Financial Options & Option Strategy

1. Financial Options & Option Strategy Financial Options- Option Strategy FINC 5000 Shanghai week 7- 2014

2. Option contracts and markets • Call Option: the right to buy a financial asset in the future at a certain price and within a certain time • Put Option: the right to sell a financial asset in the future at a certain price and within a certain time

3. Buy and Sell • Both Call and Put options can be bought and sold • The seller of the option is also called the writer of the option • For every buyer of an option there is a seller • The price at which the trader can trade is the strike price (exercise price) • Some options can only be exercised/traded at expiry date (European options) but nowadays almost all options can be traded daily (American options) More and more selling and buying is done through on line transactions

4. Call Option

5. Call Option

6. Put Option

7. Put Option

8. Option Strategies…and Time

9. Option Strategies…and Volatility

10. In-At-Out of the Money

11. Option Value=Time Value + Intrinsic Value

12. What determines option value? • Stock Price (S) • Exercise Price (Strike Price) (X) • Volatility (σ) • Time to expiration (T) • Interest rates (Rf) • Dividend Payouts (D)

13. Imagine you are still bullish about Apple..

14. Buy Calls? • X=$ 625 • So= $ 624.31 (yesterday) • P= $ 13.51 (over 2% of So) • (quotations yesterday Yahoo Finance) • Maturity: Friday 20 April 2012 (4 PM NYT) • If on 20 April St<$ 625 the option expires worthless (note St is stock price on 20 April) • If on 20 April St>$625: You exercise the option your (net) profit: St-X-(premium) or: • St-$625-$13.51

15. Or Wal Mart? • X=$ 60 • So= $ 60.26 (yesterday) • P= $ 0.71 (less than 12% of So) • (quotations yesterday Yahoo Finance) • Maturity: Friday 20 April 2012 (4 PM NYT) • If on 20 April St<$ 60 the option expires worthless (note St is stock price on 20 April) • If on 20 April St>$60: You exercise the option your (net) profit: St-X-(premium) or: • St-$60-$0.71

16. Before you know it…. • You are setting up a strategy to make money or hedge risks • In this case you buy calls and puts of the same series ; this strategy is called a Straddle… • As you can see you can combine any combination of Calls and Puts , buying or selling, strike prices and different expiry dates and built your own strategy…

17. Let’s see how you are doing on 19th July 2005 (example) • The $35 put premium has come down from $ 2.15 to $ 2.- although the share has lost value ($ 35.55 on 11 th July now $ 35.37) the time value has evaporated more quickly • The call premium also has come down from $3.20 to $ 2.75 ($ 0.18 of this move is the loss in intrinsic value-remember the call is in the money) • You see that the premiums do not move symmetric over time…given the price movements of the underlying asset • You have lost $ 5.35-$4.75=$0.60 (times 100 shares per option contract) $ 60 on your investment of $535 • What will you do? Hang in there?

19. And put premiums on 19 july

20. And on August 15…

21. And the Put…

22. So on 15th August 2005 • Your Call has increased in value (from $1.95 to $ 5.20 or $ 3.25) • Your Put has lost value (from $2.15 now $ 0.50 so $ 1.65) • To date your net gain is $ 1.60 ($ 160) • Your investment was $ 410 • Your return is: $ 160/$ 410= 39% in about 1 month!

23. Hedging and Portfolio Insurance • You are managing a well-diversified portfolio of US shares but you are worried about the possibility that the market will fall in the next 6 months (11 September…) • Buy put option on the market index; the fall in the value of the portfolio will be covered by the profit on the puts • Of course you will have to pay the premium for the puts but this is in fact an insurance premium…but…you can sell an (far) out of the money call that will provide you upfront cash to pay the premium… • What we are doing here is “financial engineering” with options Buy Puts on QQQQ- Nasdaq 100 Trust?

24. Arbitrage and put-call parity • Say you buy a put and sell a call of the same series at the same time • This is a synthetic short forward position • On such a position you should be able to make the risk less rate • Let’s take an example:

25. Buy a Put and Sell a Call • Buy Put ebaY $35 October 2005, at $ 2.15 and Sell Call ebaY $35 October 2005 at $3.20 • This will guarantee that you can sell ebaY at $35 in October ; if the price will be below $35 you will sell the put and take the profit • If the price would be higher than $35 the buyer of the call you sold will exercise the call and you will have to pay him (but since your sold call is covered i.e. you own the shares you can deliver without a cash loss) • Your strategy is risk less and should return the risk less rate… ($3.20-$2.15)/$35=<4%

26. The put-call parity • Assume: • S= Selling Price • P= Price of Put Option • C= Price of Call Option • X= strike price • R= risk less rate • T= Time then X*e^-rt= NPV of realizable risk less share price (P and C converge) • S+P-C= X*e^-rt • So P= C +(X*e^-rt - S) is the relationship between the price of the Put and the price of the Call

27. Speculations spreads and volatility • Buying a call will only profit you if the share price rises above the strike price plus the premium that you paid for the call • But you can set up a BULL SPREAD: buy a call at the money and sell one out of the money call with a premium close to the one that you are paying for the bought call • In the case of ebaY: • Buy Call $37.50 October 2005 (at $ 1.95) and sell Call $ 40 October 2005 ($ 1.15) If the price falls below $37.50 this speculator looses the net premium ($1.95-$1.15=$0.80) • A share price in between $ 37.50 and $40 will generate a profit on the call and a loss on the sold call but the profit on the call will be higher since the strike price is lower • Above $40 this higher profit on the Call is kept above the loss on the sold call (for instance at $42.50 the call profit is $5 the loss on the sold call is $2.50 we got $1.15 for the sold option and paid $1.95 for the bought call so: • +$5-$2.50+$1.15-$1.95= $ 1.70 • This profit will be the same for every share price above $40

28. Bull and Bear Strategies • Bull Spreads (speculate that the price will rise) • Using Calls (see ebaY example) • Using Puts • Bear Spreads (speculate that the price will fall) • Using Calls • Using Puts

29. Bearish Strategies • Long Put • Naked Call (sell uncovered call; very risky!) • Bear Call Spread • Bear Put Spread • Put Back Spread

30. Set up a Bear spread with Calls or Puts • Buy a Call with strike price X and sell a Call with a strike price LOWER than X • Buy a Put with strike price Y and sell a Put with a strike price LOWER than Y • Proof in both cases that this is a Bearish approach (you bet on a lower share price)

31. Bear spread EbaY (buy call $ 37.50 for $ 1.65 and sell call $ 35 at $ 2.75) Loose premium call - $ 1.65 and profit $ 2.75 from sold option; profit $ 1.10 Loose $ 2.50 sold call at $ 37.50 profit $2.75 from sold call and loose - $ 1.65 net loss $ 1.40 beyond this point the call will gain equal to what sold call looses

32. Bear spread EbaY (buy put $ 37.50 for $ 2.70 and sell put $ 35 at $ 1.20) At $ 35 profit from bought put $ 2.50 minus premium is -$0.20 (loss) and profit $ 1.20 from sold option; profit $ 1.00 At lower prices the gains from the bought put will off set the losses from the sold put. Loose $ 2.70 bought put and profit $1.20 from sold put ; net $ 1.50 loss

33. Put Back Spread • Put back spreads are great strategies when you are expecting big downward moves in already volatile stocks. (Google?) • The trade itself involves selling a put at a higher strike and buying a greater number of puts at a lower strike price.

34. Example: • Using Intel (Nasdaq: INTC), we can create a put back spread using in-the-money options. With INTC Trading at $27.75 on July 12th 2005 , you might buy two of the October 2005, 27.50 puts at $1.05 and sell one October 2005 30 put at $2.45 • In this example, you would receive $35 for putting on the trade. If the stock jumped above 30, you would profit $35. However, the real money would be made if the stock made a big move to the downside. • The downside breakeven for this trade would be $25 At this price, the 27.50 puts would be worth $2.50 while the 30 puts would be worth $5. • Below $25 the profit potential increases dramatically. • At $ 22.50: 2 bought puts will generate profit $1,000 and the sold put a loss of $ 750 and we will still have the $35 difference between the premiums: Total profit $ 285 !

35. Bullish Strategies • Long Calls • Covered Calls • Bull Call Spread • Bull Put Spread • Call Back Spread • Protective Put • Naked Put

36. Long Call, Covered Call

37. Bull Spreads with Calls and Puts

38. Class Example 1 • Bull Call Spread: • Dell Trading @ $26.85 • Buy1 DELL JUL 25 Call @ $2.95 ($295) • Sell1 DELL JUL 30 Call @ $0.50($50) • Cost of Trade$245

39. And class example 2 • Bull Put Spread • KO Trading @ $54.14 • Sell10 KO AUG 55 Put @ $2.55($2,550) • Buy10 KO AUG 50 Put @ $0.85 $850 • Credit from Trade($1700)

40. Class Example 3:Call Back Spread • IP Trading @ $43.46 • Buy 2 IP JUL 45 Call @ $1.05 ($210) • Sell 1 IP JUL 40 Call @ $4.00($400) • Credit from Trade($190)

41. Protective Put • AMGN Trading at $50.66 • Buy100 AMGEN INC @ $50.66 ($5,066) • BuyAMGN OCT 45 Put @ $2.55 ($255) • Cost of Trade$5,321 • No matter how far the stock drops, as long as there is a protective put, the combined position will be worth $4,245.

42. Naked Put • Imagine that you want to buy International Business Machines (NYSE: IBM) but think it is due for a slight correction from its current price, $82.83. By selling the $80 puts at $5.10, you collect $510 ($5.10 x 100 shares) per contract. If the stock drops to $75 and the puts are assigned to you, you will pay $80 for the stock. However, your net cost is really $74.90 per share ($80 strike - $5.10 premium)

43. Neutral Strategies • Reversals • Conversions • Collars • Straddles

44. Reversals • the reversal involves buying something in one market and simultaneously selling it in another to capitalize on whatever small discrepancy exists. • Traders do reversals when options are relatively underpriced. • In the absence of any price discrepancies, the following will be true: • Call price - put price = • stock price - strike price= $4 • by selling a stock at $104, buying the call $100 for 7.50 (the offer) and selling the put $100 for 3.60 (the bid), the trader will lock in a .1 point profit.

45. Conversions • The opposite of reversals • In the absence of any price discrepancies, the following will be true: • Call price - put price = • stock price - strike price=$4 • Again: • Thus, by buying the stock for $104, selling the call $100 for 7.60 (the bid) and buying the put $100 for 3.50 (the offer), the trader will lock in an .1 point profit.

46. Collars • NTAP Trading @ $12.84 • Buy100 NTAP @ $12.84 ($1,284) • Buy1 NTAP JUL 10 Put @ $060 ($60) • Sell1 NTAP JUL 15 Call @ $0.80($80) • Cost of Trade$1,264

47. Straddles • Have you ever had the feeling that a stock was about to make a big move, but you weren't sure which way? • Let's imagine a stock is trading around $80 per share. To prepare for a big move in either direction, you would buy both the 80 calls and the 80 puts. If the stock drops to $50 by expiration, the puts will be worth $30 and the calls will be worth $0. If the stock gaps up to $110, the calls will be worth $30 and the puts will be worth $0. • Long Straddle • Buy1 80 Call @ $7.50 $750 • Buy1 80 Put @ $7.00 $700

48. Strangles • Long strangles are comparable to long straddles in that they profit from market movement in either direction. From a cash outlay standpoint, strangles are less risky than straddles because they are usually initiated with less expensive, near-the-money rather than at-the-money options. • Long Strangle (the stock is at $ 65) • Buy1 60 Put @ $2.25 $225 • Buy1 70 Call @ $2.50 $250

49. Butterflies • The long butterfly spread is a three-leg strategy that is appropriate for a neutral forecast - when you expect the underlying stock price (or index level) to change very little over the life of the options. A butterfly can be implemented using either call or put options.

50. Butterflies (continued)