Financial Options- Option Strategy FINC 5000 Shanghai week

Option contracts and markets Call Option: the right to buy a financial asset in the future at a certain price and within a certain timeCall 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 timePut Option: the right to sell a financial asset in the future at a certain price and within a certain time

Buy and Sell Both Call and Put options can be bought and soldBoth Call and Put options can be bought and sold The seller of the option is also called the writer of the optionThe seller of the option is also called the writer of the option For every buyer of an option there is a sellerFor every buyer of an option there is a seller The price at which the trader can trade is the strike price (exercise price)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)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

Put Option

Option Strategies…and Time

Option Strategies…and Volatility

In-At-Out of the Money

Option Value=Time Value + Intrinsic Value

What determines option value? Stock Price (S) Exercise Price (Strike Price) (X) Volatility (σ) Time to expiration (T) Interest rates (Rf) Dividend Payouts (D)

Imagine you are still bullish about Apple..

Buy Calls? X=$ 625 So= $ (yesterday) P= $ (over 2% of So) (quotations yesterday Yahoo Finance) Maturity: Friday 20 April 2012 (4 PM NYT) If on 20 April St<$ 625 the option expires worthless (note St is stock price on 20 April) If on 20 April St>$625: You exercise the option your (net) profit: St-X-(premium) or: St-$625-$13.51

Or Wal Mart? X=$ 60 So= $ (yesterday) P= $ 0.71 (less than 12% of So) (quotations yesterday Yahoo Finance) Maturity: Friday 20 April 2012 (4 PM NYT) If on 20 April St<$ 60 the option expires worthless (note St is stock price on 20 April) If on 20 April St>$60: You exercise the option your (net) profit: St-X-(premium) or: St-$60-$0.71

Before you know it…. You are setting up a strategy to make money or hedge risksYou 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…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…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 19 th July 2005 (example) The $35 put premium has come down from $ 2.15 to $ 2.- although the share has lost value ($ on 11 th July now $ 35.37) the time value has evaporated more quicklyThe $35 put premium has come down from $ 2.15 to $ 2.- although the share has lost value ($ 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)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 assetYou 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 $535You 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?What will you do? Hang in there?

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 StrikeSymbolLastChgBidAskVolOpen Int 22.5QXBJB.X QXBJE.X QXBJC.X XBAJF.X6.10N/A 173, XBAJZ.X4.30N/A 331,363 35XBAJG.X2.750N/A 2257, XBAJU.X1.650N/A 5,4666,750 Get Option s for:

And put premiums on 19 july PUT OPTIONS Expire at close Fri, Oct 21, 2005 StrikeSymbolLastChgBidAskVolOpen Int 22.5QXBVB.X ,118 25QXBVE.X , QXBVC.X XBAVF.X0.560N/A 519, XBAVZ.X1.10N/A 2,2236,225 35XBAVG.X20N/A 21412, XBAVU.X3.50N/A 295,561

And on August 15… CALL OPTIONS Expire at close Fri, Oct 21, 2005 StrikeSymbolLastChgBidAskVolOpen Int 22.5QXBJB.X21.80N/A QXBJE.X16.70N/A QXBJC.X14.20N/A XBAJF.X120N/A 103, XBAJZ.X9.50N/A 21,155 35XBAJG.X7.40N/A 956, XBAJU.X5.20N/A 4011,727

And the Put… PUT OPTIONS Expire at close Fri, Oct 21, 2005 StrikeSymbolLastChgBidAskVolOpen Int 22.5QXBVB.X0.050N/A 203,118 25QXBVE.X0.050N/A 156, QXBVC.X0.050N/A XBAVF.X0.150N/A 410, XBAVZ.X0.250N/A 305,312 35XBAVG.X0.50N/A 8611, XBAVU.X0.950N/A 136,324

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

Hedging and Portfolio Insurance You are managing a well-diversified portfolio of US shares but you are worried about the possibility that the market will fall in the next 6 months (11 September…)You are managing a well-diversified portfolio of US shares but you are worried about the possibility that the market will fall in the next 6 months (11 September…) Buy put option on the market index; the fall in the value of the portfolio will be covered by the profit on the putsBuy put option on the market index; the fall in the value of the portfolio will be covered by the profit on the puts Of course you will have to pay the premium for the puts but this is in fact an insurance premium…but…you can sell an (far) out of the money call that will provide you upfront cash to pay the premium…Of course you will have to pay the premium for the puts but this is in fact an insurance premium…but…you can sell an (far) out of the money call that will provide you upfront cash to pay the premium… What we are doing here is “financial engineering” with optionsWhat we are doing here is “financial engineering” with options Buy Puts on QQQQ- Nasdaq 100 Trust?

Arbitrage and put-call parity Say you buy a put and sell a call of the same series at the same timeSay you buy a put and sell a call of the same series at the same time This is a synthetic short forward positionThis is a synthetic short forward position On such a position you should be able to make the risk less rateOn such a position you should be able to make the risk less rate Let’s take an example:Let’s take an example:

Buy a Put and Sell a Call Buy Put ebaY $35 October 2005, at $ 2.15 and Sell Call ebaY $35 October 2005 at $3.20Buy Put ebaY $35 October 2005, at $ 2.15 and Sell Call ebaY $35 October 2005 at $3.20 This will guarantee that you can sell ebaY at $35 in October ; if the price will be below $35 you will sell the put and take the profitThis will guarantee that you can sell ebaY at $35 in October ; if the price will be below $35 you will sell the put and take the profit If the price would be higher than $35 the buyer of the call you sold will exercise the call and you will have to pay him (but since your sold call is covered i.e. you own the shares you can deliver without a cash loss)If the price would be higher than $35 the buyer of the call you sold will exercise the call and you will have to pay him (but since your sold call is covered i.e. you own the shares you can deliver without a cash loss) Your strategy is risk less and should return the risk less rate… ($3.20- $2.15)/$35=<4%Your strategy is risk less and should return the risk less rate… ($3.20- $2.15)/$35=<4%

The put-call parity Assume: S= Selling Price P= Price of Put Option C= Price of Call Option X= strike price R= risk less rate T= Time then X*e ^-rt = NPV of realizable risk less share price (P and C converge) S+P-C= X*e ^-rt So P= C +(X*e ^-rt - S) is the relationship between the price of the Put and the price of the Call

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 $ 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 –Using Puts

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 XBuy 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 YBuy 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)Proof in both cases that this is a Bearish approach (you bet on a lower share price)

Bear spread EbaY (buy call $ 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 $ 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 $ 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?)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.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 12 th 2005, you might buy two of the October 2005, puts at $1.05 and sell one October 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 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

Class Example 1 Bull Call Spread: Dell $26.85 Buy1 DELL JUL 25 $2.95 ($295) Sell1 DELL JUL 30 $0.50($50) Cost of Trade$245

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

Class Example 3: Call Back Spread IP $43.46 Buy 2 IP JUL 45 $1.05 ($210) Sell 1 IP JUL 40 $4.00($400) Credit from Trade($190)

Protective Put AMGN Trading at $50.66 Buy100 AMGEN $50.66 ($5,066) BuyAMGN OCT 45 $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, $ 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)Imagine that you want to buy International Business Machines (NYSE: IBM) but think it is due for a slight correction from its current price, $ 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 $12.84 Buy100 $12.84 ($1,284) Buy1 NTAP JUL 10 $060 ($60) Sell1 NTAP JUL 15 $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 $7.50 $750 Buy1 80 $7.00 $700

Strangles 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 straddles Long Strangle (the stock is at $ 65) –Buy1 60 $2.25 $225 –Buy1 70 $2.50 $250 Stock PriceProfit (Loss) $50$525 $55.25$0 $60($475) $65($475) $70($475) $74.75$0 $80$525

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 Buy1 DJX 72 $6.10 x 100$610(wing) Sell2 DJX 75 $4.10 x 100($820) (butterfly body) Buy1 DJX 78 $2.60 x 100$260(wing) 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 $39.68 Buy 1 MER JUL 50 $10.60 $1,060 Sell 3 MER JUL 40 $2.40 ($720) Cost/Proceeds$340

Condors 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. Long Condor Sell 1 75 $6.00 ($600)(condor body) Sell 1 80 $4.00 ($400)(condor body) Buy 1 70 $9.00 $900(wing) Buy 1 85 $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.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.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).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).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.At any price above $85 or below $70, you would experience the maximum loss of $100.

Pricing Options All options prices are built up of: Intrinsic Value + Time Value –So if we buy EbaY $35 October for $ 3.20 and today’s cash price is $35.55 this option is $ 0.55 in the money (the intrinsic value) and the rest of the value ($ 2.65) is the time value of the option between now and October 21 st (this value will eventually evaporate) The Price of the option depends on how much of the value of the option is in the money or out of the money i.e. how much difference there is between the current cash price of the underlying asset and the strike price of the option The expiration date also has an impact on the price of the option; options with a longer life time tend to be more expensive The volatility of the underlying asset effects the price of the option as well; more volatile shares have higher option premiums The risk less interest rate has two effects on option prices: –Higher risk less rates lower the NPV of profits from options and thus tend to lower option premiums –Higher risk less rates tend to call higher expected values of shares and thus higher call option premiums and lower put option premiums

Homework Assignment 8: Option Strategy Take a close look at your company stock over the past couple of months Consider any special events happening now or about to happen (release 10Q?) Choose an option strategy that you think will make money for you as an investor Note we use expiration is equal to the Final Exam date You can invest unlimited amounts of money however if you are wrong you will loose your investment… You’d better cover your downward risks…. Stella will collect your option strategy before next class We need your inputs about:

INPUTS OPTION STRATEGY Name of the strategy if appropriate (long butterfly, short straddle…) How many calls/puts do you buy/sell (each represents 100 stock in your company) and at what strike price $ X What is the quoted premium on Yahoo Finance 9specify date) (closing NYSE) How much money you expect to make on this strategy (calculation) Maturity Final Exam date You can not trade your strategy and need to hold it until expiration! WE NEED YOUR INPUTS BY SUNDAY (TA for follow up)

On the day of Final Exam We will calculate how much money you made/lost on your option strategy and rank you from high to low profits BTW you can do this too since by then you know the premium at expiration…so you don’t really depend on Stella’s ranking… Top 10 profit makers will get extra credit (+5) Top 10 losers will lose credit (-5) –If you don’t hand in you lose credit too…