FPA Conference Presentation in Anaheim, Ca 10-11-2009

“Enhance your Practice with Equity Option Strategies”

Presented by:

Rutgers University; in partnership with

Presenters:Sean E. Heron, CFA, Rutgers University

and

Eric Cott, The Options Industry Council

October 10, 2009

Options Basic

What is a Derivative

Something that derives its value from an underlying instrument.

Commonly traded derivatives include options, futures and forwards that trade on equities, commodities, currencies and interest rates.

Calls and Puts are a form of equity derivatives.

Why Use Options?

Speculate on price movements.

Reduce risk (Hedging)

Reduce transaction costs (from rebalancing).

Defer Taxes

Avoid market constraints, such as short selling.

Calls and Puts A Call option gives the buyer the right, but not the

obligation, to purchase a set amount of stock (usually 100 shares) at a predetermined price (Strike Price) at any time before the options expiration date (American) or at expiration only (European).

A Put option gives the buyer the right, but not the obligation, to sell a stock at a predetermined price for a specified period of time.

The seller (writer) of the option is obligated, if assigned to sell (call) or buy (put) the stock at the predetermined strike price.

Holder (buyer) Writer (seller)

Call Right to Buy Obligated to sell

Put Right to Sell Obligated to buy

Calls and Puts

Long or Short a contract Long – Own – Right to buy or sell the underlying Short – Write – Obligated to buy or sell

Long or Short the Underlying Longs want the stock to rise Shorts want the stock to fall

Long Buyer

Short Seller

Call Right to get long

Obligated to accept short assignments

after prices have risen

Put Right to get short

Obligated to accept long assignments after

prices have fallen

6

Calls and Puts American vs. European Exercise/Assignment

American Options can be exercised at anytime European Options can only be exercised at expiration

Over-the-Counter (OTC) Options vs. Listed Options OTC markets consist of financial institutions, corporate

treasurers and investment manager trading derivatives over the phone.

Listed Options are traded on an exchange

OTC Listed

Private contractTraded on an

exchange

Customize Standardized

Settled at Expiration

Daily Settlement

Credit RiskVirtually no credit

risk7

Call and Put Prices

CallsStrik

e Puts

Symbol Last Bid Ask Vol.

Open Int Price Symbol Last Bid Ask Vol.

Open Int

WXOAK 13.7 14.45 14.7 11 819 55 WXOMK 6.8 6 6.55 27 4033

WXOAL 11.1 11.55 11.85 22 2350 60 WXOML 8.35 8.15 8.35 1451006

0

WXOAM 8.75 9.1 9.35 5 5687 65 WXOMM11.0

1 10.6510.85 205 8222

WXOAN 7 7 7.25 26 4304 70 WXOMN 14.2 13.45 13.7 45 9965

WXOAO 5.45 5.3 5.65 1551318

7 75 WXOMO 18.1 16.5517.05 1251876

2

WXOAP 4 3.95 4.1 412342

9 80 WXOMP 22 20.35 21 31998

6

Exxon Mobil (Ticker – XOM) @ 64Jan’10 Calls and Puts Closing prices on March 6, 2009

Call and Put Prices

The price of an option is called the Option Premium.

Option Premium = Time Value + Intrinsic Value

Time Value is a combination of the expected future

movement of a stock and the amount of time remaining

until the option expires. The longer the timeframe and

the greater the expected movement, the higher the Time

Value.

Intrinsic Value equals price of the underlying stock minus

the strike price. An options value can’t be below its

intrinsic value.

Source: http://www.optionseducation.org/basics/options_pricing.jsp

Price of a Call and Put

For example, XYZ stock is trading at $26. A call with a strike price of 25 is trading at $3.

Then the call has an intrinsic value of $1 (=26-25) and a time value of $2 (=premium minus intrinsic).

A put with a strike of 30 is trading at $5. Then the put has an intrinsic value of $4 and a time value of $1.

The Money

Calls Strike Puts

In the Money $7 20 $2

Out of the

Money

At the Money $3 25 $3 At the

Money

Out of the

Money$1 30 $6 In the

Money

XYZ stock trading at 25 In the money options have intrinsic

and time value ATM and OTM have only time value

Components of an Options Price

Intrinsic Value

Calls Strike PutIntrinsic Value

? ? 20 ? ?

? ? 22.5 ? ?

? ? 25 ? ?

? ? 27.5 ? ?

? ? 30 ? ?

What options are ITM, ATM or OTM? If the stock is trading at 25

Components of an Options Price

Intrinsic Value

Calls Strike PutIntrinsic Value

5 ITM 20 OTM 0

2.5 ITM 22.5 OTM 0

0 ATM 25 ATM 0

0 OTM 27.5 ITM 2.5

0 OTM 30 ITM 5

What options are ITM, ATM or OTM? If the stock is trading at 25

Call Payoff Graphs

Call with a strike of 25 trades at $3 buyer’s max gain (S-X) is unlimited, max loss is 3.

Seller’s max gain is $3, max loss is unlimited (S-X).

Break-even 28 (strike + premium)

Call Buyer (Long) Payoff Graphs

Right to buy the underlying at 25. Pays $3 for the right. Wins with the stock above 28. Effective purchase price 28 Options holders don’t have all the rights of shareholders.

No rights to dividends No voting rights

Reasons for buying: Bullish on the market or stock. Limited downside risk, with unencumbered upside potential. Stock replacement. Leverage.

Call Buyer (Long) Payoff Graphs

Closing or exiting the position.• ITM

Sell the contract Take the profit or limit the loss Before the close of trading on the option’s expiration

date. Exercise the call

At expiration and pay cash to purchase 100 shares at the strike price.

Early exercise is usually only done to capture the dividend by converting to stock.

• OTM Let expire – lose rights Max Loss = premium paid

Call Seller (Short) Payoff Graphs

Obligated to sell the underlying at 25. Receives $3 premium for accepting the obligation. Risk is unlimited on naked calls Seller must be financially and psychologically able to sell the

underlying at 25, regardless of how high the stock is currently trading.

Effective sale price if assigned is 28 (25+3). Reasons for selling:

Covered Calls – willing to lose the stock at a predetermined price.

Naked Calls – Believes the stock will remain below 28 and full premium will be captured.

Put Payoff Graphs

Put with a strike price of 30 trades at $5 Buyer’s max gain is 25 (=30-5), max loss is $5 Seller’s max gain is $5, max loss is 25 (=30-5) Break-even 25 (=strike minus premium)

Put Buyer (Long) Payoff Graphs

Right to sell the underlying at a predetermined price (30 Strike).

Pays $5 for the right. Wins with the stock below 25. Reasons for buying puts:

• Neg. view on the market or a stock.• Protecting another position.• Delay creating a taxable event, but still reduce risk.• Investor would otherwise avoid investing in equity

without some downside risk protection.

Put Seller (Short) Payoff Graphs

Obligated to buy the underlying at 30. Receives $5 premium for accepting the obligation. Seller must be financially and psychologically able to

purchase the underlying. (Margin is usually ½ the strike price).

Effective purchase price if assigned is 25 (30-5). Reasons for selling:

• Willing to own the underlying at a lower entry point.• Expects the stock to trade in a tight range (25-35),

hopefully above 30 at expiration.

Max Gain/Loss

Max Gain

Max Loss

Call Prem.

Strike Put Prem.

Max Gain

Max Loss

? ? 7 20 2 ? ?

? ? 5 22.5 2.5 ? ?

? ? 3 25 3 ? ?

? ? 2 27.5 4.5 ? ?

? ? 1 30 6 ? ?

If the stock is trading at 25, what is the max gain/loss

Max Gain/Loss

Max Gain

Max Loss

Call Prem.

Strike Put Prem.

Max Gain

Max Loss

Unlimited 7 7 20 2 18 2

Unlimited 5 5 22.5 2.5 20 2.5

Unlimited 3 3 25 3 22 3

Unlimited 2 2 27.5 4.5 23 4.5

Unlimited 1 1 30 6 24 6

If the stock is trading at 25, what is the max gain/loss for the owner of the option?

Max Gain/Loss

Max Gain

Max Loss

Call Prem.

Strike Put Prem.

Max Gain

Max Loss

? ? 7 20 2 ? ?

? ? 5 22.5 2.5 ? ?

? ? 3 25 3 ? ?

? ? 2 27.5 4.5 ? ?

? ? 1 30 6 ? ?

If the stock is trading at 25, what is the max gain/loss for the writer of the option?

Max Gain/Loss

Max Gain

Max Loss

Call Prem

.Strike Put

Prem.Max Gain

Max Loss

7 Unlimited 7 20 2 2 18

5 Unlimited 5 22.5 2.5 2.5 20

3 Unlimited 3 25 3 3 22

2 Unlimited 2 27.5 4.5 4.5 23

1 Unlimited 1 30 6 6 24

If the stock is trading at 25, what is the max gain/loss for the writer of the option?

Straddle

Call and Put with a strike price of 25 trades at $6 Buyer’s max gain is infinite, max loss is $6 Seller’s max gain is $6, max loss is infinite Break-even 19 and 31 (=strike +/- premium)

Buy (Long) Straddle

Right to buy or sell the underlying at a predetermined price (25 Strike).

Pays $6 for the right. Wins with the stock above 31 or below 19. Reasons for buying a straddle:

• Trading the underlying around the strike.• Expects the stock to move a lot in either direction.

Court Case Earnings Report FDA Approval Macro Events

Selling (Short) Straddle

Obligated to buy or sell the underlying at a predetermined price (25 Strike).

Receives $6 for the risk. Wins with the stock between 19 and 31 at expiration. Reasons for selling a straddle:

• Expect the stock to be range bound. • Feels the markets price for expected movement is to high.


Straddle

Call Strike Put PremiumLower

Breakeven

Upper Breakeve

n

3 25 3 ? ? ?

2 17.5 1 ? ? ?

1 35 4 ? ? ?

5 50 4 ? ? ?

2.5 40 4.5 ? ? ?

Call + Put = Premium. Premium +/- Strike = Breakeven

Straddle

Call Strike Put PremiumLower

Breakeven

Upper Breakeven

3 25 3 6 19 31

2 17.5 1 3 14.5 20.5

1 35 4 5 30 40

5 50 4 9 41 59

2.5 40 4.5 7 33 47

Call + Put = Premium. Premium +/- Strike = Breakeven

Strangle

Call and Put with a strike price of 22.5 and 27.5 trades at $4.50

Buyer’s max gain is infinite, max loss is $4.50 Seller’s max gain is $4.50, max loss is infinite Break-even 18 and 32 (=strike +/- premium)

Buy (Long) Strangle

Right to buy at 27.5 or sell at 22.5 the underlying. Pays $4.50 for the right. Wins with the stock above 32 or below 18. Reasons for buying a strangle:

• Trading the underlying around the strike.• Expects the stock to move a lot in either direction.


Buyer’s max gain is infinite, max loss is $4.50

Sell (short) Strangle

Obligated to buy at 22.5or sell at 27.5 Receives $4.50 for the risk. Wins with the stock between 18 and 32 at expiration. Reasons for selling a strangle:

• Expect the stock to be range bound. • Feels the markets price for expected movement is to high.


Buyer’s max gain is $4.50, max loss is unlimited

Call Bull Spread

Bull buys the 25 call at 3 and sells the 30 call at 1, net debit $2• Buyer sells a higher strike to subsidize the

purchase of the lower strike.• Max gain $3 and max loss $2

Bear sell the 25 call at 3 and buys the 30 at 1, net credit $2• Seller buys the higher strike to cap the potential

loss on the short lower strike.• Max gain $2 and max loss $3

Put Bear Spread

Bear buys the 25 put at 3 and sells the 20 put at 2, net debit $1.• Buyer sells the lower put strike to subsidize the purchases of

the higher strike.• Max gain $4 and max loss $1.

Bull sell the 25 put at 3 and buys the 20 at 2, net credit $1.• Seller caps loss with the purchases of the put with a lower

strike.• Max gain $1 and max loss $4.

Exercise and Assignments

90% of options expire worthless. False. Most option positions are closed. Automatic Exercise for ITM options at expiration. OCC notifies the clearing firms, the clearing firm

assigns the options to their clients who are short that particular option.

Why are American Options exercised early?• Deep ITM Calls may be exercised early to capture the

dividend the day before the x-div date.• Deep ITM Puts may be exercised early if the Put is

trading at parity to capture the remaining interest.

Options Industry Council

Eric S. Cott, Director, Financial Advisor Education

www.optionseducation.org

Help Desk 1-888-Options

http://www.optionseducation.org/

Pricing an Option

Pricing an Option

Option Price = Time Value + Intrinsic Value

Components of an Option’s Price (DIVUTS)

• Dividends• Interest Rates• Volatility• Underlying Stock• Time• Strike

Volatility

Volatility An options theoretical price will fluctuate with

the price of the underlying stock, but will also fluctuate with changes in implied volatility.

Similar to insurance companies raising prices for risk they don’t want, options prices rise when there is no one willing to accept (write) the risk of future price fluctuations.

If enough investors believe a stock will have greater volatility going forward, implied volatility and option prices will increase to entice others to write options.

If option prices (implied volatility) is perceived to be to high, investors will sell or at least elect not to buy.

Implied Vol. can get high if too many investors want to protect a position at the same time and no one is willing to accept the risk of future price fluctuations.

Volatility

Option Buyers• Want volatility to expand after their purchase.• Volatility is the cheapest when there is a perception that

the coast is clear with regards to events that may cause future price fluctuations.

Option Sellers• Want volatility to contract or subside after their sale.• Implied Volatility tends to be highest just ahead of

events that move stocks, i.e. Court Cases, Clinical Trials/FDA Approvals or Earnings Reports.

Volatility – Historical vs. Implied

HistoricalImplied

(Markets Opinion)

Expected

(Your Opinion)

Options

35% 45% No Opinion

Expensive

35% 25% No Opinion

Cheap

35% 20% No Opinion

Cheap

35% 55% No Opinion

Expensive

35% 40% No Opinion

Expensive

Volatility – Expected vs. Implied

Historical Implied(Markets Opinion)

Expected (Your Opinion)

Options

35% 45% 45% Fair

35% 25% 20% Expensive

35% 20% 25% Cheap

35% 55% 40% Expensive

35% 40% 55% Cheap

Historical Implied(Markets Opinion)

Expected (Your

Opinion)

Options

35% 45% No Opinion Expensive

35% 25% No Opinion Cheap

35% 20% No Opinion Cheap



Current Environment

Current Environment

• Stock Valuations - High or Low

• Implied Volatility - High or Low

What strategy works well in the current environment?

• When to buy options

• When to sell options

• When to use spreads

• When to implement a collar

Investment Strategies with Options

Investment Strategies with Options

Portfolio Income Strategy – Covered Call Writing

Portfolio Protection Strategy – Buy Puts, Put Spreads or Implement a Collar

Portfolio Recovery Strategy– Increase upside potential without increasing downside risk

Index OptionsAdvantages Diversification Taxes Lower

Transaction Cost

Broad Hedging

Disadvantages Not single stock

specific May have higher

tracking error to hedged position

Portfolio Income Strategy


Initial Investment $500,000

Buy 5000 Shares at $100 (total $500,000)

Sell 50 one year 100 Calls at $11 (Total $55,000)

Received dividends equal to $2.25 per year

80.0

82.5

85.0

87.5

90.0

92.5

95.0

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100.0

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105.0

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120.0

$0.4

$0.5

$0.6

$0.7

SPY Short Call SPY No Hedge

Stock Price

Val

ue a

t Exp

irat

ion


Expiration 1 year: Potential Outcome # 1 – SPY is Unchanged SPY is trading at $100 Calls expire worthless Client keeps the call premium received of $55,000

• Premium received taxed as short-term capital gains• Taxed at 35% - After tax return of $35,750

Dividends received $11,500 Total Return -$66,250 $66,250/500,000 = 13.25%

80.0

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97.5

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$0.4

$0.5

$0.6

$0.7


Stock Price

Val

ue

at E

xp

irat

ion


Expiration 1 year: Potential Outcome # 2 –SPY Has Risen Sharply

SPY is trading at $120 Repurchase all options at $20 per underlying share ($120,000 total) Short-term loss on options sold at $9, repurchased at $20 = loss of $45,000 Sell 375 shares of SPY at $120 per share, to raise funds to repurchase above

options (capital gain = $7,500) Net realized short-term capital loses = $37,500; Taxes due = $0

(in this example we offset short-term losses against gains. Additional tax benefits may be gained by offsetting against short-term gains elsewhere in the portfolio)

Value of remaining 4,625 shares of SPY = $555,000 Plus Dividends $11,250 Total Return $66,500 (66.25K/500K = 13.25%)

80.0

82.5

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$0.4

$0.5

$0.6

$0.7 SPY Short Call SPY No Hedge

Stock Price

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Expiration in 1 year: Potential Outcome # 3 – SPY Has Risen Less Sharply SPY is trading at $110 Repurchase all options at $1 per underlying share ($5,000 total) Short-term gain on options sold at $11, repurchased at $1 = $50,000 Sell covered calls at a higher strike price with a further expiration Strike Price = $110, options will expire in a year Premium received: $10 per underlying share ($50,000 total)

While corrective action was taken to prevent having stock called at $100 per share, by rolling the option strike price to $110 and the option expiration out to another year, the client has for the moment retained full stock ownership and has received net option premium of $20 per share ($11 - $1 + $10) or $100,000 total (5000*20).

Realized short-term capital gain from options - $50,000 Plus Dividends $11,500 Value of the 5000 shares of SPY = $550,000 Total Return $66,500 (66.5K/500K = 13.25%)

80.0

82.5

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92.5

95.0

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120.0

$0.4

$0.5

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$0.7


Stock Price

Val

ue a

t Exp

irat

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Expiration in 1 year: Potential Outcome # 4 – SPY is Lower SPY is trading at $86.75 (SPY down 13.25%) Calls expire worthless Client keeps the call premium received of $55,000

• Premium received taxed as short-term capital gains Dividends received $11,500 Sell 5000 shares of SPY at $86.70 per share, to harvest losses. Net realized short-term capital loses on SPY = $66,250; Taxes due = $0 Total Return = $ 0

80.0

82.5

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120.0

$0.4

$0.5

$0.6

$0.7


Stock Price

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ue

at E

xp

irat

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S&P Buy-Write Composite (Simple Holding Period Returns)

Performance Since Inception 12/31/03 – 8/31/09 • SPY Buy-Write Composite +11.23% Est. Stand Dev. 11.9%• S&P 500 Total Return -7.65% Est. Stand Dev. 14.9%

Down Market Performance 8/31/08– 2/28/09• SPY Buy-Write Composite -34.3% • S&P 500 Total Return -41.8%

Rapid Rising Market Performance 2/28/09 – 6/30/09• SPY Buy Write Composite 21.1%• S&P 500 Total Return 26.1%

0.70.80.9

11.11.21.31.41.5

S & P vs BuyWrite on SPY

SPY BuyWrite SPTR Index

Advantages of Covered Call Writing

Potential for additional return from option premiums Writing out-of-the-money options offers possibility of selling

stock at higher prices Capital gains tax on option is not realized at time of sale* Capital gains tax on stock is not realized unless option is

called*• Possible to delay realization of capital gains into a further tax year by writing covered calls*• Example: In December, the investor might be more likely to write covered calls expiring in the

next tax year than to sell stock

Continue to receive dividends unless stock is called Covered call premium provides partial downside protection

for stock Somewhat favorable tax treatment of qualified covered call

premiums*• If stock is called, covered call premiums received may adopt underlying

nature of stock, long or short-term*• It may be possible to write a 60-day option and receive long-term

capital gains treatment*

Simplicity; covered calls do not require a margin account

Disadvantages of Covered Call Writing

Incomplete downside protection Expired or repurchased options may be taxed at

short-term rate* It is possible for options to be exercised prior to

expiration• Occurs infrequently and is largely predictable• Corrective trades may be implemented if an early exercise

appears likely and is undesirable

Options can and will be exercised if the written stock is above the option strike price at expiration• Triggers sale of the underlying stock• Triggers realization of capital gains or losses to repurchase

the option to prevent expiration

“Unqualified” covered calls that are deep in-the-money or have less than 31 days to expiration when written may cause dividends on the underlying stock to be ineligible for the new 15% dividend tax rate*

Portfolio Protection Strategies

Portfolio Protection Strategies

Hedging – Strongest to Weakest

• Sell SPX Index Futures – Full Protection• Buy SPX Index Put – Floor Downside Risk• Buy SPX Index Put Spreads – Less protection

at a reduced cost (High Vol. Skew is better for put spreads)

• Buy VIX Futures – Inverse price relationship with SPX Futures

• Buy VIX Calls (Sell VIX Puts)• Write SPX Index calls

Portfolio Protection

Buy SPX Index puts, if protection is cheap.• Captures Upside / Limits Downside

Implement a collar • Caps Upside / Limits Downside

Buy SPX Index put spreads, if skew is high or puts are expensive.• Captures Upside / Cushions Downside

Buy VIX futures when vol. is low and forward volatility term structure is flat.• Negatively Correlated to SPX

Write SPX Index calls when volatility is elevated.• Caps Upside / Cushions Downside


What a difference a year can make.• When implied volatility is low purchasing

puts may be the best option. • In Jan’07, an ATM 1yr put cost 4.5%

Limited downside riskKnown maximum drag on upside performance

• In Jan’07, a 10% OTM put cost 1.75%• In Jan’08, implied volatility was too high

to warrant the purchase of puts.1yr ATM puts on the SPX cost 8% (115/1450)1yr 10% OTM put on the SPX cost 4.3%

(63/1450)1yr ATM straddle on the SPX cost 18%

(260/1450)


What a difference a year can make.• In Jan’09, implied volatility was too high to

warrant the purchase of puts.1yr ATM puts on the SPX cost 14.5% (130/900)1yr 10% OTM put on the SPX cost 10.5.% (95/900)1yr ATM straddle on the SPX cost 28% (253/900)

• Jan’09 with the SPX trading at 900, 1 yr ATM /10% OTM put spread ATM 900 Put – 14.5%10% OTM 810 Put – 10.5%Put Spread Cost – 4%Upside drag 4%, Downside Cushion 6%


Estimated Price of a 1-Year Put Option, 10% Out-of-the-MoneyAs a Percent of the S & P 500 Index

Estimated Prior to 2004

6.9

0%

2%

4%

6%

8%

10%

12%

14%

Jan-

87

Jan-

88

Jan-

89

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90

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91

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92

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93

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94

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00

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t Pri

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of

Ind

ex


Protecting a well diversified portfolio with a beta of 1 (with the same div. yield).• Each contract is equal to 100 times the index.

$1mm portfolio, index value 1000Portfolio is 1000 times the index.Protect the portfolio from losing more than 10%

($900,000) over the next yearStrike/Index - (Put) + Div = FloorOTM 95% - 8.5% + 3.5% = 90% FloorATM 100% - 13.5% + 3.5% = 90% Floor

• $1mm/ (1000*100) = 10 Contracts • Buy 10 one year 5% OTM Puts at 8.5% to limit

the downside loss to 10%

Portfolio Protection (Weakest)

Write SPX Index calls when vol. is elevated.• When implied volatility is high writing covered

calls may be the best option.Loss in down markets reduced by premium received Limits upside potential to premium received

• In the beginning of 20091yr ATM calls on the SPX sold @ 13.5%1yr ATM straddle on the SPX sold @ 28%


Implement a Collar to reduce risk when options are expensive, but downside risk is high.• Implement a Collar

Short call will cover the cost of the long put Risk/Return profile has a Cap/Floor

Source: OIC

Advantages of Listed Option Collars

Collars are an excellent way to delay the sale of underlying stock into future tax years while offering downside protection against catastrophes and allowing some measure of upside participation in the stock

Simplicity; listed zero-cost collars require no opening of a margin account

Competitive pricing and transparency of transactions for listed options

Widespread availability of information; listed options prices are published on the Internet and in newspapers

After collar has been executed, opportunistic trades can be made to take profits, adjust strike prices, or get out of the collar altogether• we strongly recommends taking some profits on

collars when they exist and maintains a full-time options trading desk to take advantage of these opportunities

• Adjusting positions is difficult or impossible with over-the-counter collars

Advantages of Listed Option Collars

No minimum number of contracts necessary to execute a listed options collar (listed collars may be executed on as few as 100 shares of stock; we usually recommends trades covering at least 1,000 shares)

A collared stock has not been diversified, only hedged Purchase of a put option may cause those shares of the

underlying stock to be ineligible for the reduced dividend tax rate of 15%*

Generally, no money is received from the collar transaction to purchase other diversified securities; it is possible to borrow partially against the collared stock

Disadvantages of Listed Option Collars

While a collar “locks-in” a range of returns for the underlying stock, the amount of upside return locked in may prove unattractive relative to other opportunities

The put option portion of a collar receives disadvantageous tax treatment; losses on the put option may not be realized prior to disposition of underlying stock

The amount of put protection is constrained by the IRS*• we considers it advisable to purchase protective puts

that are out-of-the-money (where the strike price is lower than current stock price)*

• It is believed that the IRS could treat the purchase of protective puts that offer too much protection as a constructive sale of the underlying stock*

Because collars are partially covered call options, the upside covered call part of a collar may be exercised early (this can be a positive outcome, and is also possible under many circumstances with over-the-counter collars, including takeovers or tender offers)

Portfolio Recovery Strategy

Getting your money back is as easy as 1 2 3

Long Stock 1x, Long 2x ATM Calls @ 3 and Short 3x OTM Calls @2 (Leverage with known risk).

Portfolio potential levered 3x to the upside, capped at OTM call strike.

Portfolio risk limited to 1x the downside.

Initially Purchased 100 shares @ 40 and Now Trading @ 25, Down $1500

Investment now worth $2500. B 2 25 Calls at $3 (-6) S 3 30 Calls $2 (+6) Capped at 30• Max Gain - $1500 over the 30 strike• Max Loss - $2500 at zero

Price 100 Shares Stock/Calls

15 $ 1,500 $ 1,500

17.5 $ 1,750 $ 1,750

20 $ 2,000 $ 2,000

22.5 $ 2,250 $ 2,250

25 $ 2,500 $ 2,500

27.5 $ 2,750 $ 3,250

30 $ 3,000 $ 4,000

32.5 $ 3,250 $ 4,000

35 $ 3,500 $ 4,000

Investment 2500. 100 shares of stock at $25 per share. B 2 25 Calls at $3 (-6) S 3 30 Calls $2 (+6) Capped at 30

• Max Gain - $1500 over the 30 strike• Max Loss - $2500 at zero

15 17.5 20 22.5 25 27.5 30 32.5 35 37.5 40 42.5 $1,500

$2,000

$2,500

$3,000

$3,500

$4,000

$4,500

Stock & 2 x 3 Call Spread

100 Shares Stock/Calls

Value at Expi-ration

Sp ecu lati o n an d Leverage

Additional Benefits of Options

Reduce cost or risk Contain risk and redeploy capital.

• Monetize Collars• Buy options to cap risk of loss

Lock in profits without creating a taxable event

Stock replacement to limit downside Diversification Target buy/sell price Rebalance asset allocation Reduce transaction cost

Portfolio Management with Options

Old investment solution for managing a portfolio:

SellHold

New investment solution for managing a portfolio:

HedgeHold Sell

Why Hedge?

• True risk management, absolute returns

• Tax deferral

• Want to sell, but at a higher price

• Don’t want to sell, but want less risk

• Can’t sell

• Raise cash (“monetize”) today, defer sale (and taxes)

• Incremental return (e.g. covered calls)

When NOT to Hedge?

When selling is better

When hedging is too expensive (including fees)

When time period is too long

When time period is too short

When hedge is not understood by client

Relative return considerations

Risk Management Products Matrix

= Yes, strong = Yes, weak No = No

Utility of Strategy to Meet These Objectives

Start Using Options to Enhance Your Practice

Trading Options In-house• Trading Desk• Operational Support• Listed Options vs. OTC Options

Anyone can trade listed options OTC contracts require internal legal review

Hire Third Party Investment Manager• Learn enough about options to advise clients about the

many benefits of using options.• Focus on clients and partner-up with a money management

firm that specializing in options.

Benefits of a Partner

Am I an asset manager or asset gatherer?• Build a recurring fee-based revenue stream • Gain access to institutional-quality solutions• Leverage expertise through partnerships• FA can find a SMA Partner for accounts as small as $100k

Strategies offered by asset managers• Portfolio Protection• Portfolio Income• Portfolio Recovery• Custom strategies for concentrated equity positions

Looking for answers

Clients:• How can I recapture some of my losses without taking

the risk of significant equity exposure?• How can I increase the yield on my portfolio?• How can you help me prevent this from happening

again?

Advisors:• I trade options for my personal account, but I don’t have

the resources to trade them for my clients.• Can using options really help me grow or retain business?• How can I get my clients/prospects off the sidelines?• How do convince a skeptical client to use options?

FPA Conference Presentation in Anaheim, Ca 10-11-2009

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