rm1 04 v5 intro to options
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RM1Chapter 4: Introduction to Options
Version 5
2008
FH-Doz. Mag. Donald Baillie, FRM
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Options: Forward Transactions, Derivatives
Options are a type ofderivative, meaning that it is a right to some kindof reference asset (the underlying)
Options are forward transactions: the value date of the contract liessome time in the future
An option entitles the buyer to a right: the right to buy or sell theunderlying asset at an agreed price at some agreed future date
A call option entitles the buyer of the option to buy the underlying assetat the agreed conditions
A put option entitles the buyer of the option to sell the underlying assetat the agreed conditions
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Options: English & German terminology
Basiswert Underlying
Kontraktgre Size
Laufzeit Expiration
Ausbungspreis Strike Price
Optionstyp Type
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Call and Put Options
Call Options A call option gives its owner the right to buy; it is not a promise to buy For example, a store holding an item for you for a fee is a call option
Put Options Aput option gives its owner the right to sell; it is not a promise to sell
For example, a lifetime money back guarantee policy on items sold by acompany is an embedded put option
AnAmerican option gives its owner the right to exercise the option anytimeprior to option expiration
A European option may only be exercised at expiration
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Categories of Options
Options giving the right to buy or sell shares of stock (stock options)are the best-known options An option contract is for 100 shares of stock
The underlying asset of an index option is some market measure like
the S&P 500 index Cash-settled
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Standardized Option Characteristics
Expiration dates
The Saturday following the third Friday of certain designated months formost options
Striking price The predetermined transaction price, in multiples of $2.50 or $5,
depending on current stock price
Underlying Security The security the option gives you the right to buy or sell Both puts and calls are based on 100 shares of the underlying security
The optionpremium is the amount you pay for the option
Exchange-traded options are fungible For a given company, all options of the same type with the same
expiration and striking price are identical
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Identifying An Option
Microsoft OCT 80 Call
Expiration (3rd Friday in October) Type of option
Underlying asset(Microsoft common stock)
Strike price($80 per share)
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Opening and Closing Transactions
When someone sells an option as an opening transaction, this is calledwriting the option No matter what the owner of an option does, the writer of the option keeps
the option premium that he or she received when it was sold
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The Basic Options Positions
The buyer of a call option is long a call option. He or she pays the
premium and purchases the right to buy the underlying asset at anagreed price. A profit is made if the market value of the underlying (S)> strike price (X) + the premium (P)
A longput entitles the buyer to the right to sell the underlying at an
agred price in return for paying the premium. A profit is made if S < X+ P
A shortcall entitles the seller of the option (writer) to receive thepremium. In return, he or she must deliver the underlying at the
exercise price if the option is exercised.
A shortput entitles the seller of the option to receive the premium. Inreturn, he or she must buy the underlying at the agreed price if theotion is exercised.
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Intrinsic Value and Time Value
Intrinsic value is the amount that an option is immediately worth giventhe relation between the option striking price and the current stock price For a call option, intrinsic value = stock price striking price (S X) For a put option, intrinsic value = striking price stock price (X S) Intrinsic value cannot be < zero
Intrinsic value(contd) An option with no intrinsic value is out-of-the-money An option whose striking price is exactly equal to the price of the underlying
security is at-the-money Options that are almost at-the-money are near-the-money
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Intrinsic Value and Time Value (contd)
Time value is equal to the premium minus the intrinsic value As an option moves closer to expiration, its time value decreases (time
value decay)
An option is a wasting asset
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Profit and Loss Diagrams
Vertical axis reflects profits or losses on the expiration day resulting from aparticular strategy
Horizontal axis reflects the stock price on the expiration day
Any bend in the diagram occurs at the striking price
By convention, diagrams ignore the effect of commissions that must be paid
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Intrinsic Value of a CALL: S - X
S: underlying X: strike Intrinsic Value
90 100 0
95 100 0
100 100 0
105 100 5
110 100 10
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In-the-Money CALL
Call: the strike price X is lower than the current price of the underlying S:
S X > 0
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At-the-Money CALL
Call: the strike price X is equal to the current price of the underlying S:
S = X
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Out-of-the-Money CALL
Call: the strike price X is higher than the current price of the underlying S:
S X < 0
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Intrinsic Value of a PUT: X - S
S: underlying X: strike Inrinsic Value
90 100 10
95 100 5
100 100 0
105 100 0
110 100 0
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In-the-Money PUT
Put: the strike price X is higher than the current price of the underlying S:
X - S > 0
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At-the-Money PUT
Put: the strike price X is equal to the current price of the underlying S:
X = S
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Out-of-the-Money PUT
Put: the strike price X is lower than the current price of the underlying S:
X - S < 0
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Buying a Call Option (Going Long)
Example: buy a Microsoft October 25 call for $3.70 Maximum loss is $3.70
Profit potential is unlimited
Breakeven is $28.70
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Buying a Call Option (contd)
Breakeven = $28.70
0 20 40 60 80 100
Maximum
loss = $3.70
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Writing a Call Option (Short Option)
Ignoring commissions, the options market is a zero sum game Aggregate gains and losses will always net to zero The most an option writer can make is the option premium
Writing a call without owning the underlying shares is called writing anaked (uncovered) call
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Writing a Call Option (contd)
Breakeven = $28.70
Maximum
Profit = $3.700 20 40 60 80 100
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Buying a Put Option (Going Long)
Example: buy a Microsoft April 25 put for $1.10 Maximum loss is $1.10
Maximum profit is $23.90
Breakeven is $23.90
B i P t O ti ( td)
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Buying a Put Option (contd)
$23.90Breakeven = $23.90
0 20 40 60 80 100
$1.10
W iti P t O ti
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Writing a Put Option
Breakeven = $23.90
$1.10
0 20 40 60 80 100
$23.90
The put option writer has the obligation to buy if the put is exercised by th
holder
P t ti P t
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Protective Puts
Definition
Microsoft example
Logic behind the protective put
Synthetic options
D fi iti
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Definition
Aprotective putis a descriptive term given to a longstock positioncombined with a longput position Investors may anticipate a decline in the value of an investment but cannot
conveniently sell
Mi ft E l
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Microsoft Example
Assume you purchased Microsoft for $28.51
Stock price at
option expiration
Profit or loss ($)
0
28.51
28.51
Microsoft Example (contd)
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Microsoft Example (contd)
Assume you purchased a Microsoft APR 25 put for $1.10
Stock price at
option expiration
0
1.10
23.90
23.90 25
Microsoft Example (contd)
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Microsoft Example (contd)
Construct a profit and loss worksheet to form the protective put:
Stock Price at Option Expiration
0 5 15 25 30 40
Long stock
@ $28.51
-28.51 -23.51 -13.51 -3.51 1.49 11.49
Long $25 put
@ $1.10
23.90 18.90 8.90 -1.10 -1.10 -1.10
Net -4.61 -4.61 -4.61 -4.61 0.39 10.39
Microsoft Example (contd)
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Microsoft Example (contd)
The worksheet shows that The maximum loss is $4.61
The maximum loss occurs at all stock prices of $25 or below
The put breaks even somewhere between $25 and $30 (it is exactly$29.61)
The maximum gain is unlimited
Microsoft Example (contd)
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Microsoft Example (cont d)
Protective put
Stock price at
option expiration
0
4.61
25
29.61
Writing Covered Calls to Protect Against
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Writing Covered Calls to Protect AgainstMarket Downturns
A call where the investor owns the stock and writes a call against it iscalled a covered call The call premium cushions the loss
Useful for investors anticipating a drop in the market but unwilling to sell theshares now
Writing Covered Calls to Protect Against
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Writing Covered Calls to Protect AgainstMarket Downturns
A JAN 30 covered call on Microsoft @ $1.20; buy stock @ 28.51
Stock price at
option expiration
0
27.31
30
2.69
27.31
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Combined Strategies
Straddles
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Straddles
A straddle is the best-known option combination
You are long a straddle if you own both a put and a call with the same Striking price
Expiration date
Underlying security
You are short a straddle if you are short both a put and a call with thesame Striking price
Expiration date Underlying security
Buying a Straddle
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Buying a Straddle
A long call is bullish
A long put is bearish
Why buy a long straddle? Whenever a situation exists when it is likely that a stock will move sharply
one way or the other
Buying a Straddle (contd)
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Buying a Straddle (cont d)
Suppose a speculator Buys a JAN 30 call on MSFT @ $1.20
Buys a JAN 30 put on MSFT @ $2.75
Buying a Straddle (contd)
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Buying a Straddle (cont d)
Construct a profit and loss worksheet to form the long straddle:
Stock Price at Option Expiration
0 15 25 30 45 55
Long 30 call
@ $1.20
-1.20 -1.20 -1.20 -1.20 13.80 23.80
Long 30 put
@ $2.75
27.25 12.25 2.25 -2.75 -2.75 -2.75
Net 26.05 11.05 -1.05 -3.95 11.05 21.05
Buying a Straddle (contd)
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Buying a Straddle (cont d)
Long straddle
Stock price at
option expiration
0
3.95
30
26.05
26.05 33.95
Two breakeven points
Buying a Straddle (contd)
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Buying a Straddle (cont d)
The worst outcome for the straddle buyer is when both options expireworthless Occurs when the stock price is at-the-money
The straddle buyer will lose money if MSFT closes near the striking
price The stock must rise or fall to recover the cost of the initial position
Buying a Straddle (contd)
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Buying a Straddle (cont d)
Buying Straddles:
If the stock rises, the put expires worthless, but the call is valuable If the stock falls, the put is valuable, but the call expires worthless
Writing Straddles: Popular with speculators
The straddle writer wants little movement in the stock price Losses are potentially unlimited on the upside because the short call isuncovered
Writing a Straddle (contd)
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g ( )
Short straddle
Stock price at
option expiration
0
26.05
30
3.95
26.05 33.95
Strangles
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g
A strangle is similar to a straddle, except the puts and calls havedifferent striking prices
Strangles are very popular with professional option traders
The speculator long a strangle expects a sharp price movement eitherup or down in the underlying security
With a long strangle, the most popular version involves buying a putwith a lower striking price than the call
Buying a Strangle (contd)
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y g g ( )
Suppose a speculator: Buys a MSFT JAN 25 put @ $0.70
Buys a MSFT JAN 30 call @ $1.20
Buying a Strangle (contd)
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y g g ( )
Long strangle
The maximum gains for the strangle writer occurs if both option expireworthless Occurs in the price range between the two exercise prices
Stock price at
option expiration0
1.90
25
23.10
23.10 31.90
30
Writing a Strangle (contd)
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g g ( )
Short strangle
Stock price atoption expiration0
23.10
25
1.90
23.10 31.90
30
Condors
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A condoris a less risky version of the strangle, with four differentstriking prices
There are various ways to construct a long condor
The condor buyer hopes that stock prices remain in the range betweenthe middle two striking prices
Buying a Condor (contd)
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Suppose a speculator: Buys MSFT 25 calls @ $4.20
Writes MSFT 27.50 calls @ $2.40
Writes MSFT 30 puts @ $2.75
Buys MSFT 32.50 puts @ $4.60
Buying a Condor (contd)
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Construct a profit and loss worksheet to form the long condor:
Stock Price at Option Expiration
0 25 27.50 30 32.50 35
Buy 25 call
@ $4.20
-4.20 -4.20 -1.70 0.80 3.30 5.80
Write 27.50 call
@ $2.40
2.40 2.40 2.40 -0.10 -2.60 -5.10
Write 30 put
@ $2.75
-27.25 -2.25 0.25 2.75 2.75 2.75
Buy 32.50 put
@ $4.60
27.90 2.90 0.40 -2.10 -4.60 -4.60
Net -1.15 -1.15 1.35 1.35 -1.15 -1.15
Buying a Condor (contd)
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Long condor
The condorwritermakes money when prices move sharply in eitherdirection
The maximum gain is limited to the premium
Stock price at
option expiration0
1.15
25
1.35
26.15
30
31.35
27.50 32.50
Writing a Condor (contd)
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Short condor
Stock price atoption expiration0
1.15
25
1.35
26.15
30
31.35
27.50
32.50
Spreads
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Introduction
Vertical spreads
Vertical spreads with calls
Vertical spreads with puts
Calendar spreads
Diagonal spreads
Butterfly spreads
Spreads: Introduction
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Option spreads are strategies in which the player is simultaneously longand short options of the same type, but with different Striking prices or
Expiration dates
Vertical Spreads
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In a vertical spread, options are selected vertically from the financialpages The options have the same expiration date
The spreader will long one option and short the other
Vertical spreads with calls
Bullspread Bearspread
Bullspread
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Assume a person believes MSFT stock will appreciate soon
A possible strategy is to construct a vertical call bullspreadand: Buy an APR 27.50 MSFT call
Write an APR 32.50 MSFT call
The spreader trades part of the profit potential for a reduced cost of theposition.
With all spreads the maximum gain and loss occur at the striking prices It is not necessary to consider prices outside this range
With a 27.50/32.50 spread, you only need to look at the stock prices from
$27.50 to $32.50
Bullspread (contd)
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Construct a profit and loss worksheet to form the bullspread:
Stock Price at Option Expiration
0 27.50 28.50 30.50 32.50 50
Long 27.50 call
@ $3
-3 -3 -2 0 2 19.50
Short 32.50 call@ $1
1 1 1 1 1 -16.50
Net -2 -2 -1 1 3 3
Bullspread (contd)
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Bullspread
Stock price atoption expiration0
2
3
32.50
29.50
27.50
Bearspread
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A bearspreadis the reverse of a bullspread The maximum profit occurs with falling prices The investor buys the option with the lower striking price and writes the
option with the higher striking price
Involves using puts instead of calls
Buy the option with the lower striking price and write the option with thehigher one
The put spread results in a credit to the spreaders account(credit spread)
The call spread results in a debit to the spreaders account(debit spread)
Bullspread (contd)
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A general characteristic of the call and put bullspreads is that the profitand loss payoffs for the two spreads are approximately the same The maximum profit occurs at all stock prices above the higher striking
price
The maximum loss occurs at stock prices below the lower striking price
Time Value of a CALL
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Quelle: FTCI Financialtraining GmbH
Time Value of a PUT
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Determinants of the price of an option
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Strike (exercise) price of the option X Current price of the underlying S
Remaining time to maturity of the option t
Volatility of the underlying
Riskless interest rate r