Option Strategies

Russell Rhoads, CFA

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In order to simplify the computations, commissions have not been included in the examples used in these materials. Commission costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Multiple-leg strategies involve multiple commission charges.

Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.

Options involve risks and are not suitable for all investors. Prior to buying or selling an option, an investor must receive a copy of Characteristics and Risks of Standardized Options. Copies are available from your broker or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606. Investors considering options should consult their tax advisor as to how taxes may affect the outcome of contemplated options transactions.

Cboe and Chicago Board Options Exchange are registered trademarks and The Options Institute is a servicemark of Cboe. All other trademarks and servicemarks are the property of their respective owners.

This presentation should not be construed as an endorsement or an indication by Cboe of the value of any non-Cboe product or service described in this presentation.

Copyright © 2017 Cboe Global Markets, Incorporated. All rights reserved.

Disclosure

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Time Decay

Covered Call

Cash Secured Put

Winged Spreads

Buffett Put Trade

Option Strategies

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A good portion of professional option trading is implemented by professionals selling calls or puts

One of the goals behind these sorts of trades is to take advantage of the time decay of option prices

Not all time decay is the same and the biggest ‘bang for the buck’ comes from selling at-the-money options

Time Decay

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60 Days of Time Decay

Time Decay

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60 55 50 45 40 35 30 25 20 15 10 5 0

Op

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Days to Expiration

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The covered call is one of the most common uses of the options market by all levels of market participants

This trade combines a long stock position with a short call option

The obligation to sell shares is ‘covered’ by the long stock position

There are two potential motivations creating a covered call, as an exit strategy or to increase performance intending to hold shares

Covered Call

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DR Horton (DHI) Daily Price Action

Data Source: Bloomberg

Covered Call

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7/26/17 8/8/17 8/21/17 9/1/17 9/15/17 9/28/17

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DHI may be considered a little extended rising over 5% in the last four days

As a holder of 100 shares of DHI we either believe the move is overdone or would be happy selling just over current levels

Based on this outlook we decide to explore selling a call option against our shares

Covered Call

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DHI @ 39.00

Sell 1 DHI Oct 27th 40.00 Call at 0.45

Data Source: www.livevolpro.com

Covered Call

Expiration Date Trading Days 39.00 Call 40.00 Call6-Oct 6 0.40 0.10

13-Oct 11 0.55 0.2020-Oct 16 0.75 0.3027-Oct 21 0.85 0.453-Nov 26 0.95 0.55

10-Nov 31 1.35 0.9017-Nov 36 1.45 1.05

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Long 100 DHI at 39.00 + Short 1 Oct 27th 40.00 Call at 0.45

Covered Call

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37 38 39 40 41 42 43

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The cash secured put has been rising in popularity over the past few years as investor knowledge of the option market has increased

A cash secured put combines a short put position with cash

The cash portion of this spread results in the position holder having the ability to make good on the obligation to buy shares that accompanies a short put

Two potential motivations behind a cash secured put may be either to purchase shares at a discount to current prices or receive income from selling the put with out purchasing shares

Cash Secured Put

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October 20, 2017

SPX at 2568.88

Sell SPX Nov 17th 2565 Put at 16.80

Cash Secured Put

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Cash + Short Nov 2565 Put Payoff At Expiration

Cash Secured Put

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2515 2540 2565 2590

November 17th

Settlement 2571.76

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Iron butterflies and iron condors are a type of spread known as a winged spread

These trades target a range of price levels for the underlying stock or index

Typically these are neutral trades, but can be directional as well

In order to realize the full profit of a condor or butterfly it will need to held until just before or through expiration

Winged Spreads

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Iron Butterfly Example

11/29/2017 – SPX @ 2626.07

Buy SPX Dec 22nd 2600 Put at 13.60

Sell SPX Dec 22nd 2625 Put at 21.30

Sell SPX Dec 22nd 2625 Call at 22.10

Buy SPX Dec 22nd 2650 Call at 10.60

Net Credit = 19.20

Winged Spreads

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SPX Dec 22nd 2600 – 2625 – 2650 Iron Butterfly Payoff Diagram

Winged Spreads

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2590 2595 2600 2605 2610 2615 2620 2625 2630 2635 2640 2645 2650 2655 2660

2 Days toExpiration

At Expiration

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SPX Dec 22nd 2600 – 2625 – 2650 Iron Butterfly Time Decay

Winged Spreads

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16 14 12 10 8 6 4 2 0

At-The-MoneyOptions

Out-of-The-MoneyOptions

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Iron Condor Example

11/29/2017 – RUT @ 1542.30

Buy RUT Dec 22nd 1520 Put at 13.80

Sell RUT Dec 22nd 1530 Put at 16.80

Sell RUT Dec 22nd 1555 Call at 15.30

Buy RUT Dec 22nd 1565 Call at 11.40

Net Credit = 6.90

Winged Spreads

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1510 1515 1520 1525 1530 1535 1540 1545 1550 1555 1560 1565 1570 1575

RUT Dec 22nd 1520 – 1530 – 1555 – 1565 Iron Condor Payoff

Winged Spreads

2 Days toExpiration

At Expiration

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In his 2002 annual letter Warren Buffett stated this,

“In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially

lethal”

And ever since it has been used incorrectly by the financial press.

The Warren Buffett Put Trade

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In the 2008 annual letter Buffett let us know this,

From 2004 and 2008 Berkshire Hathaway entered into a few dozen over the counter option trades.

They sold at the money puts on four broad based equity market indexes; the S&P 500, FTSE 100, Euro Stoxx 50, and Nikkei 225 taking in

a total of $4.5 billion in premiums.

The financial press sort of missed this one.

The Warren Buffett Put Trade

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Index Price Chart

Data Source: Bloomberg

The Warren Buffett Put Trade

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2003 2006 2008 2011 2013 2016

S&P 500

Nikkei 225

FTSE 100

EuroStoxx 50

Buffett Selling Puts

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A few years ago some of the trades were taken off and a profit of $222 million was realized

Currently index puts that were sold for $4.2 billion remain outstanding

As of the end of the 3rd quarter the value of the remaining options, using a pricing model, was $2.19 million placing the unrealized profit at about $2 billion

The intrinsic value of these options is down to $640 million

These options begin to expire on June 2018

The Warren Buffett Put Trade

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Put Trade Performance

Data Source: www.berkshirehathaway.com

The Warren Buffett Put Trade

($6.00)

($5.00)

($4.00)

($3.00)

($2.00)

($1.00)

$0.00

$1.00

$2.00

$3.00

2008 2009 2010 2011 2012 2013 2014 2015 2016 3Q2017

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All levels of successful option traders find a way to have time decay work for them

Cboe has several indexes that show how these strategies have worked over time, but also in certain market environments

Option strategies are appropriate for all levels of traders, even older gentlemen living in Nebraska

Contact for future questions

rhoads@cboe.com

Summary