Overview of Options – An Introduction.

Options Definition The right, but not the obligation, to enter into a transaction [buy or sell] at a pre-agreed price, quantity, time [by a specified date in the future], and terms. The option buyer typically pays the seller an upfront free (the premium) for the option rights.

Basic Options Structures Calls – Options acquired by a buyer (holder) and granted by a seller (writer) to buy at a fixed price Puts – Options acquired by a buyer and granted by a seller to sell at a fixed price

Basic Options Structures All option products & strategies are some combination of buying or selling of calls or puts

Basic Options Provisions Buy or Sell (Write) –Long or Short Call or Put Underlying Asset –Product, Security / Instrument Strike (Exercise) Price Premium Exercise Date and Style

Basic Options Provisions - Strike Strike Price – Fixed price to be paid if option exercised, as specified in the options agreement

Basic Options Provisions - Premium Premium – Price of the option that buyer pays and seller receives at the time of option transaction. Consideration paid for rights

Option Exercise Provisions or “Style” American - Style European - Style

American-style Exercise Provision Buyer (Holder) may exercise at any time prior to expiry

European-style Exercise Provision Buyer (Holder) may exercise only on expiry date

Option Concepts Insurance Policy Analogy Commonly Cited Fee For Providing Financial Protection

Volatility Factor Measure Of The Degree Of Change In The Value Of The Underlying Asset Historical Volatility “Implied” Volatility

Very common jargon in financial trading Delta Vega Gamma Theta The “Greeks”  V  

The “Greeks” - Delta  The Most Commonly Watched Factor Since Used In Delta Hedging The Degree Of Change In Option Value In Relation To A Change In The Value Of The Underlying Asset

The “Greeks” - Vega Measures Effect On Premium Of A Change In Perceptions Of Future Volatility The Degree Of Change In Option Value Relative To A Change In The Price Volatility Of The Underlying Asset

The “Greeks” - Vega Vega Is Closely Followed By Traders Since Trading Options Is Viewed As Trading Volatility

The “Greeks” - Gamma  The Rate Of Change Of DeltaIf Delta is viewed as the ‘speed’ of price movement of option relative to underlying then option Gamma can be viewed as the acceleration. Basically, Gamma measures the amount by which delta changes for a 1 point change in the stock price.

The “Greeks” – Theta  Measures Effect On Premium Of A Change In Time To Expiry The Degree Of Change In Option Value In Relation To A Change In The Time To Expiry Becomes More Important Closer To Expiry

The “Greeks” – Theta  Time Value Decreases At A Faster Rate As Option Expiry Date Is Approached

When Do Traders Typically Use Options In Their Portfolios When Pricing Is Viewed As Attractive When Seeking To Enhance Portfolio Income –To Play The Market With Limited Risk (No More Than Premium Paid)

Likely Factors Influencing Pricing Of Options Price Volatility Of Underlying Asset Duration Of The Option – Time To Expiration Strike Price Of The Option Value Of The Underlying

Option Pricing Factors Higher The Volatility, The More Expensive The Option Longer The Life Of The Option, The More Expensive The Option

Historical Volatility Historical Volatility Is Determined From Past Price Data

Implied Volatility Implied Volatility Is Determined Mathematically From Option Pricing Formulas When Premium Is Known Implied Volatility Is Closely Watched By Traders Reflects Market Perceptions Of Future Volatility, Not Necessarily Historical Levels

Delta Hedging Dynamic Hedging – Using Futures To Hedge An Option Position Involves Frequently Buying And Selling Futures Contracts To “Re-Balance” Options Portfolio –Widely Used Technique

Delta Hedging Delta-Neutral – Maintaining A Risk Neutral Position (Hedging) Requires Continual Monitoring And Managing Trading Expertise

Option Value At-The-Money In-The-Money Out-Of-The-Money Option Price Can Be Viewed As Comprised Of Two Components –Intrinsic Value –Extrinsic Value, Time Value

Option Value - Intrinsic Intrinsic Value Of An Option Is Simply The Amount, If Any, By Which The Option Is In-The-Money Profit That Could Be Realized If Option Were Exercised Immediately

Option Value - Extrinsic Extrinsic Value Reflects The Potential Future Value Of The Option, Influenced Primarily By The Time Remaining To Expiry And The Price Volatility Of The Underlying Asset

Financial Risk On Options For Buyers Of Options, Risk (Of Losses) Are Limited To Premium Paid For Option –& Profits Are Potentially Unlimited, But… –…Be Careful… –A Very Deceiving Perspective:

Financial Risk On Options As Writers Of Options, Financial Exposure Would Be Potentially Unlimited Profits Are Limited To Premium Received

Examples

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