Topic 3.1 Basic Option Strategies

Topic 3.1 Basic Option Strategies

Introduction Refers to right but not an obligation to buy (call) or sell (Put) within a specified period. Option Call Long call Write (short) call Put Long Put Write (short) put

Introduction Trading options is based on Efficient market hypothesis (EMH)foundations; Rational investors Irrational investors Arbitrageurs

Introduction Hedgers transfer unwanted risk to speculators who are willing to bear it E.g., insuring a home Home owner Hedges by buying the insurance, the insurance company Speculates that the house will not burn. It is important to note that neither party wants the house to catch fire. Insurance that expires without a claim does not constitute a waste of money Money spent on reducing risk is not wasted, it provides peace of mind to the insurer. The first trade someone makes in a particular option is an opening transaction and the subsequent closure of that transaction is a closing transaction. Purchases and sales can be either type of transaction

Necessary Terminologies
European Option American Option Can be exercised at any time up to the expiration date Expire the 3rd Saturday of every month. They are closed for trading the Friday prior. There are no general formulae Nearly all stock and equity options Can be exercised only at expiration date Expire the Friday prior to the 3rd Saturday of every month. They are closed for trading the Thursday prior to the 3rd Saturday of every month. Valued using the Black – Scholes or Black Model formula. Mostly indexes Commodity options can be either

Necessary terminologies
Vanilla options- (regular) options consisting of calls and puts and can be found on major exchanges Exotic options – is an option which has features making it more complex than commonly traded vanilla options. An exotic option may also include non-standard underlying instrument, developed for a particular client or for a particular market. They are generally traded over the counter OTC). Strike price - (or exercise price) of an option is the fixed price at which the owner of the option can buy (in the case of a call), or sell (in the case of a put), the underlying security or commodity. Expiration date – Date by which the option must either be exercised or expire worthless.

In the money (ITM) It means that your stock option is worth money and you can turn around and sell or exercise it. Call: Strike price < market price (spot price) Put: Strike price > market price (spot price) For example, if John buys a call option on ABC stock with a strike price of $12, and the price of the stock is $15, the option is considered to be in the money. This is because the option gives John the right to buy the stock for $12 but he could immediately sell the stock for $15, a gain of $3. Being in the money does not mean you will profit, it just means the option is worth exercising. This is because the option costs money to buy. E.g. If John paid $3.50 for the call, then he wouldn't actually profit from the total trade, but it is still considered in the money.

At the money (ATM) It is a situation where an option's strike price is identical to the price of the underlying security. Both call and put options will be simultaneously "at the money.“ Options trading activity tends to be high when options are at the money. Call: Strike price = market price Put: Strike price = market price Exercise or not For example, if XYZ stock is trading at $75, then the XYZ $75 call option is at the money and so is the XYZ $75 put option.

Out of the money (OTM) An out of the money option has no intrinsic value, but only possesses extrinsic or time value. The value of an out of the money option erodes quickly with time as it gets closer to expiry. If it still out of the money at expiry, the option will expire worthless. Call: Strike price > market price Put: Strike price < market price Not Exercise For example, consider a stock that is trading at $10. For such a stock, call options with strike prices above $10 would be out of the money calls, while put options with strike prices below $10 would be out of the money puts.

Deep in the money Strike price significantly below (call ) or above (put) the market price. Significantly is considered one strike price below/above the market price of the underlying asset. E.g. If current price of a stock was $10, a call option with a strike price of a $5 would be considered “Deep in the Money”.

Option price - The price paid to acquire the option. Also known as Premium. The premium is paid to the seller of the option and is quoted on a per-share basis. Premium is not refundable, nor does it ever come back to the option buyer in any way. Market price, volatility and time remaining are the primary forces determining the premium. There are two components to the options premium and they are intrinsic value and time value. Intrinsic Value - The intrinsic value is determined by the difference between the current trading price and the strike price. Only in- the -money options have intrinsic value.

Time Value - An option's time value is dependent upon the length of time remaining to exercise the option, the moneyness of the option, as well as the volatility of the underlying security's market price. The time value of an option decreases as its expiration date approaches and becomes worthless after that date. This phenomenon is known as time decay. As such, options are also wasting assets. For in the money options, time value can be calculated by subtracting the intrinsic value from the option price. Time value decreases as the option goes deeper into the money. For out of the money options, since there is zero intrinsic value, time value = option price. i.e. Time Value = Option Price – Intrinsic Value Typically, higher volatility give rise to higher time value. In general, time value increases as the uncertainty of the option's value at expiry increases.

Strategies Profit and loss diagram Assumptions: Notation
It depicts the profits and losses from a strategy as a function of the price of the underlying asset at expiration. Assumptions: European exercise – can only be exercised at the end. Ignore dividends, commissions and margin requirements Ignore timing of cash flows i.e. time value of money. Notation S = Stock Price; K= Strike price; C = Call premium; P = Put Premium; T = Time to expiration

Strategies Long stock Short Stock Long Call Long Put Short Call
buy the right to buy Long Put buy the right to sell Short Call sell the right to buy Short Put sell the right to sell

Strategies: Example 1 Long Call Long Put Short Call Short Put
Write $30 $1.20 Short Put Write $30 $2 Assume different stock price at expiration: 0, 5, 10, 15, 20, 25, 30, 35, 40 etc, prepare profit and loss worksheet as well as P & L Diagram

1. Long Stock Buy an underlying asset today. If the sell price in the future is lower than buy price, the investor makes a loss and if it is higher, then the investor makes a profit.

2. Short Stock The investor does not initially own the stock. They start by first selling the stock and later repurchases it..called short selling. If the purchase price is lower than sell price, the investor makes a profit and if it is higher, then the investor makes a loss.

3. Long call

2. Long Put

3. Short call

4. Short Put

5. Summary

5. Summary Call Put Long In / Below Out / Below Short In / Above
Out / Above

Options classification
Options can be categorized into put or call options. Further, options can be classified as naked options or covered option. Naked options - When you do not own the underlying shares….also known as uncovered calls/puts Covered options - when you own the underlying shares

Options classifications
Calls Puts Naked (When you do not own the underlying shares….also known as uncovered calls/puts) Naked calls = Short call = Long Call Naked puts = short put = Long Put Covered (when you own the underlying) shares Covered call =long stock + short call Covered put Protective puts = long stock + long put Fiduciary put = short stock + short put Put overwriting = long stock + short put

Why use Options You can long or write calls and puts to; To hedge
To generate income To improve on market

Using Options as a hedge
1. Using calls to hedge a long position Protective Puts Owns a stock and wants to protects against downturn market trends (cant sell coz of tax implications) Investors may anticipate a decline in the value of an investment but cannot conveniently sell, mainly because of the tax preference of the stock owner. Notice that the term “Long” has nothing to do with the time span, it means that you own something. Hence combine the stock with a long put position Protective put means a long stock position combined with a long put position. Ignore commissions, dividends, opportunity costs etc

Protective Puts Example 1: The following information relates to Microsoft shares; Long $ 28.51 Long $25 $ 1.10 **Use different stock prices at expiration** Required: Present each situation above diagrammatically Determine the break even point of the protective put and present it diagrammatically.

Protective Put Stock Price at expiration 5 10 15 20 25 28.51 30 35 40
5 10 15 20 25 28.51 30 35 40 long -28.51 -23.51 -18.51 -13.51 -8.51 -3.51 1.49 6.49 11.49 Long $25 $ 1.10 23.9 18.9 13.9 8.9 3.9 -1.1 Net -4.61 0.39 5.39 10.39

Microsoft Example Long Stock: Purchased Microsoft for $28.51
Profit or loss ($) Stock price at option expiration 28.51 28.51

Microsoft Example (cont’d)
Long Put: Purchased a Microsoft APR 25 put for $1.10 23.90 23.90 25 Stock price at option expiration 1.10

Net effect : Protective put = Long Stock + long Put = Long Call 25 Stock price at option expiration 29.61 - 4.61

The worksheet shows that The maximum loss is $4.61 ( 25 – – 1.10) The maximum loss occurs at all stock prices of $25 or below The put breaks even somewhere between $25 and $30 (it is exactly $29.61 (= $ $1.10 or ) The maximum gain is unlimited Not that by hedging, the maximum loss is $4.61, way less than when the stock is naked where the maximum loss is $28.51

Protective Put Similar to long call, hence;
Long stock + long Put = Long Call Thus, buying a protective put is similar to outright purchase of a call option, and is an example of a synthetic option Synthetic option – a collection of financial instruments that are equivalent to an option position

Logic Behind the Protective Put
A protective put is like an insurance policy You can choose how much protection you want The put premium is what you pay to make large losses impossible The striking price puts a lower limit on your maximum possible loss Like the deductible in car insurance The more protection you want, the higher the premium you are going to pay

Logic Behind the Protective Put
Insurance Policy Put Option Premium Time Premium Value of Asset Price of Stock Face Value Strike Price Deductible Stock Price Less Strike Price Duration Time Until Expiration Likelihood of Loss Volatility of Stock

2. Using calls to hedge a short position Call options can be used to provide a hedge against losses resulting from rising security prices Call options are particularly useful in short sales Investors can make a short sale The opening (first) transaction is a sale The closing transaction(second) is a purchase Short sellers borrow shares from their brokers Closing out a short position is called covering the short position A short sale is like buying a put Many investors prefer the put The loss is limited to the option premium Buying a put requires less capital than margin requirements

Using call to hedge a short position
Example 2: The following information relates to Microsoft shares; Short $ 28.51 Long $35 $ 0.50 **Use different stock prices at expiration** Required: Present each situation above diagrammatically Determine the break even point of the protective put and present it diagrammatically.

Using call to hedge a short position
Stock Price at expiration 15 20 25 28.51 30 35 40 45 Short 13.51 8.51 3.51 -1.49 -6.49 -11.49 -16.49 Long $35 $ 0.50 -0.5 4.5 9.5 Net 28.01 13.01 8.01 3.01 -1.99 -6.99

Microsoft Example Assume you short sold Microsoft for $28.51
Profit or loss ($) 28.51 Stock price at option expiration 28.51 Maximum loss = unlimited

Long put (short stock plus long call) 28.01 Stock price at option expiration 35 28.01 6.99 The potential for unlimited loss is gone Short stock + long call = long put

2. Using options to generate income
Investors use options to generate additional income on their portfolio. This is done by; Writing calls to generate income ( more popular) Writing puts to generate income

Using Options to Generate Income
Writing naked calls Writing covered calls Covered calls Writing naked puts Writing covered Puts Put overwriting Fiduciary Puts

Writing calls to generate income
Writing covered calls Writing naked calls Covered calls are frequently used. 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 A very popular activity with individual investors There is however sometimes when covered are not appropriate; When the option premium is low For a very long – term options (income is generated from numerous short-term options)

Writing naked calls: Occurs when a speculator writes (sells) a call option on a security without ownership of the underlying security. Has a potentially unlimited loss Especially if the writer must buy the shares in the market It is one of the riskiest option strategies because it carries unlimited risk. A naked call is the opposite of a covered call. Is used by institutional heavyweights to make money for their firm

Writing covered calls: Occurs when the investor writes options against stock he already owns Is the most common use of stock options by both individual and institutional investors Has a profit or loss determined by the long position and the short position Covered call writing is very popular with foundations, pension funds, and other portfolios that need to produce periodic cash flows In relatively stable or slightly declining markets, covered call writing can enhance investment returns

Naked call writing is not often used by individual investors Brokerage houses may enforce high minimum account balances Fiduciaries should be extremely careful about writing naked calls for a client

Writing covered calls against market downturns
Sometimes, an investor who owns a stock, writes a call against it, giving someone else the right to buy the shares i.e. a covered call Why? to make some income Sometimes an investor owns stocks and fears a market downturn. Hence use covered calls to cushion against losses from a falling market.

Writing covered calls against market downturns
Example 3: Long $ 28.51 Short $30 $ 1.20 **Use different stock prices at expiration** Required: Present each situation above diagrammatically Determine the break even point of the protective put and present it diagrammatically.

Stock Price at expiration
Covered call Stock Price at expiration 5 10 15 20 25 30 35 40 long -28.51 -23.51 -18.51 -13.51 -8.51 -3.51 1.49 6.49 11.49 Write $30 $ 1.20 1.2 -3.8 -8.8 Net -27.31 -22.31 -17.31 -12.31 -7.31 -2.31 2.69

Writing Covered Calls to Protect Against Market Downturns
A JAN 30 covered call on $1.20; buy 28.51 2.69 Stock price at option expiration 30 27.31 27.31 Long stock + short call = short put

Writing puts to generate income
A naked put means a short put by itself A covered put means the combination of a short put and a short stock position = short put + long stock = short call; Long stock + short call = short put We have; Fiduciary puts Put overwriting

Fiduciary Put A fiduciary put is a covered (short) put Example 4:
A special short put is a fiduciary put A fiduciary put is a covered (short) put Refers to the situation in which someone writes a put option and simultaneously deposits the striking price into a special escrow account (an interest-bearing account) or hold the necessary cash equivalents Ensures that the funds are present to buy the stock if the put owner exercises it A short stock position would cushion losses from a short put: Short stock + short put = short call Example 4: Short $ 28.51 Write $30 $ 2 The commission costs of fiduciary puts may be lower than writing covered calls

Put Overwriting Put overwriting involves owning shares of stock and simultaneously writing put options against these shares Long stock + short put Both positions are bullish Both owning shares and writing puts are bullish strategies Appropriate for a portfolio manager who needs to generate additional income but does not want to write calls for fear of opportunity losses in a bull market

Put Overwriting Example 5: Required: Long MSFT stock @ $ 28.51
Short $30 $ 2 **Use different stock prices at expiration** Required: Present each situation above diagrammatically Determine the break even point of the protective put and present it diagrammatically.

Put overwriting Stock Price at expiration 15 20 25 28.255 28.51 30 35 long -28.51 -13.51 -8.51 -3.51 -0.255 1.49 6.49 Write $30 $ 2 -28 -13 -8 -3 0.255 3.49 2 Net -56.51 -26.51 -16.51 -6.51 0.51 8.49

Writing an OCT 30 put on $2; buy $28.51 3.49 Stock price at option expiration 30 56.51 Breakeven point =

Put overwriting Stock Price at expiration 15 20 22.50 24 25 30 35 long -22.50 -7.50 -2.50 1.50 2.50 7.50 12.50 Write $25 $ 3.63 -21.37 -6.37 -1.37 1.13 2.63 3.63 Net -43.87 -13.87 -3.87 4.13 6.13 11.13 16.13

Writing a March 25 put on Blk @ $3.63; buy stock @ $22.50
6.13 Stock price at option expiration 25 43.87 Breakeven point =

Put overwriting If the portfolio does continue to increase in value, the puts expires worthless, the portfolio will benefit from the premium income received, and the portfolio remains intact. However, if the stock prices turn down and the portfolio manager does not trade out of the put positions quickly, the overall effect on the portfolio will be disastrous.

Profit and Loss Diagrams With Seasoned Stock Positions
Adding a put to an existing stock position Writing a call against an existing stock position

Adding a Put/ Call to an Existing Stock Position
Sometimes, an investor who had bought a stock at a lower price realizes an increase in price and fears that it might fall, they may thus add a protective put or write a covered call. Example 5 In the previous examples while the stock price we have used is $28.51, assume that it had been acquired at $22. The investor decides to long $25 $1.10 Short $30 $1.20

Adding a Put/ Call to an Existing Stock Position
Long $22, long $25 $1.10 Stock Price at expiration 10 20 25 30 35 40 long -22 -12 -2 3 8 13 18 Long $25 $ 1.10 23.9 13.9 3.9 -1.1 Net 1.9 6.9 11.9 16.9

Adding A Put to an Existing Stock Position (cont’d)
Protective put with a seasoned position 1.90 Stock price at option expiration 25

2. Writing A Call Against an Existing Stock Position
Assume an investor Bought $22 Writes a JAN 30 $1.20 The stock price is currently $28.51

Writing a Call against an Existing Stock Position
Long $22, Short $30 $1.20 Stock Price at expiration 10 20 25 30 35 40 long -22 -12 -2 3 8 13 18 Write$30 $ 1.20 1.2 -3.8 -8.8 Net -20.8 -10.8 -0.8 4.2 9.2

Writing A Call Against an Existing Stock Position (cont’d)
Covered call with a seasoned equity position 9.20 Stock price at option expiration 30 20.80 20.80

3. Improving on the Market
There are two important strategies that have both hedging and income generation aspects. These methods are neither the best means of hedging nor the best means of generating income Writing calls to improve on the market Investors owning stock may be able to increase the amount they receive from the sale of their stock by writing deep-in-the-money calls against their stock position

Writing Calls to Improve on the Market (cont’d)
Writing Deep-in-the-Money Microsoft Calls Example Assume an institution holds 10,000 shares of MSFT. The current market price is $ OCT 20 call options are $8.62 per share. The institution could sell the stock outright for a total of $285,100. Alternatively, the portfolio manager could write 100 OCT 20 calls on MSFT, resulting in total premium of $86,200. If the calls are exercised on expiration Friday, the institution would have to sell MSFT stock for a total of $200,000. Thus, the total received by writing the calls is $286,200, $1,100 more than selling the stock outright.

Writing Calls to Improve on the Market (cont’d)
There is risk associated with writing deep-in-the-money calls It is possible that Microsoft could fall below the striking price It may not be possible to actually trade the options listed in the financial pages

Writing Puts to Improve on the Market
An institution could write deep-in-the-money puts when it wishes to buy stock to reduce the purchase price

Conclusion The following key strategies and their combinations can be deduced; Long stock + Long put = Long call => Protective long Short stock + Long call = Long put =>Protective Short Short stock + Short put = Short call => Fiduciary Put Long stock + short call = Short Put => Covered Call

Assignment Discuss in detail why investors (i.e. market movements and investors expectation) would use the following strategies; Long Call Short Call Short Put Protective Put Long Position Short Position Writing covered call Put Overwriting Fiduciary puts

Topic 3.1 Basic Option Strategies

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