls @ 45 ea 90 Cr

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Ratio Call Spread: Own S&P @ 1,425, +1 1450 Call @ 70, –2 1500 Calls @ 45 ea S&P Level Long S&P at 1425 +1 1450 C at 70 –2 1500 C at 45 ea P /(L) 1600 1550 1500 1450 1425

+175

+125

+75

+25

-0-

+145

+80

(110)

+145

+30

(10)

+145

(20)

+90

+45

+20

(70)

(70)

+90

+90

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 +    0       ][       ][       ][     -  

No market

1,425

Case 4 – Ratio Call Spread Overlay

1,500 1,450 1400

+145

+20

1,570

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Case 4 – Spread Overlay – Outcomes

Market

< 1,450: Long 1

performs 20 points better than S&P 500

1,450-1,500: Long 2

> 1,500: No market exposure – maximum profit = +145 (+10.2% in 5 months)

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Case 5 – Target Buying Lower, but Can’t Miss a Rally

Market View: Think market will decline, but

worried about missing a rally

Objective: Establish a buy point down 5%

and participate in the upside.

Strategy: Split-strike synthetic

Sell 1 SPX Mar 1350 Put @ 65 Cr Buy 1 SPX Mar 1450 Call @ (70) Dr T-Bills $135,000 Net Cost ( 5) Dr

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Sell 1,350 Put @ 65.00 Buy 1,450 Call @ 70.00 S&P Level –1350 Put at 65 +1450 Call at 70 P /(L) 1500 1450 1400 1350 1300

+65

(20)

+45

(55)

(70)

+15

+65

( 5)

( 5)

( 5)

(70)

(70)

(70)

+65

+65

(28)

 +    0        ][        ][        ][     -    1425

Case 5 – Split-Strike Synthetic

1,550 1,450 1350

1,455

5

No market

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Case 5 – Split-Strike Syn. – Outcomes

Market

< 1,350: Put assigned

long the S&P 500 at 1,355

1,350-1,450: No market exposure (

–5

pts)

> 1,450: Exercise call

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1 Strategy that:

Targets Buy and Sell Prices

and Generates Income

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Case 6 – Trading a Range

Market View: The S&P 500 is “range bound” between 1,300 and 1,600

Objective: Increase exposure near 1,300, Decrease exposure near 1,600, and earn income while waiting. Strategy: Covered Strangle

Sell SPX Mar 1,500 Calls @ 45 Cr Sell SPX Mar 1,350 Puts @ 65 Cr Own 10 SPY for each call and put

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Covered Strangle: Own S&P @ 1,425,

Sell 1350 Put @ 65, Sell 1500 Call @ 45

S&P Level Long S&P at 1425 –1350 P at 65 –1500 Call at 45 P /(L) 1600 1500 1425 1350 1250

+175

+ 75

-0-

( 75)

(175)

+185

+65

(55)

+185

+65

+45

+110

+65

+45

+ 10

+65

+45

(165)

(35)

+45

(33)

 +    0       ][      ][       ][       ][      ][     -    +110

Long 1

1425

Case 6 – Covered Strangle

1500 1450 1350

+185

1400 Puts Assigned Equal to buying at S&P 1,315 Calls Assigned Sell S&P 1,610 1300

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Case 6 – Covered Strangle – Outcomes

Market

> 1,500: Calls assigned; equal to

selling at S&P 1,610

1,350-1,500: Long S&P + 110 points

< 1,350: Puts assigned; equal to

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1. CLIFTON GROUP DEFENSIVE EQUITY 2. HARVEST VOLATILITY MANAGEMENT

Actual Money Manager

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Clifton Group – “Defensive Equity

Strategy

Portfolio Construction

Clifton’s  Defensive  Equity  strategy  is  comprised  of  a  ba se  poi r tfolio  combined  wp th  an  o tion  overlay.

50% US Treasury Bills

50% S&P 500 Index

Option Details Short-term expirations

Out-of-the-money, volatility-based dynamic strikes European style, exchange-traded

Cash settled upon expiration when new options are sold

Base Portfolio Higher S&P Prices Lower S&P Prices 0% Option Overlay

S&P 500 Call Overlay

Sell covered calls above current market price (out-of-money)

S&P 500 Call Overlay

Sell covered calls above current market price (out-of-money)

S&P 500 Put Overlay

Sell cash covered puts below current market price (out-of-money)

S&P 500 Put Overlay

Sell cash covered puts below current market price (out-of-money)

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CHICAGO BOARD OPTIONS EXCHANGE

Selecting the Options to Trade

37 -20% -15% -10% -5% 0% 5% 10% 15% 20% 1990 1993 1997 2000 2004 2007 2011 SPX - Price Return

Dynamic Strike Prices

In 82% of the monthly periods since 1990, option sales were additive to performance*

See simulated disclosures in Appendices.

Median Call Strike: +4.03%

Median Put Strike: -4.46%

*Said another way, in 18% of the monthly periods, total premium collected was less than the loss on an option that expired in-the-money. Monthly Call and Put Strikes (% Out- of- Money)

Since 1990 the S&P 500 Index price at expiration:

• Rallied above the call strike 20.8% of the time

• Declined below the put strike 10.2% of the time

• Remained between the call and put strikes 69.0% of the time

Since 1990 the S&P 500 Index price at expiration:

• Rallied above the call strike 20.8% of the time

• Declined below the put strike 10.2% of the time

• Remained between the call and put strikes 69.0% of the time

S&P 500 Index: Monthly Price Change versus Option Strike Prices 1/1/1990 to 12/31/2011

The dynamic strike process adapts to volatility changes, selling further out-of-money options when expected volatility is higher

(38)

Monthly Trading Strategy

Using S&P 500 index options or SPY

It is Friday, Nov 21st and SPY is at 140. Assume you

own 3,500 shares of SPY and hold $500,000 in cash.

Strategy: Sell SPYoptions with Δ≅.20.

• Sell 35 Dec 145 Calls ($60×35) = $ 2,100

• Sell 37 Dec 135 Puts ($500,000/13,500)

($90 × 37) = $ 3,330

• Net Premium Income $ 5,430

You have sold covered calls and cash secured puts, so

(39)

Recent Actual Performance

Actual Performance Actual performance for the Defensive Equity strategy

Date: 12/31/2011 Month: Actual Defensive Equity (net) S&P 500 Total Return Difference 09/30/11 -2.62% -7.03% 4.41% 10/31/11 6.75% 10.93% -4.18% 11/30/11 0.96% -0.22% 1.19% 12/31/11 1.14% 1.02% 0.12% Monthly Returns -2.62% 6.75% 0.96% 1.14% -7.03% 10.93% -0.22% 1.02% -8.00% -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

Sep-11 Oct-11 Nov-11 Dec-11 Actual Defensive Equity (net) S&P 500 Total Return

Note: The inception date for Clifton's Defensive Equity strategy was September 2011. The returns are presented net of 35bps fee. (unified fee is inclusive of investment management, administrative and custody fees)

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Simulated Long Run Returns

0 100 200 300 400 500 600 700 800 900 1990 1993 1997 2000 2004 2007 2011

S&P 500 Total Return

Simulated Defensive Equity (Gross) 50% S&P 500 / 50% T-Bills

Defensive Equity Strategy Simulation – Summary of Results

Return Period: 12/31/1989 – 12/31/2011 G ro w th o f $ 1 0

0 S&P 500 outperforms in major bull markets

Defensive Equity seeks to outperform in major bear markets 0 Simulated Defensive Equity1 (Gross) Simulated Defensive Equity2 (Net) S&P 500 50% S&P 500/ 50% T-Bills Defensive Equity vs. S&P 500 (Gross) Annualized Return 10.3% 9.9% 8.2% 6.2% 2.1% Standard Deviation 8.3% 8.3% 15.2% 7.6% (6.9)% Sharpe Ratio 0.81 0.76 0.30 0.34 0.50 Insurance Risk Insurance Risk Premium Capture Equity Risk Equity Risk Premium Give Up

(41)

HARVEST VOLATILITY

MANAGEMENT

(42)

Harvest Strategy

“Harvest” offers a strategy which involves selling put and call spreads against a cash portfolio that’s used to support margin

requirements for trading.

Similar to Clifton, they sell a “strangle” using S&P 500 index options, but they buy a

further out call and put to reduce required margin.

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Harvest November Example

Friday, Nov 9: S&P 500 at 1390

• Buy Dec 1515 Call

• Sell Dec 1480 Call

• Sell Dec 1300 Put

• Buy JAN 1160 Put

Receive $6.70/share (credit spread)

Manage position if market makes dramatic

move up or down.

Trade out of position if market dictates

Sell a Call Spread

References

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