By Lawrence G. McMillan
This article was originally published in The Option Strategist Newsletter Volume 5, No. 4 on February 22, 1996.
An understanding of equivalent positions is mandatory knowledge for option traders. Two positions or strategies are equivalent if their profit graphs have the same shape. For example, we have repeatedly stressed that covered call writing and naked put writing are equivalent. This can be quickly verified by looking at the profit graph on the right. Both strategies have limited profit potential, large downside risk, and can make money if the underlying remains relatively unchanged in price until expiration.
One of the simplest, but often overlooked, equivalences is the one in which an option position is equivalent to the underlying instrument itself — whether that be stock, futures, or index. In looking back over the more than four years' worth of articles that we have written, it was surprising to find that this subject of underlying equivalence had not actually been addressed in the newsletter. So we are going to look at ways in which one might benefit from taking an option position, as opposed to a position in the underlying stock or futures contract.
If one both owns a call and is short a put — with the same terms — he has a position that is equivalent to owning the underlying. For example, buying the IBM April 120 call and selling the April 120 put produces a position that is equivalent to owning 100 shares of IBM. Either position — the option combination or stock ownership — has unlimited profit potential to the upside and large downside risk. Of course, there are differences in the margin requirements. If one buys stock, he can either pay cash for it, or he can buy it on margin. The option position requires a smaller investment: the long call must be paid for in full, and the short put must be margined as a naked option position. The exchange minimum requirement for selling a naked option is 20% of the stock price, plus the option premium, less any out-of-the-money amount. Let's see how these compare, using actual prices:
Example: suppose that IBM is selling at 117, and the April 120 call is selling for 5½, while the April 120 put is trading at 7½. The stock trader would buy 100 IBM, either on cash or margin, while the option trader would buy the call and sell the put, thereby taking in a credit of 2 points, or $200.
Profitability: first, let's look at the actual price differences in order to determine if the option position is actually a "good deal". If IBM were unchanged at 117 at April expiration, the stock holder would not have any capital gains or losses, and would have collected a 25 cent dividend. The option trader, however, would appear — on the surface — to be at a disadvantage: his call would expire worthless, and he would have to pay 3 ($300) to buy back the put. Thus the option trader has a $100 loss, and has not received a dividend. In order to see if both the stock trader and the option trader are really on an even footing, we need to look at the investment required.
Investment: the stock trader, who bought for cash, invested $11,700. The option trader, however, doesn't need any cash at all: he can use T-Bills to satisfy the margin requirement.
Option Position Requirement
Call paid for in full: $ 500
Put requirement:
20% of stock price: $2340
Put premium: 750
Out-of-money amount: 0
$3090
Less Put Premium received: –750
Total Option Requirement: $2840
Since the put premium is larger than the call premium when the position is established, no cash outlay is required. Thus, the option trader could put $11,700 in T-Bills and earn interest from now until April expiration. That interest, which amounts to about $146 (at 6% interest for 75 days), essentially compensates for the seeming "advantage" that the stock owner had. All this means is that the option prices take the anticipated dividends into account when you establish the trade.
What are the true advantages here, for either side? The option trader is putting up less money. In fact, if you want, you could think of the option strategy as buying IBM on about 20% margin. If you are a margin trader, you should give serious consideration to the option strategy, for it not only allows you greater leverage, but you don't pay any margin interest to your broker, for there is no debit balance.
The disadvantage is that one is paying two commissions instead of one, and is also dealing with two bid-asked spreads instead of one. However, market makers are sometimes willing to trade inside the stated markets on this type of a position because they can often establish a riskless arbitrage, so if you're not in a hurry to jump into the position, a limit order might work well.
Short sellers enjoy an added benefit. Owning a put and selling a naked call, with the same terms, is equivalent to being short the underlying. For stock traders, this means that you can get short the stock without needing an uptick (there is no uptick requirement to sell a naked call). This can be very beneficial.
In any option equivalent position, though, there is always the risk of early assignment. For example, if you have the equivalent long position, and the stock falls, you could get assigned on your put. Such an assignment would raise your margin requirements and necessitate paying more commissions, so one should monitor his naked options and — when their time value premium disappears — roll them into options that do have time value premium.
The above commentary mainly addressed using the option equivalent position for stock substitution. However, it is an equally important concept for futures and index traders as well. There is no margin benefit for futures traders (as we have often stated, the futures margin rules are light years ahead of the margin rules for stock and index options, so equivalent positions in the futures market all require the same margin, since they have the same risk and reward. What a unique concept, eh?). However, the real benefit to the equivalence strategy for futures traders is that they can use it to extract themselves from a losing position when the futures are locked limit against them. In such a case, there will be options that are trading, even though the futures are not. Thus, if you are long a futures contract, and it is locked limit down, you can extricate yourself by equivalently selling that futures contract through options — buy a put and sell a call with the same terms.
Index traders use the option equivalent position all the time — especially those who are interested in arbitrage or in having a position that behaves exactly like the index would. Since there are no physical shares traded on indices, and since most of them don't have companion futures contracts, the only way to have a position that behaves like the index itself is to use the option equivalent strategy. For example, if you want to buy the Oil and Gas Index (Symbol:$XOI), then the only way to do this is to buy an XOI call and sell an XOI (naked) put with the same terms.
If you are going to use this strategy, you will have to decide which striking price and which expiration month to use in your option position. There is one additional consideration that should be factored in, before you make that decision: your broker will allow you to earn interest on credit balances generated by option sales, as long as your T-Bills cover the entire collateral of the option position. If your broker does not allow you to earn such interest, find another broker. As an example, look at the requirement for the naked put in the previous example. That requirement was $3090, and it did not include the $750 received from the put sale itself. Now, when one sells a naked option, he can always just use the naked option premium — $750 in this case — to reduce the collateral requirement. However, if he has enough T-Bills in his account, he is better off to using the T-Bills to satisfy the entire requirement ($3090 in this case), and then putting the $750 in a money market account and earning interest on it.
Thus, when using the option equivalent strategy, you might want to structure your striking price so that you take in an initial credit when you establish your positions. This will allow you to earn some additional interest on your positions while they are in place. However, in order to do this, you will need to sell inthe- money options in order to generate the credit (in the previous IBM example, the put that we sold was in-the-money, and we had a 2-point credit on the option position, but if we had used a lower strike, then the call would have been more expensive than the put, and the option position would be a debit instead of a credit).
The fact that the option trader can earn interest on his credit balances is the good news; the bad news is that the sale of an in-the-money option might increase your chances of early assignment, on down the road.
As for how much time to allow in the options, that is more a matter of liquidity in the option market (you may find a much tighter market in relatively short-term options) and your time horizon for owning the underlying. If you envision yourself to be a long-term holder, you might want to use LEAPS options; but if you are a short-term trader, then you would use options with only a month or two of life remaining.
Selling in-the-money Puts As A Stock Substitute
A branch of the option equivalent strategy is to sell in-themoney puts as a substitute for owning the stock. These puts would have to be fairly deep in-the-money options, though, or they would seriously underperform the stock during a rally. This, of course, raises the specter of early assignment again, but even so, it holds a certain attraction because of the credit balances generated. If you are going to use this in-the-money put strategy, I would only suggest it with fairly long-term puts, that have a significant amount of time value premium to begin with — even if you are not intending to be a long-term holder of the position.
Also, I would suggest that you buy out-of-the-money calls in order to preserve your upside profit potential, and the expiration date of those calls should reflect your anticipated holding period for the position. For example, with IBM at 117, the deepest in-the-money puts are the July 130's. If you sold those as a substitute for owning IBM as a rather short-term trade, then you might buy the Mar 130 calls for a mere point in order to have upside potential. If you are intending to hold the position long-term, then you should buy calls that have the same expiration date as your puts.
Overall, the option equivalent position is often a more efficient way for stock traders — particularly those trading on margin — to use their capital. Short sellers get the benefit of not needing an uptick. Futures and index traders should be aware of the usefulness of the strategy as well.
This article was originally published in The Option Strategist Newsletter Volume 5, No. 4 on February 22, 1996.
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