1. A Primer on Call and Put Options
OLLI Class
Fall, 2011

2. Call options
A listed call option on an individual stock is a contract that allows the call buyer to
buy from the call option seller (or writer)
100 shares of a specified stock
at a specified price (striking price)
any time before the date of expiration
by paying a premium to the option seller

3. Put options
A listed put option is a contract which allows the put buyer to:
sell to the put option seller (writer)
100 shares of a specified stock
at a specified price (striking price)
any time before the date of expiration
by paying a premium to the option seller

4. Essential terms
The buyer of a put or call has a long position in the option and the right of exercise.
The call seller has a short position and has the obligation to sell the stock if assigned.
The put seller is short the put and must buy the stock if assigned.

5. American or European Style
All listed options can be traded prior to expiration, but:
American options can be exercised anytime prior to expiration. All listed equity options and the OEX (S&P100) are American options.
European options can be exercised only at expiration. Most index options are European style options.
All else equal, an American option will have a higher premium than the identical European option

6. Types of Options Available
Individual equity/stock options
Index Options
Broad Based (S&P 500, DJIA, S&P 100)
Sector indexes
LEAPS (long term options up to 2 years)
FLEX options (customized contracts)
Interest Rate options
Foreign Currency options

7. Basic Option Strategies

8. Creating a call payoff diagram
Exercise price = days to expiration
Interest rate = Stock price = $70
Premium = $ 5.25
Stock and call payoff at expiration
stock call payoff stock payoff
= =
= =
= =
= =

9. Risk Management Strategies:
Long stock compared to buying call
Profit
long stock 70
75.25
stock price at
expiration
buy call
5.25
Market outlook: bullish
Loss

10. Risk Management Strategies:
Short the call: (i.e. sell the call)
Profit
sell call
5.25 70
stock price
at expiration
Market outlook: bearish
Loss

11. Risk Management Strategies:
Covered Call: long stock - sell call
long stock
Profit
sell call
5.25
long stock - short call
64.75 70
stock price
at expiration
Loss
Market outlook:
long term bullish but short term neutral

12. Risk Management Strategies:
Buy Put compared to shorting stock
Profit
short stock
stock price at
expiration 70
65.375
buy put
4.625
Market outlook: bearish
Loss

13. Risk Management Strategies:
Short put: (sell the put)
Profit
sell put
4.625
stock price at
expiration 70
65.375
Market outlook: bullish
Loss

14. Risk Management Strategies:
Protective put: long stock + buy put
long stock
Profit
long stock
+ buy put
buy put 70
stock price at
expiration
4.625
Market outlook: nervously bullish
Loss

15. The Costless Collar: long stock + put - call
Buy $70 buy
sell net cost of $69.375
Profit
+stock
-call
5.625 65 70
3.25 75
2.65
4.375
+put
stock price
at expiration
Loss
Market outlook: neutral but nervously bearish

16. Trading Volatility: The Straddle
Long straddle: buy the call and put with same characteristics. Exercise price is $70:
profit/loss profit/loss
Stock portfolio

17. Risk Management Strategies:
Long straddle: buy call + buy put
Profit
buy put
buy call 70
stock price at
expiration
9.875
Market outlook: volatility will increase
Loss

18. Risk Management Strategies:
Sell the straddle: short call + short put
9.875
Profit
sell call
sell put 70
stock price at
expiration
Market outlook: volatility will decrease
Loss

19. Creating a Synthetic Forward
Sell the 70 put for $4.625 and buy the 70 call for $5.25 for a debit of $ .625.
-put + call
profit
4.625
-put 70
Stock price
At expiration
+call
5.25
loss

20. Strategies for Today’s Market
It Depends on Your Market View

21. Just the fact, ma’am:
The S&P 500 (SPY) is at having varied between 135 and 125 since January 2011.
Volatility is relatively low, about 17 on the VIX
You own 1,000 shares of SPY stock.

22. SPY Option Premiums:
June 17, 2011 SPY 128 Strike Aug Sep Dec Price Calls Puts Calls Puts Calls Puts Aug: 63 days Sep: 105 days Dec: 182 days

23. Case 1: You are neutral to bearish between now and October
You could sell all your stock, but … what if you’re wrong. Let’s consider some option strategies:

24. Conservative Strategies to Manage Downside Risk
Covered call strategy: Sell Aug calls with strike of 130 (neutral to slightly bearish)
Protective put strategy: Buy Sep puts with strike of 125 (bearish, but don’t want to be out of the market).
Collar strategy: Sell Aug 130 calls and buy Aug 120 puts (very bearish).

25. Payoff Table Covered Call: long stock @ 128 +sell Aug 130 call @ 2.65
Stock portfolio
115 ( ) =
120 ( ) =
125 ( ) =
128 ( ) =
130 ( ) =
( ) =
( ) =

26. Covered Call: long stock - sell call
Own Stock at 128; Sell 130 Aug Call $2.65
Profit
4.65
long stock - short call
125.35
130
stock price
at expiration
Loss
Market outlook:
long term bullish but short term neutral
Max Return = (4.65/128) = 3.6% for 63 days; max loss unlimited less $2.65

27. Payoff Table Protective Put: Long Stock @ 128 + Buy Sep 125 put @ 4.40
Stock portfolio 115 ( ) = ( ) = ( ) = ( ) = ( ) = ( ) = ( ) =

28. Protective put: long stock + buy put
Profit
long stock
+ buy put
125
stock price at
expiration
Max loss price
134.40
7.40
Market outlook: nervously bullish
Loss
Max loss = 7.40/128 = 5.8% over 105 days; Max gain = unlimited

29. Payoff Table Collar: Long Stock @ 128 Sell Sep 130 call @ 3
Payoff Table Collar: Long 128 Sell Sep ; Buy Sep
Stock portfolio

30. The Costless Collar: long stock + put - call
Profit
$2.30
120
130
$7.30
stock price
at expiration
Loss
Market outlook: neutral but nervously bearish
Max loss = 5.7%; Max gain = 1.8%; over 105 days

31. Instead of a limit order below the market, sell a “cash secured” put
Case 2: You have cash and are neutral to bearish between now and December but willing to buy if market goes down another 5+%.
Instead of a limit order below the market, sell a “cash secured” put

32. Payoff table “Cash Secured Put”: Sell Dec 120 put @4
Payoff table “Cash Secured Put”: Sell Dec 120 Invest cash (T-bills) of $120-$4.95 = $115.05
Stock Cash of portfolio
1Would include 182 days of interest, which today is close to 0%
2This is a return of 4.95/ = 4.3% for 182 days (8.6% annualized)
if the market stays above 120.

33. Case 3: The Bullish Case by year end
You think the market will be flat until early fall then will rally above 140 by December.
Split Strike Synthetic:
Buy the Dec 135 call for $3.25
Sell the Dec 120 put for $4.95

34. Payoff table Split Strike Synthetic: Sell Dec 120 put @4
Payoff table Split Strike Synthetic: Sell Dec 120 Buy Dec 135
Stock portfolio

35. Synthetic Forward: Long Call + Short Put
profit
1.70
-put
120
135
Stock price
At expiration
loss
You are out of the market between 120 and 135 with a return of $1.70 over 182 days

36. Case 4: You are neutral to bearish between now and December, but …
You are willing to buy stock if the market goes below 120 and sell what you have above 135

37. Sell a “Strangle” – sell a put and call with same expirations but different strikes.
Sell the Dec 135 Call for $3.25 and sell the Dec 120 put for $4.95, you own the stock at 128:
Stock call 120 put stock portfolio

38. Sell a strangle and own the stock: Sell 120 put; sell 135 call; own the stock
Profit
15.20
.20
115
120
135
stock price at
expiration
Loss
Sell you stock at $ if market goes above 135;
Buy more stock at $11.80 if market goes below 120.