I. Options.

I. Options

Distinguishing Stock Options From Stock Ownership
I. Options A. Definition: The right to buy or sell a specific issue at a specified price (the exercise price) on or before a specified date regardless of what the market price of the security is on the date the option is exercised. B. Call: The right to buy a security (Upside). C. Put: The right to sell a security (Downside). Distinguishing Stock Options From Stock Ownership It is important to understand the distinction between buying stock options and owning the stock. Unlike stocks, options have a limited life. If an expected move does not immediately occur, a stock investor can say, "I’ll give it another week" over and over, ostensibly forever. This is not the case with options trading. Each option has a set expiration date. At expiration, an option is either worth the difference between its strike price and the current stock price, or it is worthless. There is a key concept to keep in mind when dealing with the limited life of options: profiting from an options purchase depends on the ability to correctly predict both the direction and timing of a move in the price of the underlying stock. The first variable, direction, is easily understood. If the expectation is that the underlying stock price will rise but instead it declines, the investor loses money on a call position. (However, a put option investor could earn money if the expectation is that the underlying stock price will fall and the price does fall.) The second key variable in options trading is the timing of the move. For instance, the holder (buyer) of an XYZ May 35 call is guaranteed the right to buy 100 shares of the stock at $35 per share at any time before the option’s May expiration, even if the stock rallies to $40, $50, or even $70 per share or more. However, it costs more for a July 35 call than a May 35 call because of the additional time, and therefore the improved likelihood that the stock will rally above the price of $35 per share. 9/19/2018 Professor James Kuhle

I. Options (continued) D. Option Writer E. Option Buyer
The person who writes the call or put and receives a premium E. Option Buyer The person who buys the call or put and pays the premium 9/19/2018 Professor James Kuhle

I. Options (continued) F. Relation of Options to Stock Stock Market
Option Market Option Investor Company Investor Stock and Option Markets are unrelated except for the market price of a stock in the stock market and the exercise price of the stock option. 9/19/2018 Professor James Kuhle

II. Investor Profit Profiles
Assume you bought 1 share of T.I. at $50. This is your profit profile given various assumptions about T.I.’s future market price. 9/19/2018 Professor James Kuhle

Profit Profile for the Long Stock Position
Gain $20 Loss $-50 $50 Price Profit Market Price $70 This is a straight profit profile. If we buy the stock in the long position and pay $50 per share than this is the profit profile when the price of the stock moves up or down. For example, if the price goes to $70 and we sell, then our gain will be $20 per share. If the company goes bankrupt, then the most we will lose is $50. 9/19/2018 Professor James Kuhle

II. Investor Profit Profiles
A. Call Option Profit Profile of Buyer and Seller Situation: Investor thinks a security will increase in price -- can buy security or a call option. If price declines, Investor has a capital loss in long position or loses his option premium when expired. 9/19/2018 Professor James Kuhle

1. Profit Profile of Call Buyer (the Upside)
Gain Loss Premium Paid (Price to purchase Option) Strike $50 Price Profit Market Price $3 $53 Let’s say you’re considering buying stock in XYZ, which is trading at $50, and you think the company is undervalued. You believe that the valuation will return to normal over the next year. If you buy the stock for $50, you put $50 at risk and you hope that the share price rises over the next year, earning you a profit on your $50. Of course, if the stock price declines over the next year, you lose some of your $50. Alternatively, let’s say someone agrees to pay you all of the return above $50 over the next year. If the stock price rises to $60, he will pay you $10. If the stock price declines below 50, he won’t pay you anything, and you don’t owe him anything. In this example, he’s giving you the upside on the shares of XYZ. Anything above $50 is yours to keep. Let me repeat that: He’s giving you the upside on XYZ above $50 for the next year. This is also known as a 50 strike one-year call option. Traditionally, a call option is depicted graphically on a “payoff diagram,” as shown in our example. In a payoff diagram, the stock price at expiration is shown on the x axis and the profit is shown on the y axis. The profit profile diagram shows a payoff starting at $50, and rising toward the right. Obviously, someone is not going to agree to give you the upside from $50 over the next year without some compensation in return, which is why the profit profile line starts below zero. Someone is going to require you to pay him for that right to the upside, and this distance below zero is the price you have to pay for the option. The real question—and the key to options investing—is deciding what the upside is worth, and comparing that with the price the seller is trying to charge you. That’s what separates the investors from the gamblers when it comes to options investing. This is called the option premium. Assume the premium is $3.00. Note: Upside potential is unlimited, Downside risk is limited 9/19/2018 Professor James Kuhle

Upside (Call) 2. Profit Profile of a Call Seller (the other side of the mirror)
Gain Loss Premium Received Strike Price $50 Profit Market Price $3 $53 The mechanics of the actual transaction to capture the upside are slightly more complex than I’ve laid out here because technically, the option seller agrees to give the option buyer the shares for $50, or allows the buyer, to “call” the shares away at $50, hence the name “call” option. If the stock price is at $60, by calling the shares away at $50 and reselling them, the buyer can capture the upside I’ve been discussing. For practical purposes, however, the call owner can sell the stock immediately after calling it, and it is so much simpler to think of the definition as the “upside.” This is important: We can go long with options by “buying” the call. We can also go short by “selling” the call. Given the same stock and option scenario, a call seller (the writer or maker of the option) receives the $3 premium and believes the price will decline or stay the same. The option writer will only begin to lose money when the price of the stock actually goes above $53. The writer will have to deliver 100 shares of the stock at $50 if the option buyer exercises. Note: Upside potential is limited to the premium received. Downside risk is unlimited. 9/19/2018 Professor James Kuhle

The Downside B. Put Option Profit Profile of Buyer and Seller
Situation: Investor thinks a security will decrease in price -- can short sell or buy a PUT option. If the security increases in price, the short position produces a capital loss and the option position produces a premium loss. An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. This is the opposite of a call option, which gives the holder the right to buy shares. A put becomes more valuable as the price of the underlying stock depreciates relative to the strike price. For example, if you have one Mar 08 Taser 10 put, you have the right to sell 100 shares of Taser at $10 until March 2013 (usually the third Friday of the month). If shares of Taser fall to $5 and you exercise the option, you can purchase 100 shares of Taser for $5 in the market and sell the shares to the option's writer for $10 each, which means you make $500 (100 x ($10-$5)) on the put option. Note that the maximum amount of potential profit in this example ignores the premium paid to obtain the put option. We would have to subtract that amount from the $500. So, assuming the option premium was $1.25, the total cost would be 100 x $1.25 = $125. This would be deducted from the $500 proceeds resulting in a net gain of $375. 9/19/2018 Professor James Kuhle

1. Profit Profile of Put Buyer
Gain Loss Premium $1.50 Market Price Strike Price $50 Technically, the option seller agrees to let you, the put buyer, sell the shares for $50, or “put” the shares to the option seller for $50, hence the name “put” option. For practical purposes, however, the put owner can buy the stock and immediately put it to the put seller, which produces the profit from the drop in the stock price. It is much easier to think of a put as “the downside.” Note: Upside potential is limited to the price of the security. Downside risk is limited to the premium. 9/19/2018 Professor James Kuhle

2. Profit Graph of Put Seller
Gain Loss Premium $1.50 Strike Price $50 Market Price Note: Upside potential is limited to the premium. Downside risk is limited to the price of the security. 9/19/2018 Professor James Kuhle

C. Listed Options Quotes
KO Spot Price Calls Last Sale Net Bid Ask Vol Open Int $65.70 12/02/10 Puts KO1018L62.5-E 3.25 +0.44 3.15 3.30 3320 10225 10 Dec 62.50 KO1018X62.5-E 0.02 0.0 9643 KO1018L65-E 0.72 +0.36 0.68 0.75 1099 11448 10 Dec 65.00 KO1018X65-E 0.03 -0.10 537 7151 KO1018L67.5-E 0.01 1602 10 Dec 67.50 KO1018X67.5-E 2.35 -0.75 1.73 1.91 10 1495 KO1122A62.5-E 3.35 +0.23 3.45 3.55 26 27267 11 Jan 62.50 KO1122M62.5-E 0.29 -0.07 0.26 0.28 486 14536 KO1122A65-E 1.49 +0.12 1.52 786 40281 11 Jan 65.00 KO1122M65-E 0.82 -0.18 0.77 0.80 323 6677 KO1122A67.5-E 0.40 +0.10 0.38 589 8372 11 Jan 67.50 KO1122M67.5-E 2.27 -0.37 2.15 2.19 101 1256 KO1122A70-E 0.07 -0.02 0.06 0.09 5373 11 Jan 70.00 KO1122M70-E 5.20 4.30 4.40 2437 9/19/2018 Professor James Kuhle

D. Option Premiums 1. Option premium is the price an option buyer must pay for the right and the price an option writer receives for selling the right. 9/19/2018 Professor James Kuhle

D. Option Premiums (continued)
2. Effected by: a. The Security Price Premiums are directly related to the relative magnitude of the security price since the risk of price change is a function of the price. Example: Stock A: P = $100 Stock B: P = $10 Loss potential as a result of changes in security price is greater for Stock A, and hence, the option writer will require a greater premium. 9/19/2018 Professor James Kuhle

b. Length of Option Life: 3, 6, 9 months Longer term options on the same security are riskier since the probability of adverse price changes increases with time. Higher premiums compensate the seller for this greater risk. 9/19/2018 Professor James Kuhle

c. Variability of Returns The greater the past variability of return on the security the more likely that the option will be exercised. Greater return variability translates into greater option risk, for which, the writer wants to be compensated for. 9/19/2018 Professor James Kuhle

d. Exercise Price 1. In-the-Money: Call exercise price is below the current market price. 2. At-the-Money: Call exercise price is equal to the current market price. 3. Out-the-Money: Call exercise price is above the current market price. Relation between Call Premium and Exercise Price: 9/19/2018 Professor James Kuhle

LEAPS Long-term Equity AnticiPation Securities, referred to as “LEAPS,” are either calls or puts with expiration dates up to 2-1/2 years in the future. Like standard equity options, each LEAPS contract represents 100 shares of the underlying security. LEAPS offer both option and stock investors an excellent profit vehicle by allowing a big-picture trend on a stock to play out, with much less capital required compared to buying the underlying stock outright. Yet LEAPS are less risky than their short-term options counterparts. For those who prefer a one-to-two-year time horizon for their investments, LEAPS offer an excellent alternative using options. 9/19/2018 Professor James Kuhle

E. Option Trading Strategies
1. Buying Call Options a. Buying to achieve leverage The price of a call of 100 shares is significantly lower than buying the shares outright. Example: Stock XYZ sells at $50/share and a $50 call costs $5/share. The Investor can buy the call for $500 instead of the 100 shares for $5,000. If XYZ goes to $60, the value of the option is $1000. Return on option: $500/$500 = 100% Return on stock purchase: $1000/$5000 = 20% 9/19/2018 Professor James Kuhle

E. Option Trading Strategies (continued)
b. Buying call options to limit risk Investor dislikes the risk of buying XYZ and watching it go down in value. Therefore, Investor purchases XYZ 50 call at $5 and puts remaining $ in risk-free securities. Hence, given the same $5,000, the Investor buys call and puts $4,500 into Rf securities. Example: If XYZ goes to $60, the Investor can buy or exercise the option to net $500 plus interest from Rf investment. If XYZ stays at $50 or falls below, the investor has lost his option premium which is partly offset by interest income. 9/19/2018 Professor James Kuhle

c. Buying call option to hedge short stock position Investor believes XYZ will decline. Investor sells XYZ short to obtain total profit potential but he is exposed to unlimited loss from stock price increase. The Investor buys a call to eliminate loss. 9/19/2018 Professor James Kuhle

2. Put Option Strategies a. Buying Put options for leverage and limited risk Investor anticipates significant decrease in the stock price but does not have the margin money for a short sale, and does not want to be exposed to unlimited risk of stock price increases. Investor buys a put. NOTE: Stock price must decline enough to break even. 9/19/2018 Professor James Kuhle

b. Buying Put options to hedge against a stock price decline Investor holds IBM and has already taken a paper profit. Investor believes IBM will go higher and would like to participate in upside without risking a loss on paper profit. So he buys a put. If price goes up, the potential is only diminished by the cost of the put, whereas the paper profits are protected by the put and decreased only by the put price. 9/19/2018 Professor James Kuhle

Buying Put Options Long Position Gain Net Profit Market Price
Loss Option Profit Long Position 9/19/2018 Professor James Kuhle

3. Option Writing Strategies Definition: An investor holds 100 shares of IBM. Writes 2 calls and receives the option call premiums. One option is covered and the other is naked. 9/19/2018 Professor James Kuhle

4. Writing Call Options Strategies a. Writing covered calls Investor owns 100 shares of IBM ($50) and writes a call at $55 to earn a greater return than the stock alone. Investor earns D = $1.00 plus $5.00 on the call. Return is $6.00 plus any capital gains. Disadvantage: if price goes above $55, the upside is limited to $6.00. Note: Covered call also provides limited protection to writer against price decline. Price can decline to $45 ($50-Premium) before writer experiences paper loss. 9/19/2018 Professor James Kuhle

b. Writing naked calls Investor writes a call on IBM and receives a premium income without owning the security. 9/19/2018 Professor James Kuhle

Writing Naked Calls Gain Limited Gain Market Price $50 Loss
Limited Gain Unlimited Loss Market Price $50 Gain is limited to the value of the premium. Loss is unlimited because the investor must go to the market to buy at a higher price to deliver $50/share stock at the exercise price. 9/19/2018 Professor James Kuhle

5. Writing Put Option Strategies a. Writing Puts for Premium Income Investor expects the price of the stock he holds to increase. Therefore, he can write a covered put to increase income. The only risk is that the stock falls below current market price. 9/19/2018 Professor James Kuhle

Profit Profile Profit Profile Market Price Profit Gain Loss
Option Profit Long Position Net Profit/Loss 9/19/2018 Professor James Kuhle

6. Buying or Writing an Option Straddle An Option Straddle is the purchase or the writing of both a put and a call on the same security. a. Buying a Straddle: Price of underlying security is expected to move SHARPLY up or down before option expiration date. Buy a put and a call. Say you pay for a put and a call premium of $3.00 each. If the stock moves from $50 to above $56 or below $44, a profit is made. 9/19/2018 Professor James Kuhle

Profit Profile b. Writing a Straddle: Price of the underlying security is expected to stay at its current market value until the option expires. Write a put and write a call at $3.00 each and receive a total premium of $6.00. As long as the stock price remains between $44 and $56, the option straddle writer makes a profit. 9/19/2018 Professor James Kuhle

F. Other Option Strategies
1. Bull Spread Buying a call and selling a call with a higher strike price Examples: 1. Buy call with $90 SP Premium = $5 2. Sell a call with $95 SP Premium = $2 9/19/2018 Professor James Kuhle

Profit Profile 85 90 95 100 105 110 P = $90 Question: If stock price goes to $97, what is the net profit to the investor? Assignment: Determine profits from a range of $85 to $110 & profit profile. 9/19/2018 Professor James Kuhle

F. Other Option Strategies (continued)
2. Bear Spread Buy a put option and sell a put with a lower strike price Examples: 1. Buy a put with $110 SP Premium = $5 2. Sell put with $105 SP Premium = $2 9/19/2018 Professor James Kuhle

Profit Profile 85 90 95 100 105 110 P = $110 115 Assignment: Determine net profits from a range of prices of $85-$115. Also generate a graph or “profile”. 9/19/2018 Professor James Kuhle

3. BUTTERFLY SPREAD The butterfly spread is a neutral position that is a combination of both a bull and bear spread. Example: P = $60 July 50 call: $12 July 60 call: 6 July 70 call: 3 Butterfly spread: Buy 1 July 50 call: ($1200) Sell 2 July 60 calls: Buy 1 July 70 call: (300) (300) 9/19/2018 Professor James Kuhle

Profit Profile (Bicycle)
50 53 60 67 70 Assignment: Determine net profits from a range of $40-$80. Profit profile. 9/19/2018 Professor James Kuhle

4. Calendar or Time Spread Involves the sale of one option and the simultaneous purchase of a more distant option, both with the same strike price. 9/19/2018 Professor James Kuhle

Calendar or Time Spread
Example JAN. APR50’s JUL50’s OCT50’s XYZ: $ $ $10 $50 Neutral Spread: investor should have the initial intent of closing the spread by the time the near-term option expires. 9/19/2018 Professor James Kuhle

Calendar or Time Spread (continued)
Assume the following: Call Options APRIL 50 JULY 50 OCT 50 JAN(3 mo.) (6 mo.) (9 mo.) APR 9/19/2018 Professor James Kuhle

Calendar or Time Spread (continued)
In January the investor sells the APR 50 call and buys the July 50. His debit position is -3 points. In April the price is unchanged and the 3 month call (July) should be worth 5. The spread between the April 50 and the July 50 has now widened to 5. Since the spread cost 3, a 2 pt. profit exists. Investor should now close his long position by selling his July 50 call and reaping a 2 pt. profit. 9/19/2018 Professor James Kuhle

Bullish Calendar Spread
Investor sells the near-term call and buys a longer-term call when the underlying stock is some distance below the SP of the calls. Feature of low dollar investment and large potential profit. Example: XYZ: $45 in Jan. Sell April 50 for $1 Buy July 50 for $1 1/2 9/19/2018 Professor James Kuhle

Bullish Calendar Spread (continued)
Investor wants 2 things to happen: 1. Near-term call expires worthless 2. Stock price must rise by the time July call expires Assume price goes to 52 b/w April & July. Investor nets 1 1/2 pts. How? 9/19/2018 Professor James Kuhle

Key Terms Definition of a Put and a Call Option.
Option Writer and an Option Buyer. Investor Profit Profile and how to use. Covered call and naked call. Derivative security: what it means. In-the-money and out-of-the-money Option writing and option premium. Bull and a Bear spread. Calendar spread. Butterfly or Bicycle spread. 9/19/2018

Problems You purchase 25 call contracts on Blue Ox stock. The strike price is $22, and the premium is $1. If the stock is selling for $24 per share at expiration, what are your call options worth? What is your net profit? What if the stock were selling for $23? $22? Stock in Bunyan Brewery is currently priced at $20 per share. A call option with a $20 strike and 60 days to maturity is quoted at $2. Compare the percentage gains and losses from a $2,000 investment in the stock versus the option is 60 days for stock prices of $26, $20, and $18. A put option on XYZ stock has a strike price of $40 and is priced at $2 per share, while a call with a strike price of $40 is priced at $3.50. What is the maximum per share loss to the writer of the uncovered put and the maximum per-share gain to the writer of the uncovered call? Key: Blue Ox is selling for $24. You own 25 contracts, each of which gives you the right to buy 100 shares at $22. Your options are thus worth $2 per share on 2500 shares, or $5000. The option premium was $1, so you paid $100 per contract, or $2500, so your net profit is exactly zero. If the stock is selling for $22, your options are worthless, and you lose the entire $2500 you paid. Key: Bunyan stock costs $20 per share, so if you invest $2000, you’ll get 100 shares. The option premium is $2, so an option contract costs $200. If you invest $2000, you’ll get $2000/$200 = 10 contracts. If the stock is selling for $26 in 60 days, your profit on the stock is $6 per share, or $600 total. The percentage gain is 600/2000 = 30%. The most the writer of the put could lose is -$40+$2 premium or -$38. The most the writer of the call can get is the call premium which is $3.50. 9/19/2018

Problems Bill holds 600 shares of P&G. He bought the stock several years ago at $48.50, and the shares are now trading at 75. Bill is concerned that the market will fall over the next 60 days. He doesn’t want to sell the stock, but he would like to be able to protect the profit he’s made. He decides to hedge his position by buying 6 puts on P&G. The 2 month puts carry a strike price of 75 and are currently trading at $2.50. a. What is Bill’s total capital gain if the price of P&G drops to $60/share by the expiration date on the puts and he liquidates his holdings in P&G? If he wants to continue holding 600 shares what would he do? b. How would he do if the stock kept going up in price and hit $90/share? c. Would Bill have been better off using puts with an $70 strike price, trading at $1.00? Madam Butterfly would like to own Coca Cola stock. She plans to purchase 100 shares at the current price of $65. She is unsure of which way the price will move so she plans to create a Butterfly spread with three different call options: Strike prices are $75, $65, $55. The premiums for these three options are $2, $4, and $8, respectively. Calculate the net profit for the following market prices: $74, $70, $66, $55, and $52. Angelo just purchased 500 shares of AT&T at $30/share and has decided to write covered calls against these stocks. Accordingly, he sells 5 AT&T calls at their current market price of $5.25. The calls have 3 months to expiration and carry a strike price of $35/share. The stock pays a quarterly dividend of $.60 which will be paid during the 3 month call period. a. Determine the total dollar profits that will be made during the holding period if the price of the stock moves to $32 just before expiration, assuming he keeps the 500 shares? b. How high can the price of the stock go before Angelo’s return falls to zero (include dividend)? c. What is Angelo’s HPR as a percentage of his initial investment at $32, assuming he keeps his 500 shares? 4. a. Cost is $2.50 per share. His total capital gain would be $75 - $48.50 = $ $2.50 = $24 x 600 = $14,400. If he wanted to hold on to his shares then he would buy 600 more shares at a price of $60, and he would make $15 - $2.50 = $12.50 x 600 = $7,500. b. $90.00 – ($ $2.50) = $39.00 x 600 = $23,400. If he kept his shares, then: 90 - ( ) = 12.5 x 600 = $7,500. At $52: - 8 (the 55s) + (4x2) (the 65s) – 2 (the 75s) = - 2 x 100 = - $200 At $55: - 8 (the 55s) + 8 (the 65s) – 2 (the 75s) = - 2 x 100 = - $200 At $66: (11-8) = – = + 7 x 100 = $700 At $70: (15-8) = (8-10) = = + 3 x 100 = $300 At $74: (19-8) = (8-18) = - 10 – = -1 x 100 = - 100 a. $5.25 x 500 = $2,625 from premiums; plus .60 x 500 = $300 in dividends for a total of $2,925 b. $ = $5.85; so the price can go to $35.85 at zero profit. c. $2,925/$15,000 = 19.5% 9/19/2018

9/19/2018 Professor James Kuhle

I. Options.

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