Might I suggest taking a trip to MyStockOptions.com. I know the Editor-In-Chief Bruce Brumberg and the site is a great place to get any questions you have answered.
Wow - interesting strategy. What would be the risk factor of losing your job?
If problems surfaced that pushed you out of the job wouldn't this multiply the impact with the uncovered options?
You say you would net 40K of income right now from this deal. How does this work in your equity account? Aren't you required to keep some margin on hand to deal with a potential rise in price where you would owe money on those options?
Can you actually write options and extract the money? If so what would prevent someone from writing options on 300,000 shares and just extracting 1 million dollars in cash?
MM - pardon me if I have this all wrong, as I am not an options expert. But, it seems to me that using the term 'hedge' is a bit of a misnomer in this case, as by writing the call options you are only 'hedging' your exposure to the extent that you receive proceeds now; if MSFT drops this will (to a limited extent) reduce your damage. Wouldn't a true hedge involve writing the calls you mentioned for $1.80/ea, and simultaneously buying January 2009 puts, $27.50 strike, (VMFMY.X) for $1.95/ea? The cost of the puts is virtually completely offset by the 'insurance' you sold, and you've drastically reduced your volatility; ie. you know with absolute certainty that your stike price will be between $27.50 and $35. Not coincidentally, the $27.50 strike is very close to today's closing price of $28.95. However, I could very well have this all wrong; you are the CFA, and I am only a lowly CPA.
In any case, your post was very interesting. I've been contemplating how to buy 'insurance' for my portfolio as a whole, which is invested in index and managed funds. For example, I am 26 yrs old, and will not retire for many years. However, the longest puts on the S&P only go out to December 2008.
I just sold all my MicroSoft stock yesterday because it is hitting its highs. Diversify your money so you cannot get hurt too bad by one stock's performance.
don't take this the wrong way but i think you're making a mistake based on your thought process. just note, for a moment, that you're actually talking about leaps. it really sounds like you need to do a lot more research before getting into this stuff.
few thoughts:
1) if it does hit 35, you do realize that you will have to sell your shares and will have to pay taxes on that money. if you're really willing to essentially net out 36.80 and will be happy with that, that's fine.
2) you will need to hold your MSFT shares that entire time - unless, of course, you want to potentially be in the position of having to "risk" being in a "naked" position. actually, depending on whether you actually try to exercise your options, it sounds like you're going to have to have a "naked" position anyways. unless you're actually holding the shares, you are going to be naked. not necessarily a big deal but a consideration towards risk. at least you're on the call side where there is "limited" downside.
3) the other user is correct in that this is not a hedge. this is trying to make your assets yield more.
4) of course, if you exercise and hold, you will be subject to AMT pre-tax payments which can be quite large, if you're not careful.
5) i would, personally, not risk doing ANYTHING with unvested stock options. just plain, not a good idea unless you truely understand the potential downside of what you're doing.
6) personally, sounds like you're in a "good" position right now. as a percentage of your net worth, it is pretty good level - about 10%. if i were you, i would start rotating out of my options and investing in a more diversified approach. just like dollar cost averaging, what i do is that i exercise and sell 1/2 shares of the grant that i get "this year". so, if you're getting 1900 shares this year as an award, exercise only 950 shares of your oldest options. that way, i continue to accumulate additional shares and upside ability and be done with it. if you really believe in MSFT, use a share of those proceeds to buy the leaps. for 1.80, buy those 35 dollar leaps for the number of shares. to replace those 950 shares you sold, $1710 needed to buy those options is so little it isn't even funny. also, taking into consideration you don't want to hold them all the way to 2009 - the time component of the option will erode quite quickly.
Thanks for all the great comments. Yes, the original idea in the post is more to monetize some time value of the ESOP than to "hedge." I will seriously considering to buy puts to cover my downside.
Running my math now ...
MM,
Could you comment on how the money extraction works. I am interested in option plays like this as well but I didn't think I could actually extract the money. In fact I thought it was the case that it would actually tie up money since there was a large exposure if the stock moved against you.
Is that not how it works?
The selling strategy that you have proposed is a good one if you don't mind selling the MSFT stock at $35 at that point even if its market price is higher that $35 at point. Of course, you still would have made some profit, plus if the stock is below $35 at that point, you get to keep the stock along with the call option premium you get right when you sell the call options.
Regarding the comments of Q-Ball, in order to sell call options without owning the stock, you have to first be approved by the brokerage firm. The brokerage firm will not approve you to sell naked call options without first verifying your financial situation, background and experience.
i have about 11 years of options trading experience - mostly daytrading and hedging my own positions.
you really need to understand the downside of alot of this stuff. it is one thing to convince a brokerage firm to allow you to do these trades and another to actually know what you're doing. while you can make a lot of money with options, you will see increased volitility in your portfolio (typically, depending on what you're trying to do).
as for monitizing MSFT stock, usually a "reasonable" idea. large companies that don't have huge swings but solid returns and dividends are prime targets in doing this. you do, however, have to look for the patterns. e.g. you probably need to look at when earnings reports happen relative to the strike date of your options because that may cause spikes up or down.
again, looking at the scenario you're talking about, unless you're prepared to sell your shares for effectively 36.80 in 2 years no matter if it is at 60, fine, go ahead. if you're writing the naked, you need to be disciplined enough to walk away and cover the position. it would be interesting to understand your reasoning. do you think it is going to be stuck below 35 for the next year and that you'll sell the calls for 1.80 and buy them back for say, 1 buck and walk away with the 80 cents per share? if you are thinking of that way, you need to also look at how the price is derrived - look up all of the valuation techniques (e.g. black-sholes). what you'll find is that the time component is not a linear degradation. it isn't entirely dependant on time - you probably are also looking at the Jan 08's and seeing them at 65 cents. but you cannot say that a years worth of time for MSFT is equiv to 1.15.
again, just my 2 cents...
RA,
Thanks for addressing my question. I am approved by my brokerage to write calls and puts without being protected by the underlying security.
They did not do too much due dilligence on me. Asked me some questions about my trading experience which is quite a bit but I have no options experience. I have 100K in the account that can do it but I could easily draw that out.
However I am still trying to get at exactly how this would work.
For instance, consider the following scenario:
If I wrote a call option on 1000 shares of a stock that trades at 30 dollars per share and I wrote the option for 2 bucks per share, how are the following questions answered:
(1) Does my account balance show $2000.00 extra cash in it at that point?
(2) If 1 is yes can I (a) earn interest on that money in a sweep account (b) use that money to buy other stock (c) take that money out as cash
(3) Does the action of writing the call option lock up any of my account balance in some kind of margin/escrow status that doesn't allow me to take it out and if so is that money in a status that cannot earn interest and cannot be leveraged to buy other stocks?
(4) If 1 is yes and 3 is no then is there anything that doesn't stop me from continuing this process of writing options that result in millions of dollars of cash getting added to my account.
#4 just doesn't seem possible that this could be true. Even if it was I wouldn't do it because the exposure would be crazy but if there is cash added to the account it seems like this could really be abused.
So can anyone directly address questions 1-4 in this post?
Thanks very much.
answers to q-ball's questions:
1) your account would be credited with the 2000 cash. your margin and ability to withdraw money will be impacted. e.g. if you are writing calls on MSFT, have 1000 shares of MSFT, you will no longer be able to put those shares up for margin.
2) yes, you can use that money to buy other stock. but as per #1's answer, those shares will be encumbered and not be eligable for margin so therefore, you may be net more limited depending on if you want to do things on margin.
3) yes. see above. in the case of covered calls, those shares would be encumbered and therefore not eligable to be put on margin.
4) as you point out, this is NOT true. however, in the case you're writing uncovered calls, you will need to have enough cash to cover 50% of the options that you are underwriting. basically, putting cash on margin. of course, you will need to deal with margin calls appropriately.
thanks drchunger,
I was talking about uncovered calls so #4 answers my question.
In the case that mm was talking about since he doesn't have the underlying stock in his account but only has unexercised options, I am guessing his strategy would actually tie up a lot of cash, not release extra cash to him.
Thanks again for the answers.
I just skimmed this, but I didn't see mention of MSFT's expect dividend payouts. If they are not going to pay a dividend, exercising options whose strike price is a large fraction of the share price is a disastrous move from a pure-EV perspective. You can think of the option quantity times the strike price as an interest-free loan which must be invested in MSFT. When you exercise, you lose the loan.
Since stock price + dividends goes up at an average of about 12% a year, having an interest-free loan to invest in something that goes up at an average 12% a year is a huge win, even if you ignore the insulation from downside risk provided by options.
Simple example: Suppose your strike price is $10, and current price is $12, and you have 1000 options. Let's pretend stocks earn 10%/year, and ignore taxes (they turn out not to matter much). If you don't exercise, you have options on $12,000 of MSFT, which will go an average of 10% a year, or $1,200. If you exercise, you have $2K in cash, which you can put into an index fund which will go up 10% a year, or $200. So you earn $200/year instead of $1200 - a disaster. The index fund has less volatility, but it would be insane to reduce your earn that much just for volatility.
Dividend payouts weaken this argument, since option-holders don't get dividends, your earn as an option holder is less than as a stockholder.
Here is my post on the subject:
http://catallarchy.net/blog/archives/2005/10/29/is-it-usually-wrong-to-exercise-employee-stock-options/
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