Options & Trading Strategies

Options ► Right to Buy/Sell a specified asset at a known price on or before a specified date. ► Call Option - Right to buy ► Put Option - Right to sell ► When Option Bought/Sold, Premium is exchanged.

Option Specifications ► Current Price of Specified Asset - S (S as we consider options on stocks first) ► Specified Price of Buy/Sell - X (or Strike Price, so some use K) ► Last time to Buy/Sell – Expiry ( T ) (or Expiration date) ► Note: There will be other factors when we actually start calculating prices, but for now we will take all market prices as given.

Basic Option Payoffs: Call Option Payoff Price Current Stock Price Stock Payoffs Payoff Price Option Exercise Price Call Option Payoffs Out of the Money In the Money Call Option Payoff = Max[ 0, S - X ] (Intrinsic Value)

Basic Option Payoffs: Put Option Payoff Price Current Stock Price Stock Payoffs Payoff Price Option Exercise Price Put Option Payoffs In the Money Out of the Money Put Option Payoff = Max[ 0, X - S ] (Intrinsic Value)

Option Usage ► Portfolio Risk Mgmt ► Risk Transfer ► Financial Leverage ► Income Generation

Quotations ► Newspaper (WSJ; sometimes non-synchronous) ► Internet (Brokers, Exchange Sites) ► News Feed (Bloomberg, Reuters, etc.)

Working Basic Profiles ► Buy Call ► Sell Call ► Buy Put ► Sell Put

First Applications ► Protective Put ► Covered Call

Protective Put ► Combine Long Stock with Purchase of Put ► Choose Expiry to match horizon of desired protection of downside. ► Choose Strike around (usually just above) current Stock Price ► Protects Stock Price from loss beyond put premium ► Very Similar to Car Insurance (although everyone’s strike is below the current car value due to deductibles)

Covered Calls ► Combine Long Stock with Sale of Call ► Choose Strike around (usually just above) current Stock Price ► Protects Stock Price from loss less than call premium ► Guarantees Sale Price (X + Prem Recv’d)

Writing Calls to Generate Income ► Can be very conservative or very risky, depending on the remainder of the portfolio ► An attractive way to generate income with foundations, pension funds, and other portfolios that will always hold the stock used in the cover ► A very popular activity with individual investors

Writing Calls to Generate Income (cont’d) ► Writing calls may not be appropriate when  Option premiums are very low  The option is very long-term

Multi-Option Trading Strategies Take a position in: ► A mixture of calls & puts  This is known as a combination ► 2 or more options of the same type  This is known as a spread

A Long Straddle Combination Figure 4-1: Buy 1 Call & 1 Same X Profit STST X Prices are expected to move, but don’t know which way.

A Short Straddle Combination Profit STST X Prices are not expected to move, either way (RISKY!!!). Get to keep premiums, but possible unlimited losses. Figure 4-2: Sell 1 Call & 1 Same X

A Long Strangle Combination X1X1 X2X2 STST Figure 4-3: Buy 1 Hi X & Buy 1 Low X Profit Prices are expected to move BIG, but don’t know which way, and willing to give up some profit to pay less for position.

A Short Strangle Combination X1X1 X2X2 STST Figure 4-3: Sell 1 Hi X & Sell 1 Low X Profit Prices are not expected to move beyond X 1 or X 2, but not willing to bet they might move between. Get to keep premiums, but unlimited possible losses.

Bull Spread Using Calls ► Figure 4.7: Buy 1 Low X Call, and Sell 1 Hi X Call X1X1 X2X2 Profit STST Prices are expected to rise, but only modestly (not above X 2 ). Willing to give up “above X 2 ” to pay less for position (compare to naked call).

Bull Spread Using Puts Buy 1 Low X Put and Sell 1 Hi X Put X1X1 X2X2 Profit STST

Bear Spread Using Puts Sell 1 Lo X Put and Buy 1 Hi X Put X1X1 X2X2 Profit STST Again, as you are willing to give up move “below X 1 ”, position costs less than naked put.

Bear Spread Using Calls Figure 4-8 : Buy 1 Hi X Call, and Sell 1 Lo X Call X1X1 X2X2 Profit STST Prices are expected to fall, but only modestly (not below X 1 ). Willing to give up “below X 1 ” to pay less for position (compare to naked put).