Long-call cash sleeve as an option-income case study

One procedure and one holding period

The archive presents option-income-strategy as a single capital book that can be checked over one holding-period-horizon. The items to specify are the cash-equivalent-sleeve, the call that is bought, and the comparison of that package with outright stock over the life of the purchased option.

Covered-call-writing is described as selling a call against stock already held, with a better fit in stable or declining markets and a hard cap on gains if the stock rallies.

An alternative construction, long-call-plus-cash, buys a call and places unused funds in a cash-equivalent, aiming to keep most capital intact while retaining upside if the stock rises.

Rates and the cash-equivalent-sleeve

The construction is presented as more appealing when short-term interest rates are relatively high and less appealing when those rates are low, as at the end of 1991.

The cash-equivalent-sleeve is the money-market or Treasury-bill book that earns short-term interest on capital not spent on the option premium.

The 100-dollar stock case

The worked case starts from a 100-dollar stock. It contrasts buying 100 shares for 10,000 dollars with parking that cash in a money-market or Treasury-bill sleeve at about 5 percent a year and buying a six-month 105-strike call costing 5 dollars a share, or 500 dollars.

The holding-period-horizon is the life of that purchased option, used as the comparison window against outright stock.

Strike choice is treated as a budget-and-volatility decision. That is the delta-premium-tradeoff: a nearer strike raises both premium and delta, while a farther strike is cheaper but less sensitive to the stock.

Two endings after six months

If the stock is 115 dollars after six months, the share position is shown with a 1,500-dollar gain. The call is 10 points in the money, so 1,000 dollars of option value minus the 500-dollar premium, plus about 250 dollars of cash interest.

If the stock falls to 80 dollars, the share position is shown with a 2,000-dollar loss, while the call expires worthless and the 500-dollar premium is partly offset by about 250 dollars of cash interest, leaving starting capital largely intact.

The call holder forgoes stock dividends during the option life. Those dividends are described as likely smaller than the cash-equivalent interest over the same window.

Index calls and the put-plus-cash flip

The same rule set can be applied with a broad-index call for a market-wide bullish view, or flipped to a long put plus cash instead of a short stock position for a bearish view. In that flip, the holding-period-horizon is still the life of the purchased option, now compared with a short-stock alternative.