OptionsOptions

Topic 9Topic 9

I. I. OptionsOptions

A. Definition: The right to buy or sell a A. Definition: The right to buy or sell a specific issue at a specified price (the specific issue at a specified price (the exercise price) on or before a specified exercise price) on or before a specified date regardless of what the market price date regardless of what the market price of the security is on the date the option of the security is on the date the option is exercised.is exercised.

B. Call: The right to buy a security.B. Call: The right to buy a security. C. Put: The right to sell a security.C. Put: The right to sell a security.

I. I. Options (continued)Options (continued)

D. Option WriterD. Option Writer• The person who writes the call or put and The person who writes the call or put and

receives a premium.receives a premium. E. Option BuyerE. Option Buyer• The person who buys the call or put and The person who buys the call or put and

pays the premium.pays the premium.

I. I. Options (continued)Options (continued)

Stock and Option Markets are unrelated Stock and Option Markets are unrelated except for the market price of a stock in except for the market price of a stock in the stock market and the exercise price of the stock market and the exercise price of the stock option.the stock option.

CompanyCompany Stock Stock MarketMarket

InvestorInvestor Option Option MarketMarket

Option Option InvestorInvestor

F. Relation of Options to Stock

II. II. Investor Profit ProfilesInvestor Profit Profiles

Assume you bought 1 share of T.I. at Assume you bought 1 share of T.I. at $40. This is your profit profile given $40. This is your profit profile given various assumptions about T.I.’s future various assumptions about T.I.’s future market price.market price.

II.II. Investor Profit Profiles Investor Profit Profiles

A. Call Option Profit Graph of Buyer A. Call Option Profit Graph of Buyer and Sellerand Seller• Situation: Investor thinks a security will Situation: Investor thinks a security will

increase in price -- can buy security or a increase in price -- can buy security or a call option. If price declines, Investor has a call option. If price declines, Investor has a capital loss in long position or loses his capital loss in long position or loses his option premium when expired.option premium when expired.

1. 1. Profit Graph of Call BuyerProfit Graph of Call Buyer

• Note: Upside potential is unlimited, Note: Upside potential is unlimited, Downside risk is limitedDownside risk is limited

Gain

Loss

0

Premium Paid (Price to purchase Option)

Strike Price

ProfitGain

MarketPrice

2. 2. Profit Graph of a Call SellerProfit Graph of a Call Seller

• Note: Upside potential is limited to the premium Note: Upside potential is limited to the premium received. Downside risk is unlimited.received. Downside risk is unlimited.

Gain

Loss

0

Premium Received

Strike Price

ProfitLoss

MarketPrice

B. B. Put Option Profit Graph of Put Option Profit Graph of Buyer and SellerBuyer and Seller

SituationSituation: Investor thinks a security will : Investor thinks a security will decrease in price -- can short sell or buy decrease in price -- can short sell or buy a PUT option. If the security increases a PUT option. If the security increases in price, the short position produces a in price, the short position produces a capital loss and the option position capital loss and the option position produces a premium loss.produces a premium loss.

1. 1. Profit Graph of Put BuyerProfit Graph of Put Buyer

Note: Upside potential is limited to the price Note: Upside potential is limited to the price of the security. Downside risk is limited to of the security. Downside risk is limited to the premium.the premium.

Gain

Loss

0

Premium

Strike PriceMarketPrice

2. 2. Profit Graph of Put SellerProfit Graph of Put Seller

Note: Upside potential is limited to Note: Upside potential is limited to premium. Downside risk is limited to premium. Downside risk is limited to price of security.price of security.

Gain

Loss

0

Premium

Strike Price

MarketPriceLoss

C. C. Listed Options QuotesListed Options Quotes

OptionOption StrikeStrike CallsCalls Price MayPrice May AugAugNovNov

MobilMobil 2020 88 8 3/48 3/4 99

27 1/827 1/8 2525 33 3 5/83 5/8 44

27 1/827 1/8 3030 1/21/2 1 1/41 1/4 1 5/8 1 5/8

C. Listed Options Quotes C. Listed Options Quotes (continued)(continued)

OptionOption StrikeStrike PutsPuts PricePrice MayMay AugAug

NovNov

MobilMobil 2020 1/81/8 5/165/16 5/85/8

27 1/827 1/8 2525 11/1611/16 1 1/81 1/8 1 1/4 1 1/4

27 1/827 1/8 3030 3 3/83 3/8 3 3/83 3/8 rr

Mobil common stock closed at 27 1/78 per Mobil common stock closed at 27 1/78 per share on February 25, 1996.share on February 25, 1996.

D. D. Option PremiumsOption Premiums

1. Option premium is the price an 1. Option premium is the price an option buyer must pay for the right option buyer must pay for the right and the price an option writer and the price an option writer receives for selling the right.receives for selling the right.

D. D. Option Premiums (continued)Option Premiums (continued)

2. 2. Affected byAffected by• a. The Security Pricea. The Security Price

– Premiums are directly related to the relative Premiums are directly related to the relative magnitude of the security price magnitude of the security price since the risk since the risk of price change is a function of the price.of price change is a function of the price.

– Example:Example: Stock A: P = $100Stock A: P = $100

Stock B: P = $10Stock B: P = $10– Loss potential as a result of changes in security Loss potential as a result of changes in security

price is greater for Stock A and hence, the option price is greater for Stock A and hence, the option writer will require a greater premium.writer will require a greater premium.

D. D. Option Premiums (continued)Option Premiums (continued)

• b. Length of Option Life:b. Length of Option Life:• 3, 6, 9 months3, 6, 9 months

• Longer term options on the same Longer term options on the same security are riskier since the security are riskier since the probability of adverse price changes probability of adverse price changes increases with time. Higher increases with time. Higher premiums compensate the seller for premiums compensate the seller for this greater risk.this greater risk.

D. D. Option Premiums (continued)Option Premiums (continued)

• c. Variability of Returnsc. Variability of Returns

–The greater the past variability of return The greater the past variability of return on the security, the more likely that the on the security, the more likely that the option will be exercised. Greater return option will be exercised. Greater return variability translates into greater option variability translates into greater option risk, for which, the writer wants to be risk, for which, the writer wants to be compensated for.compensated for.

D. D. Option Premiums (continued)Option Premiums (continued)

• d. d. Exercise PriceExercise Price– 1. In-the-Money: Call exercise price is below 1. In-the-Money: Call exercise price is below

the current market price.the current market price.– 2. At-the-Money: Call exercise price is equal 2. At-the-Money: Call exercise price is equal

to the current market price.to the current market price.– 3. Out-the-Money: Call exercise price is above 3. Out-the-Money: Call exercise price is above

the current market price.the current market price.– Relation between Call Premium and Exercise Relation between Call Premium and Exercise

Price:Price:

E. E. Option Trading StrategiesOption Trading Strategies

1. 1. Buying Call OptionsBuying Call Options• a. Buying to achieve leveragea. Buying to achieve leverage

– The price of a call of 100 shares is significantly The price of a call of 100 shares is significantly lower than buying the shares outright.lower than buying the shares outright.

– Example: IBM sells at $50/share and a $50 call Example: IBM sells at $50/share and a $50 call costs $5/share. The Investor can buy the call for costs $5/share. The Investor can buy the call for $500 instead of the shares for $5,000. If IBM $500 instead of the shares for $5,000. If IBM goes to $60, the value of the option is $1000.goes to $60, the value of the option is $1000.

– Return on option: $1000/$500 = 200%Return on option: $1000/$500 = 200%

– Return on stock purchase: $1000/$5000 = 20%Return on stock purchase: $1000/$5000 = 20%

E. E. Option Trading StrategiesOption Trading Strategies (continued) (continued)

• b. Buying call options to limit riskb. Buying call options to limit risk– Investor dislikes the risk of buying IBM and watching Investor dislikes the risk of buying IBM and watching

it go down in value. Therefore, Investor purchases it go down in value. Therefore, Investor purchases IBM 50 call at $5 and puts remaining $ in risk-free IBM 50 call at $5 and puts remaining $ in risk-free securities. Hence, given the same $5,000, the securities. Hence, given the same $5,000, the Investor buys call and puts $4,500 into R securities.Investor buys call and puts $4,500 into R securities.

– Example: If IBM goes to $60, the Investor can buy Example: If IBM goes to $60, the Investor can buy or exercise the option to net $1,000 plus interest or exercise the option to net $1,000 plus interest from R investment. If IBM stays at $50 or falls from R investment. If IBM stays at $50 or falls below, the investor has lost his option premium below, the investor has lost his option premium which is partly offset by interest which is partly offset by interest income.income.

E. E. Option Trading StrategiesOption Trading Strategies (continued) (continued)

• c. Buying call option to hedge c. Buying call option to hedge short stock positionshort stock position– Investor believes IBM will decline. Investor believes IBM will decline.

Investor sells IBM short to obtain total Investor sells IBM short to obtain total profit potential but he is exposed to profit potential but he is exposed to unlimited loss from stock price increase. unlimited loss from stock price increase. The Investor buys a call to eliminate The Investor buys a call to eliminate loss.loss.

E. E. Option Trading Strategies Option Trading Strategies (continued) (continued)

2. Put Option Strategies2. Put Option Strategies• a. Buying Put options for leverage and a. Buying Put options for leverage and

limited risklimited risk– Investor anticipates significant decrease in the Investor anticipates significant decrease in the

stock price but does not have the margin stock price but does not have the margin money for a short sale, and does not want to be money for a short sale, and does not want to be exposed to unlimited risk of stock price exposed to unlimited risk of stock price increases. Investor buys a put.increases. Investor buys a put.

– NOTE: Stock price must decline enough to NOTE: Stock price must decline enough to break even.break even.

E. E. Option Trading Strategies Option Trading Strategies (continued) (continued)

• b. Buying Put options to hedge against b. Buying Put options to hedge against a stock price declinea stock price decline– Investor holds IBM and has already taken a Investor holds IBM and has already taken a

paper profit. Investor believes IBM will go paper profit. Investor believes IBM will go higher and would like to participate in upside higher and would like to participate in upside without risking a loss on paper profit. Buys a without risking a loss on paper profit. Buys a put. If price goes up, the potential is only put. If price goes up, the potential is only diminished by the cost of the put, whereas the diminished by the cost of the put, whereas the paper profits are protected by the put and paper profits are protected by the put and decreased only by the put price.decreased only by the put price.

Buying Put OptionsBuying Put Options

Market Price

Net Profit

Gain

Loss

0

OptionProfit

LongPosition

E. E. Option Trading Strategies Option Trading Strategies (continued)(continued)

3. Option Writing Strategies3. Option Writing Strategies• DefinitionDefinition: An investor holds 100 : An investor holds 100

shares of IBM. Writes 2 calls and shares of IBM. Writes 2 calls and receives the option call premiums. receives the option call premiums. One option is One option is coveredcovered and the other and the other is is nakednaked..

E. E. Option Trading Strategies Option Trading Strategies

4. Writing Call Options Strategies4. Writing Call Options Strategies• a. Writing covered callsa. Writing covered calls

– Investor owns 100 shares of IBM ($50) and writes a Investor owns 100 shares of IBM ($50) and writes a call at $55 to earn a greater return than the stock call at $55 to earn a greater return than the stock alone. Investor earns D = $1.00 plus $5.00 on the call. alone. Investor earns D = $1.00 plus $5.00 on the call. Return is $6.00 plus any capital gains. Return is $6.00 plus any capital gains.

– Disadvantage: if price goes above $55, the upside is Disadvantage: if price goes above $55, the upside is limited to $6.00.limited to $6.00.

– Note: Covered call also provides limited protection to Note: Covered call also provides limited protection to writer against price decline. Price can decline to $45 writer against price decline. Price can decline to $45 ($50-Premium) before writer experiences paper loss.($50-Premium) before writer experiences paper loss.

E. E. Option Trading StrategiesOption Trading Strategies

• b. Writing naked callsb. Writing naked calls

• Investor writes a call on IBM Investor writes a call on IBM and receives a premium and receives a premium income without owning the income without owning the security.security.

Writing Naked CallsWriting Naked Calls

Gain

Loss

0Limited Gain

UnlimitedLoss

Market Price$50

Gain is limited to the value of the premium. Gain is limited to the value of the premium. Loss is unlimited because the investor must Loss is unlimited because the investor must go to the market to buy at a higher price to go to the market to buy at a higher price to deliver $50/share stock at the exercise price.deliver $50/share stock at the exercise price.

E. E. Option Trading Strategies Option Trading Strategies (continued)(continued)

5. Writing Put Option Strategies5. Writing Put Option Strategies• a. Writing Puts for Premium Incomea. Writing Puts for Premium Income– Investor expects the price of the stock Investor expects the price of the stock

he holds to increase. Therefore, he can he holds to increase. Therefore, he can write a covered put to increase income. write a covered put to increase income. The only risk is that the stock falls below The only risk is that the stock falls below current market price.current market price.

Profit ProfileProfit Profile

Market Price

Profit

Gain

Loss

0Option Profit

Long PositionNet Profit/Loss

E. E. Option Trading Strategies Option Trading Strategies (continued)(continued)

6. Buying or Writing an Option Straddle6. Buying or Writing an Option Straddle• An Option Straddle is the purchase or the writing An Option Straddle is the purchase or the writing

of both a put and a call on the same security.of both a put and a call on the same security.• a. Buying a Straddle: Price of underlying a. Buying a Straddle: Price of underlying

security is expected to move SHARPLY up or security is expected to move SHARPLY up or down before option expiration date. Buy a put down before option expiration date. Buy a put and a call. Say you pay a put and a call and a call. Say you pay a put and a call premium of $3.00 each. If the stock moves from premium of $3.00 each. If the stock moves from $50 to above $56 or below $44, a profit is made.$50 to above $56 or below $44, a profit is made.

Profit ProfileProfit Profile

• b. Writing a Straddle: Price of the b. Writing a Straddle: Price of the underlying security is expected to stay at underlying security is expected to stay at its current market value until the option its current market value until the option expires. Write a put and write a call at expires. Write a put and write a call at $3.00 each and receive a total premium of $3.00 each and receive a total premium of $6.00.$6.00.

• As long as the stock price remains As long as the stock price remains between $44 and $56, the option straddle between $44 and $56, the option straddle writer makes a profit.writer makes a profit.

F. Other Option StrategiesF. Other Option Strategies

1. Bull Spread1. Bull Spread• Buying a call and selling a call with a Buying a call and selling a call with a

higher strike pricehigher strike price• Examples:Examples:– 1. Buy call with $90 SP1. Buy call with $90 SP

• Premium = $5Premium = $5

– 2. Sell a call with $95 SP2. Sell a call with $95 SP• Premium = $2Premium = $2

Profit ProfileProfit Profile

85 90 95 100 105 110

P = $90

Question: If stock price goes to $97, Question: If stock price goes to $97, what is the net profit to the investor?what is the net profit to the investor?

Assignment: Determine profits from a Assignment: Determine profits from a range of $85 to $110 & profit profile.range of $85 to $110 & profit profile.

F. Other Option Strategies F. Other Option Strategies (continued)(continued)

2. Bear Spread2. Bear Spread• Buy a put option and sell a put with a lower Buy a put option and sell a put with a lower

strike pricestrike price• Examples:Examples:– 1. Buy a put with $110 SP1. Buy a put with $110 SP

• Premium = $5Premium = $5

– 2. Sell put with $105 SP2. Sell put with $105 SP• Premium = $2Premium = $2

Profit ProfileProfit Profile

85 90 95 100 105 110

P = $110

115

Assignment: Determine net profits from Assignment: Determine net profits from a range of prices of $85-$115.a range of prices of $85-$115.• Also generate a graph or “profile”.Also generate a graph or “profile”.

F. Other Option Strategies F. Other Option Strategies (continued)(continued)

3. BUTTERFLY SPREAD3. BUTTERFLY SPREAD• The butterfly spread is a neutral position that is a The butterfly spread is a neutral position that is a

combination of both a bull and bear spread.combination of both a bull and bear spread.– Example: P = $60Example: P = $60

July 50 call:July 50 call: $12$12July 60 call:July 60 call: 6 6July 70 call:July 70 call: 3 3

– Butterfly spread:Butterfly spread:Buy 1 July 50 call:Buy 1 July 50 call: ($1200)($1200)Sell 2 July 60 calls:Sell 2 July 60 calls: 1200 1200Buy 1 July 70 call:Buy 1 July 70 call: (300)(300)

(300) (300)

Profit Profile (Bicycle)Profit Profile (Bicycle)

Assignment: Determine net profits from Assignment: Determine net profits from a range of $40-$80. Profit profile.a range of $40-$80. Profit profile.

50 53 60 67 70

F. Other Option Strategies F. Other Option Strategies (continued)(continued)

4. Calendar or Time Spread4. Calendar or Time Spread• Involves the sale of one option and the Involves the sale of one option and the

simultaneous purchase of a more distant simultaneous purchase of a more distant option, both with the same strike price.option, both with the same strike price.

Calendar or Time SpreadCalendar or Time Spread

ExampleExample• JAN.JAN. APR50’sAPR50’s JUL50’s OCT50’sJUL50’s OCT50’s• XYZ: 50XYZ: 50 $5 $5 $8 $8 $10 $10

Neutral Spread: investor should have Neutral Spread: investor should have the initial intent of closing the spread by the initial intent of closing the spread by the time the near-term option expires.the time the near-term option expires.

Calendar or Time Spread Calendar or Time Spread (continued)(continued)

Assume the following:Assume the following:Call OptionsCall Options

APRIL 50APRIL 50 JULY 50JULY 50 OCT 50OCT 50

JANJAN (3 mo.) (3 mo.) (6 mo.)(6 mo.) (9 mo.)(9 mo.)

P=50P=50 5 5 8 8 10 10

APRAPR

P=50P=50 0 0 5 5 8 8

Calendar or Time Spread Calendar or Time Spread (continued)(continued)

In January the investor sells the APR 50 call In January the investor sells the APR 50 call and buys the July 50. His debit position isand buys the July 50. His debit position is-3 points.-3 points.

In April the price is unchanged and the 3 month In April the price is unchanged and the 3 month call (July) should be worth 5. The spread call (July) should be worth 5. The spread between the April 50 and the July 50 has now between the April 50 and the July 50 has now widened to 5. Since the spread cost 3, a 2 pt. widened to 5. Since the spread cost 3, a 2 pt. profit exists. Investor should now close his long profit exists. Investor should now close his long position by selling his July 50 call and reaping a position by selling his July 50 call and reaping a 2 pt. profit.2 pt. profit.

Profit ProfileProfit Profile

50 6040

Bullish Calendar SpreadBullish Calendar Spread

Investor sells the near-term call and buys a Investor sells the near-term call and buys a longer-term call when the underlying stock longer-term call when the underlying stock is some distance below the SP of the calls.is some distance below the SP of the calls.

Feature of low dollar investment and large Feature of low dollar investment and large potential profit.potential profit.

Example:Example: XYZ: $45 in Jan.XYZ: $45 in Jan.Sell April 50 for $1Sell April 50 for $1

Buy July 50 for $1 1/2Buy July 50 for $1 1/2

Bullish Calendar Spread Bullish Calendar Spread (continued)(continued)

Investor wants 2 things to happen:Investor wants 2 things to happen:• 1. Near-term call expires worthless1. Near-term call expires worthless• 2. Stock price must rise by the time July 2. Stock price must rise by the time July

call expirescall expires

Assume price goes to 52 b/w April & Assume price goes to 52 b/w April & July. Investor nets 1 1/2 pts. How?July. Investor nets 1 1/2 pts. How?