Financial Options & Option Strategy Financial Options & Option Strategy

Financial Options- Option StrategyFinancial Options- Option Strategy

FINC 5000FINC 5000

Shanghai week 7- 2014Shanghai week 7- 2014

Option contracts and markets

• Call OptionCall Option: : the right to buy a the right to buy a financial asset in the future at a financial asset in the future at a certain price and within a certain certain price and within a certain timetime

• Put OptionPut Option: : the right to sell a the right to sell a financial asset in the future at a financial asset in the future at a certain price and within a certain certain price and within a certain timetime

Buy and Sell• Both Call and Put options can be Both Call and Put options can be

bought and sold bought and sold

• The seller of the option is also The seller of the option is also called called the writerthe writer of the option of the option

• For every buyer of an option there is For every buyer of an option there is a sellera seller

• The price at which the trader can The price at which the trader can trade is the strike price (exercise trade is the strike price (exercise price)price)

• Some options can only be Some options can only be exercised/traded at expiry date exercised/traded at expiry date (European options) but nowadays (European options) but nowadays almost all options can be traded almost all options can be traded daily (American options) daily (American options)

More and more selling and buying is done through on line transactions

Call OptionCall Option

Call OptionCall Option

Put OptionPut Option

Put OptionPut Option

Option Strategies…and TimeOption Strategies…and Time

Option Strategies…and VolatilityOption Strategies…and Volatility

In-At-Out of the MoneyIn-At-Out of the Money

Option Value=Time Value + Intrinsic ValueOption Value=Time Value + Intrinsic Value

What determines option value?

• Stock Price (S)

• Exercise Price (Strike Price) (X)

• Volatility (σ)

• Time to expiration (T)

• Interest rates (Rf)

• Dividend Payouts (D)

Imagine you are still bullish about Apple..

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

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

Before you know it….

• You are setting up a You are setting up a strategy to make money or strategy to make money or hedge riskshedge risks

• In this case you buy calls In this case you buy calls and puts of the same series and puts of the same series ; this strategy is called a ; this strategy is called a Straddle…Straddle…

• As you can see you can As you can see you can combine any combination combine any combination of Calls and Puts , buying of Calls and Puts , buying or selling, strike prices and or selling, strike prices and different expiry dates and different expiry dates and built your own strategy…built your own strategy…

Let’s see how you are doing on 19th July 2005 (example) • The $35 put premium has come down The $35 put premium has come down

from $ 2.15 to $ 2.- although the share from $ 2.15 to $ 2.- although the share has lost value ($ 35.55 on 11 th July has lost value ($ 35.55 on 11 th July now $ 35.37) the time value has now $ 35.37) the time value has evaporated more quicklyevaporated more quickly

• The call premium also has come down The call premium also has come down from $3.20 to $ 2.75 ($ 0.18 of this move from $3.20 to $ 2.75 ($ 0.18 of this move is the loss in intrinsic value-remember is the loss in intrinsic value-remember the call is in the money)the call is in the money)

• You see that the premiums do not move You see that the premiums do not move symmetric over time…given the price symmetric over time…given the price movements of the underlying assetmovements of the underlying asset

• You have lost $ 5.35-$4.75=$0.60 (times You have lost $ 5.35-$4.75=$0.60 (times 100 shares per option contract) $ 60 on 100 shares per option contract) $ 60 on your investment of $535your investment of $535

• What will you do? Hang in there?What will you do? Hang in there?

Options

19 july 2005

View By Expiration: Aug 05 | Sep 05 | Oct 05 | Jan 06 | Jan 07 | Jan 08

CALL OPTIONS Expire at close Fri, Oct 21, 2005

Strike Symbol Last Chg Bid Ask Vol Open Int

22.5 QXBJB.X 13 0 12.9 13.3 2 174

25 QXBJE.X 10.5 0 10.5 10.9 6 617

27.5 QXBJC.X 8.5 0 8.2 8.5 11 273

30 XBAJF.X 6.1 0 N/A N/A 17 3,910

32.5 XBAJZ.X 4.3 0 N/A N/A 33 1,363

35 XBAJG.X 2.75 0 N/A N/A 225 7,805

37.5 XBAJU.X 1.65 0 N/A N/A 5,466 6,750

And put premiums on 19 julyPUT OPTIONS Expire at

close Fri, Oct 21,

2005

Strike Symbol Last Chg Bid Ask Vol Open Int

22.5 QXBVB.X 0.1 0 0.05 0.1 1 3,118

25 QXBVE.X 0.2 0 0.1 0.2 10 7,103

27.5 QXBVC.X 0.3 0 0.2 0.35 31 844

30 XBAVF.X 0.56 0 N/A N/A 51 9,805

32.5 XBAVZ.X 1.1 0 N/A N/A 2,223 6,225

35 XBAVG.X 2 0 N/A N/A 214 12,486

37.5 XBAVU.X 3.5 0 N/A N/A 29 5,561

And on August 15…CALL OPTIONS Expire at close

Fri, Oct 21, 2005

Strike Symbol Last Chg Bid Ask Vol Open Int

22.5 QXBJB.X 21.8 0 N/A N/A 20 158

25 QXBJE.X 16.7 0 N/A N/A 10 447

27.5 QXBJC.X 14.2 0 N/A N/A 10 281

30 XBAJF.X 12 0 N/A N/A 10 3,737

32.5 XBAJZ.X 9.5 0 N/A N/A 2 1,155

35 XBAJG.X 7.4 0 N/A N/A 95 6,580

37.5 XBAJU.X 5.2 0 N/A N/A 40 11,727

And the Put…PUT OPTIONS Expire at

close Fri, Oct 21,

2005

Strike Symbol Last Chg Bid Ask Vol Open Int

22.5 QXBVB.X 0.05 0 N/A N/A 20 3,118

25 QXBVE.X 0.05 0 N/A N/A 15 6,722

27.5 QXBVC.X 0.05 0 N/A N/A 1 858

30 XBAVF.X 0.15 0 N/A N/A 4 10,089

32.5 XBAVZ.X 0.25 0 N/A N/A 30 5,312

35 XBAVG.X 0.5 0 N/A N/A 86 11,511

37.5 XBAVU.X 0.95 0 N/A N/A 13 6,324

So on 15th August 2005

• Your Call has increased in Your Call has increased in value (from $1.95 to $ 5.20 value (from $1.95 to $ 5.20 or $ 3.25)or $ 3.25)

• Your Put has lost value Your Put has lost value (from $2.15 now $ 0.50 so $ (from $2.15 now $ 0.50 so $ 1.65)1.65)

• To date your net gain is $ To date your net gain is $ 1.60 ($ 160)1.60 ($ 160)

• Your investment was $ 410Your investment was $ 410• Your return is: $ 160/$ 410= Your return is: $ 160/$ 410=

39% in about 1 month! 39% in about 1 month!

Hedging and Portfolio Insurance• You are managing a well-diversified You are managing a well-diversified

portfolio of US shares but you are portfolio of US shares but you are worried about the possibility that worried about the possibility that the market will fall in the next 6 the market will fall in the next 6 months (11 September…)months (11 September…)

• Buy put option on the market Buy put option on the market index; the fall in the value of the index; the fall in the value of the portfolio will be covered by the portfolio will be covered by the profit on the putsprofit on the puts

• Of course you will have to pay the Of course you will have to pay the premium for the puts but this is in premium for the puts but this is in fact an insurance premium…but…fact an insurance premium…but…you can sell an (far) out of the you can sell an (far) out of the money call that will provide you money call that will provide you upfront cash to pay the premium…upfront cash to pay the premium…

• What we are doing here is What we are doing here is “financial engineering” with “financial engineering” with options options

Buy Puts on QQQQ- Nasdaq 100 Trust?

Arbitrage and put-call parity

• Say you buy a put and Say you buy a put and sell a call of the same sell a call of the same series at the same timeseries at the same time

• This is a synthetic short This is a synthetic short forward positionforward position

• On such a position you On such a position you should be able to make should be able to make the risk less ratethe risk less rate

• Let’s take an example: Let’s take an example:

Buy a Put and Sell a Call• Buy Put ebaY $35 October 2005, at $ 2.15 Buy Put ebaY $35 October 2005, at $ 2.15

and Sell Call ebaY $35 October 2005 at and Sell Call ebaY $35 October 2005 at $3.20$3.20

• This will guarantee that you can sell ebaY This will guarantee that you can sell ebaY at $35 in October ; if the price will be at $35 in October ; if the price will be below $35 you will sell the put and take below $35 you will sell the put and take the profitthe profit

• If the price would be higher than $35 the If the price would be higher than $35 the buyer of the call you sold will exercise buyer of the call you sold will exercise the call and you will have to pay him (but the call and you will have to pay him (but since your sold call is covered i.e. you since your sold call is covered i.e. you own the shares you can deliver without a own the shares you can deliver without a cash loss)cash loss)

• Your strategy is risk less and should Your strategy is risk less and should return the risk less rate… return the risk less rate… ($3.20-$2.15)/$35=<4%($3.20-$2.15)/$35=<4%

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

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

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

Bearish Strategies

• Long Put• Naked Call (sell uncovered call; very risky!)

• Bear Call Spread

• Bear Put Spread

• Put Back Spread

Set up a Bear spread with Calls or Puts

• Buy a Call with strike Buy a Call with strike price X and sell a Call price X and sell a Call with a strike price with a strike price LOWER than XLOWER than X

• Buy a Put with strike Buy a Put with strike price Y and sell a Put price Y and sell a Put with a strike price with a strike price LOWER than Y LOWER than Y

• Proof in both cases Proof in both cases that this is a Bearish that this is a Bearish approach (you bet on approach (you bet on a lower share price)a lower share price)

Bear spread EbaY (buy call $ 37.50 for $ 1.65 and

sell call $ 35 at $ 2.75)

Bear spread w ith calls EbaY

-2

-1.5

-1

-0.5

0

0.5

1

1.5

25 28 31 34 37 40 43

Bear spreadw ith calls EbaY

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

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

Bear spread w ith puts EbaY

-2

-1.5

-1

-0.5

0

0.5

1

1.5

25 28 31 34 37 39 42 45

Bear spreadw ith puts EbaY

Put Back Spread

• Put back spreads are Put back spreads are great strategies when great strategies when you are expecting you are expecting big big downward moves in downward moves in already volatile already volatile stocksstocks. (Google?). (Google?)

• The trade itself The trade itself involves selling a put involves selling a put at a higher strike and at a higher strike and buying a greater buying a greater number of puts at a number of puts at a lower strike price.lower strike price.

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 !

Bullish Strategies

• Long Calls

• Covered Calls

• Bull Call Spread

• Bull Put Spread

• Call Back Spread

• Protective Put

• Naked Put

Long Call, Covered Call

Bull Spreads with Calls and Puts

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

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)

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)

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.

Naked Put• Imagine that you want to Imagine that you want to

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

Neutral Strategies

• Reversals

• Conversions

• Collars

• Straddles

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.

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.

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

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

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

Stock Price Profit (Loss)

$50 $525

$55.25 $0

$60 ($475)

$65 ($475)

$70 ($475)

$74.75 $0

$80 $525

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.

Long Butterfly - DJX = $75.28

Buy 1 DJX 72 Call @ $6.10 x 100 $610 (wing)

Sell 2 DJX 75 Call @ $4.10 x 100 ($820)(butterfly body)

Buy 1 DJX 78 Call @ $2.60 x 100 $260 (wing)

Net Debit from Trade $50($870 - $820)

Butterflies (continued)

Put Ratio Spread

• To create a put ratio spread, you would buy puts at a higher strike and sell a greater number of puts at a lower strike. Ideally, this trade will be initiated for a minimal debit or, if possible, a small credit.

MER Trading @ $39.68

Buy1 MER JUL 50

Put @ $10.60$1,060

Sell3 MER JUL 40

Put @ $2.40($720)

Cost/Proceeds $340

Condors• The condor takes the body of

the butterfly-two options at the middle strike-and splits it between two middle strikes rather than just one. In this sense, the condor is basically a butterfly stretched over four strike prices instead of three.

Long Condor

Sell1 75 Call @

$6.00($600)(condor body)

Sell1 80 Call @

$4.00($400)(condor body)

Buy1 70 Call @

$9.00$900(wing)

Buy1 85 Call @

$2.00$200(wing)

Cost of Trade $100 ($1,100-$1,000

Condors Continued• In this case, the maximum profit is In this case, the maximum profit is

achieved at expiration with the stock achieved at expiration with the stock between 75 and 80. between 75 and 80.

• At $75, the 75, 80, and 85 calls would At $75, the 75, 80, and 85 calls would expire worthless and the 70 calls expire worthless and the 70 calls would be worth $500. would be worth $500.

• Thus, you would achieve your Thus, you would achieve your maximum profit of $400 ($500 - $100 maximum profit of $400 ($500 - $100 initial debit). initial debit).

• Between 75 and 80, the loss on the Between 75 and 80, the loss on the short 75 calls is more than offset by short 75 calls is more than offset by the 70 calls. Since the 80 and 85 calls the 70 calls. Since the 80 and 85 calls would again expire worthless, the would again expire worthless, the value at expiration is the same as the value at expiration is the same as the value of the 70/75 bull call spread ($5).value of the 70/75 bull call spread ($5).

• At any price above $85 or below $70, At any price above $85 or below $70, you would experience the maximum you would experience the maximum loss of $100.loss of $100.

Pricing Options• All options prices are built up of: Intrinsic Value + Time Value

– So if we buy EbaY $35 October for $ 3.20 and today’s cash price is $35.55 this option is $ 0.55 in the money (the intrinsic value) and the rest of the value ($ 2.65) is the time value of the option between now and October 21 st (this value will eventually evaporate)

• The Price of the option depends on how much of the value of the option is in the money or out of the money i.e. how much difference there is between the current cash price of the underlying asset and the strike price of the option

• The expiration date also has an impact on the price of the option; options with a longer life time tend to be more expensive

• The volatility of the underlying asset effects the price of the option as well; more volatile shares have higher option premiums

• The risk less interest rate has two effects on option prices:

– Higher risk less rates lower the NPV of profits from options and thus tend to lower option premiums– Higher risk less rates tend to call higher expected values of shares and thus higher call option premiums

and lower put option premiums

Homework Assignment 8: Option Strategy

• Take a close look at your company stock over the past couple of months

• Consider any special events happening now or about to happen (release 10Q?)

• Choose an option strategy that you think will make money for you as an investor

• Note we use expiration is equal to the Final Exam date• You can invest unlimited amounts of money however if you are

wrong you will loose your investment…• You’d better cover your downward risks….• Stella will collect your option strategy before next class• We need your inputs about:

INPUTS OPTION STRATEGY

• Name of the strategy if appropriate (long butterfly, short straddle…)• How many calls/puts do you buy/sell (each represents 100 stock in

your company) and at what strike price $ X• What is the quoted premium on Yahoo Finance 9specify date)

(closing NYSE)• How much money you expect to make on this strategy (calculation)• Maturity Final Exam date• You can not trade your strategy and need to hold it until expiration!• WE NEED YOUR INPUTS BY SUNDAY (TA for follow up)

On the day of Final Exam

• We will calculate how much money you made/lost on your option strategy and rank you from high to low profits

• BTW you can do this too since by then you know the premium at expiration…so you don’t really depend on Stella’s ranking…

• Top 10 profit makers will get extra credit (+5)• Top 10 losers will lose credit (-5)

– If you don’t hand in you lose credit too…