1 Chapter 15 Options Markets-The applications

2 outline Features of options –Call vs., put, Long vs. short –In the money, out of the money and at the money Profit and payoff at expiration (examples and calculations) –for calls Call buyer Call seller Graph –For Puts Put buyer Put seller Graph

3 Outline Option strategy –The risk return trade off –Basic Strategies Buy Call: the dangerous one Sell Call (covered call): Cap your gain Buy Put (protective put): Do you really need the protection? Sell Put: Get paid for a limit order –Advanced Strategies Straddle: bet the price would have huge move Spread: betting on the price pattern Collar: bracket your profit –Index options and options on index futures

I. Features and payoff of options

5 Define option Option is the right to buy or sell an asset at a specified exercise price on or before a specified expiration date. Call Option: Put Option: Check:

6 American vs. European Options American - the option can be exercised at any time before expiration or maturity European - the option can only be exercised on the expiration or maturity date

7 Option Terminology Buy - Long Sell - Short Call Put Key Elements –Exercise or Strike Price –Premium or Option Price –Maturity or Expiration

8 Market and Exercise Price Relationships In the Money - exercise of the option would be profitable (without considering the cost/premium of the option) Call: market price>exercise price Put: exercise price>market price Out of the Money - exercise of the option would not be profitable Call: market price>exercise price Put: exercise price>market price At the Money - exercise price and asset price are equal

9 Payoffs and Profits on Options at Expiration - Calls Notation Stock Price = ST Exercise Price = X Premium=P Payoff: value of option at expiration S T <X (Out) S T =X (At) S T >X (In) Payoff00S T -X Profit-P (S T -X)-P

10 Payoffs and Profits on Options at Expiration - Calls Payoff to Call Writer - ( S T - X) if S T >X 0if S T < X Profit to Call Writer Payoff + Premium

11 Profit Stock Price at expiration 0 Call Writer Call Holder Profit Profiles for Calls

12 Payoffs and Profits at Expiration - Puts Payoffs to Put Holder 0if S T > X (X - S T ) if S T < X Profit to Put Holder Payoff - Premium

13 Payoffs and Profits at Expiration - Puts Payoffs to Put Writer 0if S T > X -(X - S T )if S T < X Profits to Put Writer Payoff + Premium

14 Profit Profiles for Puts 0 Profits Stock Price at expiration Put Writer Put Holder

II. option strategy

16 Equity and Options-risk and return InvestmentStrategyInvestment Equity onlyBuy shares$8,000 Options onlyBuy options$8,000 Option exercise price: $80, expire in one year

17 Equity and Options Apple Price $75$80$100 All Stock$7,500$8,000$10,000 All Options$0$0$16,000

18 Equity and Options Apple Price $75 $80$100 $75 $80$100 All Stock-6.25% 0% 25% All Options-100% -100%100%

19 Option Strategies-Long Call Long call: bullish –Leap Call –Calls that will expire soon –Out of the money call: a gamble –Deep in the money call: a replacement of stock investing The downside –90% of the time, you lose 100% of your investment (out of the money call) –You lose money even you are right about the stock –You often pay short term capital gain

20 Option Strategies-Long Put Protective Put (you stock hold is protected by put option) Goal: Buy insurance for your stock, protect it from falling price. Tax reason: ST tax v. LT tax Execution: buy Stock and buy Put Critics: why pay for unnecessary insurance You need to continue to roll over

21 Option Strategies Covered Call (potential obligation to deliver the stock is covered by the stock held, compared with naked option writing) Execution: Long Stock, Short Call Critics: Why cap the gain when sky is the limit

22 Option Strategies-Short Put The Process: Sell a put secured by cash The payoff: –Keep Premium when price above Ex. –Exercised when price below Ex. The idea: a limit order with upfront pay The view: bullish, flat

23 Option Strategies-Short Put Buy stock vs. Sell put: a risk return trade off Short In-the-Money vs. Out-of-the- Money

24 Advanced Option Strategies Straddles Spreads Collar

25 Option Strategies Straddle (Same Exercise Price) Bet price will move a lot –Long Call –Long Put Short straddle –Short SPX (S&P 500 index) Puts and Calls, 2 year leap, both out of the money

26 Option Strategies Spread: A combination of two or more call options (or put options) on the same stock with differing exercise prices or time to maturity –Money spread: buy one and sell another with same maturity, but different exercising price (betting on price range) Bullish call spread –Buy AAPL call ex with maturity Jan 2015 – Sell AAPL call ex with maturity Jan 2015 –Cost: 35-15=$20 –Bet: stock go up above $400, but not high enough to touch $500 –Idea: Use premium from selling calls (with higher ex price) to lower the cost of buying call (with lower ex price) Bearish Call spread –Sell NFLX call with maturity Jan 2013 (bet NFLX won’t go above $330) –Buy NFLX call (protect unlimited loss)

27 Spread (continued) –Money spread (continued) Bullish Put –Sell AAPL put, ex $300 (bet price won’t go below $300) –Buy AAPL put, ex $250 (protect it stock drops below $250) –Idea: bet stock price won’t fall below $300, but cap the loss if stock does fall below $250. Bearish Put spread: –Buy E-Mini S&P put, ex –Sell E-mini S&P put, ex –Bet index might fall below 1300, but above 1200 –Time spread (price timing) Short AAPL call ex $900 Jan 2014, buy call ex$900 Jan 2015 Bet price will be much higher than $900 by Jan 2015, but not by Jan 2014.

28 Option Strategies Collar –Goal: Brackets the value of your portfolio between two bounds. (so you can keep the profit without selling the stock, for tax reasons) –Execution: buy a protective put (to protect the very possible downside) and sell a covered call (to offset the cost of put) –Example: You hold 100 shares of Dell, current price $14 Buy a put : Expiration-Jan 2014, Ex-$13, premium$0.46 Sell a call: Expiration-Jan 2014, Ex-$15, premium$0.36 Cost: =$0.1