Corporate Finance IMBA 2015 – session 7 Financial Options Corporate Finance IMBA 2015 – session 7

What are financial options The right to buy or sell financial assets in the future at a certain price (strike price) at a certain time (expiry date) or earlier… Difference with Futures: The buyer can chose not to exercise the option (futures are always exercised) An options contract is not symmetric (it is not a zero sum game) The buyer has more rights than the seller of the option (the buyer decides if the option will be exercised) The buyer of an option pays the seller an upfront price for the option (premium)

Option contracts and markets Call Option: the right to buy a financial asset in the future at a certain price and within a certain time Put Option: the right to sell a financial asset in the future at a certain price and within a certain time Yes it is true!

Buy and Sell Both Call and Put options can be bought and sold The seller of the option is also called the writer of the option For every buyer of an option there is a seller The price at which the trader can trade is the strike price (exercise price) Some options can only be exercised/traded at expiry date (European options) but nowadays almost all options can be traded daily (American options) More and more selling and buying is done through on line transactions

Call Option

Call Option

Put Option

Put Option

Option Strategies…and Time

Option Strategies…and Volatility

In-At-Out of the Money

Option Value=Time Value + Intrinsic Value

Let’s look at reality You like ebaY You expect the share price to grow fast based on the guidance of analysts So you buy Call Options Let’s first see where ebaY trades today and decide what Call Option to buy Last Trade $ 35.55 July 11th 2005 If you buy call $35 your option is in the money and the premium will be relatively high

The Equity Market CALL OPTIONS Expire at close Fri, Jul 15, 2005 Strike Symbol Last Chg Bid Ask Vol Open Int 22.5 QXBGB.X 11.5 12.9 13.1 20 420 25 QXBGE.X 10.4 10.5 10.6 402 749 27.5 QXBGC.X 6.6 8 8.1 10 584 30 XBAGF.X 5.5 5.6 769 3,963 32.5 XBAGZ.X 3 3.1 1,248 10,004 35 XBAGG.X 0.8 0.75 11,082 34,152 37.5 XBAGU.X 0.1 0.05 2,335 41,129 The $35 series is $0.55 in the money; the $ 37.50 series is out of the money but you will pay $ 0.10 time value

If you buy an option with a longer life… CALL OPTIONS Expire at close Fri, Oct 21, 2005 Strike Symbol Last Chg Bid Ask Vol Open Int 22.5 QXBJB.X 11.5 13.3 13.5 10 152 25 QXBJE.X 11.2 10.9 11.1 15 625 27.5 QXBJC.X 8.5 8.6 8.8 11 276 30 XBAJF.X 6.6 6.4 74 3,898 32.5 XBAJZ.X 4.6 4.5 4.7 135 1,189 35 XBAJG.X 3.2 3 1,135 6,963 37.5 XBAJU.X 1.95 1.9 621 5,388 So now you can see the extra time value of adding 3 months to expiry date; $ 1.85 for the $ 37.50 series

Your decision You do not want to buy in the money (simply too expensive) You do not want to buy a series that expires 15th July (in 4 days) So you buy the $ 37.50 October 2005 for $ 1.95 Depending on the share price movements of ebaY you will add profits or losses but you can never loose more than $ 1.95 (note that this is for 100 options/shares and thus you will pay $ 195.- excluding transaction costs) You can follow the premium for this series every day/hour/minute when the market is opened You can calculate your profit/loss and decide to sell before 21st October 2005 (expiry date)

Performance of shares

You are not sure… After you have looked at the share price performance of ebaY recently you have become less sure about the upward potential of this share between today (11th July) and 21st October 2005 You know this share is very volatile and it will definitely at a different level on 21st October but you do not know if it will be much higher or lower than today’s level of $ 35.55 From the last 3 months you can see the share price can easily deviate 10% from today’s level ($ 3.55) So you decide to buy a Call Option and a Put Option (both out of the money; both October 2005 and both as close as possible to today’s share price as possible) You still buy Call $37.50 October 2005 (at $ 1.95) and you buy Put $ 35 October 2005 (at $ 2.15) Every set of 1 Call and 1 Put will cost you $ 195+$ 215= $ 410 and this is the maximum amount you can loose…

Quotes for puts October 2005 ebaY PUT OPTIONS Expire at close Fri, Oct 21, 2005 Strike Symbol Last Chg Bid Ask Vol Open Int 22.5 QXBVB.X 0.15 0.1 19 3,118 25 QXBVE.X 0.25 116 7,100 27.5 QXBVC.X 0.4 0.35 10 755 30 XBAVF.X 0.7 N/A 38 9,852 32.5 XBAVZ.X 1.3 620 6,161 35 XBAVG.X 2.15 256 11,744 37.5 XBAVU.X 3.57 614 4,523

Before you know it…. You are setting up a strategy to make money or hedge risks In this case you buy calls and puts of the same series ; this strategy is called a Straddle… As you can see you can combine any combination of Calls and Puts , buying or selling, strike prices and different expiry dates and built your own strategy…

Let’s see how you are doing on 19th July 2005 The $35 put premium has come down from $ 2.15 to $ 2.- although the share has lost value ($ 35.55 on 11 th July now $ 35.37) the time value has evaporated more quickly The call premium also has come down from $3.20 to $ 2.75 ($ 0.18 of this move is the loss in intrinsic value-remember the call is in the money) You see that the premiums do not move symmetric over time…given the price movements of the underlying asset You have lost $ 5.35-$4.75=$0.60 (times 100 shares per option contract) $ 60 on your investment of $535 What will you do? Hang in there?

19 july 2005 CALL OPTIONS Strike Symbol Last Chg Bid Ask Vol Open Int Get Options for: Options 19 july 2005 View By Expiration: Aug 05 | Sep 05 | Oct 05 | Jan 06 | Jan 07 | Jan 08 CALL OPTIONS Expire at close Fri, Oct 21, 2005 Strike Symbol Last Chg Bid Ask Vol Open Int 22.5 QXBJB.X 13 12.9 13.3 2 174 25 QXBJE.X 10.5 10.9 6 617 27.5 QXBJC.X 8.5 8.2 11 273 30 XBAJF.X 6.1 N/A 17 3,910 32.5 XBAJZ.X 4.3 33 1,363 35 XBAJG.X 2.75 225 7,805 37.5 XBAJU.X 1.65 5,466 6,750

And put premiums on 19 july PUT OPTIONS Expire at close Fri, Oct 21, 2005 Strike Symbol Last Chg Bid Ask Vol Open Int 22.5 QXBVB.X 0.1 0.05 1 3,118 25 QXBVE.X 0.2 10 7,103 27.5 QXBVC.X 0.3 0.35 31 844 30 XBAVF.X 0.56 N/A 51 9,805 32.5 XBAVZ.X 1.1 2,223 6,225 35 XBAVG.X 2 214 12,486 37.5 XBAVU.X 3.5 29 5,561

And on August 15… CALL OPTIONS Strike Symbol Last Chg Bid Ask Vol Expire at close Fri, Oct 21, 2005 Strike Symbol Last Chg Bid Ask Vol Open Int 22.5 QXBJB.X 21.8 N/A 20 158 25 QXBJE.X 16.7 10 447 27.5 QXBJC.X 14.2 281 30 XBAJF.X 12 3,737 32.5 XBAJZ.X 9.5 2 1,155 35 XBAJG.X 7.4 95 6,580 37.5 XBAJU.X 5.2 40 11,727

And the Put… PUT OPTIONS Expire at close Fri, Oct 21, 2005 Strike Symbol Last Chg Bid Ask Vol Open Int 22.5 QXBVB.X 0.05 N/A 20 3,118 25 QXBVE.X 15 6,722 27.5 QXBVC.X 1 858 30 XBAVF.X 0.15 4 10,089 32.5 XBAVZ.X 0.25 5,312 35 XBAVG.X 0.5 86 11,511 37.5 XBAVU.X 0.95 13 6,324

So on 15th August 2005 Your Call has increased in value (from $1.95 to $ 5.20 or $ 3.25) Your Put has lost value (from $2.15 now $ 0.50 so $ 1.65) To date your net gain is $ 1.60 ($ 160) Your investment was $ 410 Your return is: $ 160/$ 410= 39% in about 1 month!

Speculations spreads and volatility Buying a call will only profit you if the share price rises above the strike price plus the premium that you paid for the call But you can set up a BULL SPREAD: buy a call at the money and sell one out of the money call with a premium close to the one that you are paying for the bought call In the case of ebaY: Buy Call $37.50 October 2005 (at $ 1.95) and sell Call $ 40 October 2005 ($ 1.15) If the price falls below $37.50 this speculator looses the net premium ($1.95-$1.15=$0.80) A share price in between $ 37.50 and $40 will generate a profit on the call and a loss on the sold call but the profit on the call will be higher since the strike price is lower Above $40 this higher profit on the Call is kept above the loss on the sold call (for instance at $42.50 the call profit is $5 the loss on the sold call is $2.50 we got $1.15 for the sold option and paid $1.95 for the bought call so: +$5-$2.50+$1.15-$1.95= $ 1.70 This profit will be the same for every share price above $40

Bull and Bear Strategies Bull Spreads (speculate that the price will rise) Using Calls (see ebaY example) Using Puts Bear Spreads (speculate that the price will fall) Using Calls

Bearish Strategies Long Put Naked Call (sell uncovered call; very risky!) Bear Call Spread Bear Put Spread Put Back Spread

Set up a Bear spread with Calls or Puts Buy a Call with strike price X and sell a Call with a strike price LOWER than X Buy a Put with strike price Y and sell a Put with a strike price LOWER than Y Proof in both cases that this is a Bearish approach (you bet on a lower share price)

Bear spread EbaY (buy call $ 37. 50 for $ 1 Bear spread EbaY (buy call $ 37.50 for $ 1.65 and sell call $ 35 at $ 2.75) Loose premium call - $ 1.65 and profit $ 2.75 from sold option; profit $ 1.10 Loose $ 2.50 sold call at $ 37.50 profit $2.75 from sold call and loose - $ 1.65 net loss $ 1.40 beyond this point the call will gain equal to what sold call looses

Bear spread EbaY (buy put $ 37.50 for $ 2.70 and sell put $ 35 at $ 1.20) At $ 35 profit from bought put $ 2.50 minus premium is -$0.20 (loss) and profit $ 1.20 from sold option; profit $ 1.00 At lower prices the gains from the bought put will off set the losses from the sold put. Loose $ 2.70 bought put and profit $1.20 from sold put ; net $ 1.50 loss

Put Back Spread Put back spreads are great strategies when you are expecting big downward moves in already volatile stocks. (Google?) The trade itself involves selling a put at a higher strike and buying a greater number of puts at a lower strike price.

Example: Using Intel (Nasdaq: INTC), we can create a put back spread using in-the-money options. With INTC Trading at $27.75 on July 12th 2005 , you might buy two of the October 2005, 27.50 puts at $1.05 and sell one October 2005 30 put at $2.45 In this example, you would receive $35 for putting on the trade. If the stock jumped above 30, you would profit $35. However, the real money would be made if the stock made a big move to the downside. The downside breakeven for this trade would be $25 At this price, the 27.50 puts would be worth $2.50 while the 30 puts would be worth $5. Below $25 the profit potential increases dramatically. At $ 22.50: 2 bought puts will generate profit $1,000 and the sold put a loss of $ 750 and we will still have the $35 difference between the premiums: Total profit $ 285 !

Bullish Strategies Long Calls Covered Calls Bull Call Spread Bull Put Spread Call Back Spread Protective Put Naked Put

Long Call, Covered Call

Bull Spreads with Calls and Puts

Remember Bull Call Spread: Dell Trading @ $26.85 Buy1 DELL JUL 25 Call @ $2.95 ($295) Sell1 DELL JUL 30 Call @ $0.50($50) Cost of Trade$245

And Bull Put Spread KO Trading @ $54.14 Sell10 KO AUG 55 Put @ $2.55($2,550) Buy10 KO AUG 50 Put @ $0.85 $850 Credit from Trade($1700)

Call Back Spread IP Trading @ $43.46 Buy 2 IP JUL 45 Call @ $1.05 ($210) Sell 1 IP JUL 40 Call @ $4.00($400) Credit from Trade($190)

Protective Put AMGN Trading at $50.66 Buy100 AMGEN INC @ $50.66 ($5,066) BuyAMGN OCT 45 Put @ $2.55 ($255) Cost of Trade$5,321 No matter how far the stock drops, as long as there is a protective put, the combined position will be worth $4,245.

Naked Put Imagine that you want to buy International Business Machines (NYSE: IBM) but think it is due for a slight correction from its current price, $82.83. By selling the $80 puts at $5.10, you collect $510 ($5.10 x 100 shares) per contract. If the stock drops to $75 and the puts are assigned to you, you will pay $80 for the stock. However, your net cost is really $74.90 per share ($80 strike - $5.10 premium)

Neutral Strategies Reversals Conversions Collars Straddles

Reversals the reversal involves buying something in one market and simultaneously selling it in another to capitalize on whatever small discrepancy exists. Traders do reversals when options are relatively underpriced. In the absence of any price discrepancies, the following will be true: Call price - put price = stock price - strike price= $4 by selling a stock at $104, buying the call $100 for 7.50 (the offer) and selling the put $100 for 3.60 (the bid), the trader will lock in a .1 point profit.

Conversions The opposite of reversals In the absence of any price discrepancies, the following will be true: Call price - put price = stock price - strike price=$4 Again: Thus, by buying the stock for $104, selling the call $100 for 7.60 (the bid) and buying the put $100 for 3.50 (the offer), the trader will lock in an .1 point profit.

Collars NTAP Trading @ $12.84 Buy100 NTAP @ $12.84 ($1,284) Buy1 NTAP JUL 10 Put @ $060 ($60) Sell1 NTAP JUL 15 Call @ $0.80($80) Cost of Trade$1,264

Straddles Have you ever had the feeling that a stock was about to make a big move, but you weren't sure which way? Let's imagine a stock is trading around $80 per share. To prepare for a big move in either direction, you would buy both the 80 calls and the 80 puts. If the stock drops to $50 by expiration, the puts will be worth $30 and the calls will be worth $0. If the stock gaps up to $110, the calls will be worth $30 and the puts will be worth $0. Long Straddle Buy1 80 Call @ $7.50 $750 Buy1 80 Put @ $7.00 $700

Strangles Stock Price Profit (Loss) $50 $525 $55.25 $0 $60 ($475) $65 $70 $74.75 $80 Long strangles are comparable to long straddles in that they profit from market movement in either direction. From a cash outlay standpoint, strangles are less risky than straddles because they are usually initiated with less expensive, near-the-money rather than at-the-money options. Long Strangle (the stock is at $ 65) Buy1 60 Put @ $2.25 $225 Buy1 70 Call @ $2.50 $250

Butterflies The long butterfly spread is a three-leg strategy that is appropriate for a neutral forecast - when you expect the underlying stock price (or index level) to change very little over the life of the options. A butterfly can be implemented using either call or put options. Long Butterfly - DJX = $75.28 Buy 1 DJX 72 Call @ $6.10 x 100 $610 (wing) Sell 2 DJX 75 Call @ $4.10 x 100 ($820) (butterfly body) 1 DJX 78 Call @ $2.60 x 100 $260 Net Debit from Trade $50 ($870 - $820)

Butterflies (continued)

Put Ratio Spread To create a put ratio spread, you would buy puts at a higher strike and sell a greater number of puts at a lower strike. Ideally, this trade will be initiated for a minimal debit or, if possible, a small credit. MER Trading @ $39.68 Buy 1 MER JUL 50 Put @ $10.60 $1,060 Sell 3 MER JUL 40 Put @ $2.40 ($720) Cost/Proceeds $340

The condor takes the body of the butterfly-two options at the middle strike-and splits it between two middle strikes rather than just one. In this sense, the condor is basically a butterfly stretched over four strike prices instead of three. Condors Long Condor Sell 1 75 Call @ $6.00 ($600)(condor body) 1 80 Call @ $4.00 ($400)(condor body) Buy 1 70 Call @ $9.00 $900(wing) 1 85 Call @ $2.00 $200(wing) Cost of Trade $100 ($1,100-$1,000

Condors Continued In this case, the maximum profit is achieved at expiration with the stock between 75 and 80. At $75, the 75, 80, and 85 calls would expire worthless and the 70 calls would be worth $500. Thus, you would achieve your maximum profit of $400 ($500 - $100 initial debit). Between 75 and 80, the loss on the short 75 calls is more than offset by the 70 calls. Since the 80 and 85 calls would again expire worthless, the value at expiration is the same as the value of the 70/75 bull call spread ($5). At any price above $85 or below $70, you would experience the maximum loss of $100.

Black Scholes The Black-Scholes model is used to calculate a theoretical call price (ignoring dividends paid during the life of the option) using the five key determinants of an option's price: stock price, strike price, volatility, time to expiration, and short-term (risk free) interest rate. Myron Scholes and Fischer Black

Playing around with Black Scholes http://www.spreadsheetmodeling.com/Black%20Scholes%20Option%20Pricing%20-%20Basics.htm

Option Clearing Corporation

Assignment : Option Strategy Consider the stock options of your team’s company Choose a combination of options (calls or/and puts) that will give you a nice pay off at a limited risk Take the premiums from Yahoo Finance! Show your pay offs within a certain range of values of the stock at maturity…