INDEX OPTIONS Are almost always European Options Eurpoean vs American Option Examples

American vs. European Options American options are better, because they’re American American Options can be exercised at any time up until expiration time T. European options cost less or the same European options can only be exercised at expiration T.

Arbitrage – Making money from nothing Price discrepancies between exchanges occur less and less frequently anymore because information moves so fast, but they DO happen. In June 2016, I noticed that CBOE mispriced call options on a gold ETF I had been following. The bid price of the $22 call was $0.02 less than the ask price of the $22.50 call. I immediately placed an order to sell 2000 contracts on the $22.50 call, while buying 2000 contracts of the $22. Only 31 contracts were executed before the prices were adjusted. I made $62 in under 2 minutes with zero-risk. If my entire order had filled, I would have made $4000 – too bad they realize their mistakes so quickly.

Pricing Bid – the highest price a buyer is willing to pay for an asset Ask – the lowest price at which a seller is willing to sell the asset Long position : you pay the Ask price Short position : you get the Bid price

Limit Orders - Get the best price Buy Limit @ $3.00 - Your order is executed when the ask price is $3.00 or less Sell Limit @ $3.00 - Your order is executed when the bid price is $3.00 or more

Stop orders - Ride the Wave Sell Stop Order @ $3.00 Current price is above $3.00. Your order is placed when the bid price reaches $3.00 Buy Stop Order @ $3.00 Current price is below $3.00. Your order is placed when the ask price reaches $3.00

Long or Short Long : You are buying Short : You are selling

Stock vs. Option - Risk involved When you buy a either, the most you can lose is the amount invested. Generally, the cost of an option is less than the cost of the underlying stock Ultimately, you are risking less capital in buying an option. So, what’s the downfall? Options can expire in-the-money or out-of-the-money. Out of the money means your option is worthless, equivalent to owning share of a company that goes bankrupt with senior debt.

ITM, ATM, OTM If a stock is trading at $100, and you buy a call option with an strike price of $99, you are in-the-money $1. Important consideration: If you paid $1 for the option, your profit is 0 until the underlying stock is above $100 If a stock is trading at $100, and you buy a call option with an strike price of $101, you are in-the-money $1.

Buying Stock Options A call is bullish on the underlying asset You are paying a premium for the option to purchase the stock at strike price K at time T. If the value of the underlying asset St > K at time T, you make money on the option by exercising it, capturing the difference St-K as your payoff. Your profit at T is St-K-C(St,T) A put option is bearish on the underlying asset You are paying for the option to sell the stock at K at time T. If St<K at T, you exercise the option capturing K-St as your payoff. Your profit at T is K-St-P(St,T)

The Downside to Options Call Option: If K>St at T, you paid for nothing. Your profit is -C(St,T) We don’t want that! Put Option: Similarly, if K<St at T, you paid for nothing Your profit is –P(St,T)

So why Choose Options? - Leverage Assume you have $100,000 to invest in a particular stock. You are considering buying XYZ stock that trades at $100 per share You can buy 1,000 shares of XYZ and when St = $101, you make $1,000 Instead, you choose to buy call options on XYZ for $0.80. You can buy 1,250 call contracts (100 options per contract) The stock price at T , ST = $101 and you make ($1-$0.80)*125,000 = $25,000

Whoops! It Didn’t Reach $100.80 You invested in XYZ at $100 and by T, the price is $100.50 Stock You made $0.50 * 1,000 shares = $500 on a $100,000 investment - meh Options You made ($0.50 - $0.80) * 125,000 = -$37,500 - Yikes!

Worst Case Scenario - XYZ drops to $99 Stock You lose $1,000 - and that sucks Call Option You lose everything. You’re broke. Your entire investment is worthless. As you can see, it’s very easy to lose everything in options if you end up being wrong.

Payoffs Calls and Puts

Long Short Payoff

Profit - Assume C=P=$0.50

Strategies Various Strategies can be employed based on your market expectations. One of my favorites is the Straddle. In this strategy, volatility is your friend. During the Brexit vote, I employed this strategy to secure +66% profit with very little (in my opinion) risk.

Straddle - Play both sides Gold is frequently bought in times of uncertainty. The Direxion Gold Miners 3X ETF (NUGT) is a favorite play for me. A Straddle is simply buying both a call and a put with the same strike price and expiration. In the following chart, I illustrate what went on during the trade time around the Brexit vote. The prices are not what actually happened, but the point should be clear.

On the next day, I exercised my call and sold off my put option at St=$22.50 for a fantastic return of over 66% with very low risk

Trump up my gains! On 11/8/16, I bought a similar Straddle on NUGT, exercised the call the next day, and exercised the put on 11/11. Catching BOTH sides of the volatility, I made a ridiculous 89% return that week, again with very little risk.

Short Straddle - For when markets stagnate We’ve seen how money can be made on volatility with the long straddle strategy, but what about when a stock just doesn’t move? The short straddle is the antithesis of the long straddle, as the name implies. Rather than making a profit on the price movement of the underlying stock, we hope to take a profit C+P from selling a call and a put where K=St

As long as the price of the underlying stock doesn’t move more than C+P, you profit.