Introduction A derivative is a financial instrument whose return is derived from the return on another instrument. Size of the derivatives market at year-end.

Introduction A derivative is a financial instrument whose return is derived from the return on another instrument. Size of the derivatives market at year-end 2001: $3.8 trillion in market value All financial institutions can make some productive use of derivative assets Use of Derivatives: –Risk Management—Hedging and tuning risk to an acceptable level –Speculation and tactical asset allocation—Maximize thrust in a given asset class –Of course, arbitrage operations from temporally mispriced securities –Operational Advantages: Low transaction costs, very liquid, can be written (short-sold) easily

Categories of Derivatives Futures Listed, OTC futures Forward contracts Options Calls Puts Swaps Interest rate swap Foreign currency swap Derivatives

Options Option terminology price/premium call/put exchange-listed; over-the-counter options An option is the right to either buy or sell something at a set price, within a set period of time –The right to buy is a call option –The right to sell is a put option You can exercise an option if you wish, but you do not have to do so

Futures Contracts Futures contracts involve a promise to exchange a product for cash by a set delivery date. So, futures contracts deal with transactions that will be made in the future. A futures contract involves a process known as marking to market –Money actually moves between accounts each day as prices move up and down A forward contract is functionally similar to a futures contract, however: –There is no marking to market –Forward contracts are not marketable –Exclusively over-the-counter

Swaps Swaps are arrangements in which one party trades something with another party—i.e. cash flows The swap market is very large, with trillions of dollars outstanding In an interest rate swap, one firm pays a fixed interest rate on a sum of money and receives from some other firm a floating interest rate on the same sum –Popular with corporate treasurers as risk management tools and as a convenient means of lowering corporate borrowing costs In a foreign currency swap, two firms initially trade one currency for another Subsequently, the two firms exchange interest payments, one based on a foreign interest rate and the other based on a U.S. interest rate. Finally, the two firms re-exchange the two currencies

Product Characteristics Both options and futures contracts exist on a wide variety of assets –Options trade on individual stocks, on market indexes, on metals, interest rates, or on futures contracts –Futures contracts trade on products such as wheat, live cattle, gold, heating oil, foreign currency, U.S. Treasury bonds, and stock market indexes The underlying asset is that which you have the right to buy or sell (with options) or the obligation to buy or deliver (with futures) Listed derivatives trade on an organized exchange such as the Chicago Board Options Exchange or the Chicago Board of Trade OTC derivatives are customized products that trade off the exchange and are individually negotiated between two parties Options are securities and are regulated by the Securities and Exchange Commission (SEC) Futures contracts are regulated by the Commodity Futures Trading Commission (CFTC)

Derivative Usage Hedging: If someone bears an economic risk and uses the futures market to reduce that risk, the person is a hedger Speculating: A person or firm who accepts the risk the hedger does not want to take is a speculator. Speculators believe the potential return outweighs the risk –The primary purpose of derivatives markets is not speculation. Rather, they permit the transfer of risk between market participants as they desire Arbitrage is the existence of a riskless profit. Arbitrage opportunities are quickly exploited and eliminated. Persons actively engaged in seeking out minor pricing discrepancies are called arbitrageurs. Arbitrageurs keep prices in the marketplace efficient

Application of Derivatives Risk management:The hedger’s primary motivation is risk management –Someone who is bullish believes prices are going to rise. Someone who is bearish believes prices are going to fall. Then, we can tailor our risk exposure to any points we wish along a bullish/bearish continuum Income generation: Writing an option is a way to generate income. It involves giving someone the right to purchase or sell your stock at a set price in exchange for an up-front fee (the option premium) that is yours to keep no matter what happens. Popular during a flat period in the market or when prices are trending downward Financial engineering refers to the practice of using derivatives as building blocks in the creation of some specialized product. Financial engineers:Select from a wide array of puts, calls futures, and other derivatives and know that derivatives are neutral products (neither inherently risky nor safe)

OPTIONS

Options Basics A call option gives its owner the right to buy; it is not a promise to buy. A put option gives its owner the right to sell; it is not a promise to sell. An American option gives its owner the right to exercise the option anytime prior to option expiration. A European option may only be exercised at expiration –Options giving the right to buy or sell shares of stock (stock options) are the best-known options. An option contract is for 100 shares of stock –The underlying asset of an index option is some market measure like the S&P 500 index.It is Cash-settled Option characteristics Expiration dates:The Saturday following the third Friday of certain designated months for most options Striking price: The predetermined transaction price, in multiples of $2.50 or $5, depending on current stock price Underlying Security: The security the option gives you the right to buy or sell. Both puts and calls are based on 100 shares of the underlying security

Opening and Closing Transactions The first trade someone makes in a particular option is an opening transaction When the individual subsequently closes that position out with a second trade, this latter trade is a closing transaction When someone buys an option as an opening transaction, the owner of an option will ultimately do one of three things with it: –Sell it to someone else –Let it expire –Exercise it:1)Notify your broker; 2) Broker notifies the Options Clearing Corporation who selects a contra party to receive the exercise notice The option premium is not a down payment on the purchase of the stock The option holder, not the option writer, decides when and if to exercise In general, you should not buy an option with the intent of exercising it When someone sells an option as an opening transaction, this is called writing the option –No matter what the owner of an option does, the writer of the option keeps the option premium that he or she received when it was sold

The Role of the Options Clearing Corporation (OCC) The Options Clearing Corporation (OCC) contributes substantially to the smooth operation of the options market –It positions itself between every buyer and seller and acts as a guarantor of all option trades –It sets minimum capital requirements and provides for the efficient transfer of funds among members as gains or losses occur

Exchanges Major options exchanges in the U.S.: –Chicago Board Options Exchange (CBOE) –American Stock Exchange (AMEX) –Philadelphia Stock Exchange (Philly) –Pacific Stock Exchange (PSE) –International Securities Exchange (ISE) Bid Price and Ask Price Types of orders –A market order and limit order ( specifies a particular price (or better) beyond which no trade is desired. It requires a time limit, such as “for the day” or “good ‘til canceled (GTC)” Margins

Underlying SymbolLast SaleNet Change iShares Dow Jones US TelecommunicationsIYZ 23.150.2000

Option Terminology Option= right to buy or sell an asset at a fixed price and by a specific time. Call Option= right to buy the underlying asset. Put Option=the right to sell the underlying asset. Exercise Price (Strike Price or X): Fixed price at which the underlying asset can be bought or sold. Option Premium (C=call; P=put): Price of the option itself.

The Option Premium =Intrinsic Value + Time Value Intrinsic value is the amount that an option is immediately worth given the relation between the option striking price and the current stock price For a call option, intrinsic value =MAX(0,stock price –striking price) For a put option, intrinsic value =MAX(0,striking price – stock price) –Intrinsic value cannot be < zero Out, at and in-the -money –An option with no intrinsic value is out-of-the-money –An option whose striking price is exactly equal to the price of the underlying security is at-the-money –Options that are “almost” at-the-money are near-the-money –An option whose striking price is positive is in-the-money Time value is equal to the premium minus the intrinsic value –As an option moves closer to expiration, its time value decreases (time value decay) –AKA: speculative value Difference between option premium and intrinsic value. –Speculative value=0 at maturity –Before, speculative value= the chance that the option will expire in-the- money; e.g., the intrinsic value is greater than zero!

Intrinsic Value of Option Value if option is exercised immediately= Intrinsic value: –Call option: MAX(0,S-X) –Put option: MAX(0,X-S) In-the-money: –Call: S>X –Put: X>S Out-of-the-money: –Call: S<X –Put: X<S At-the-money: X=S

Illustration :Assume that you bought a call option 3 months ago at $10 with a strike at $100

Illustration 2: Assume that you sold a call option 3 months ago at $10 with a strike at $100

Expiration Date Payoffs to Long and Short Call Positions

Illustration 3: Assume that you bought a put option 3 months ago at $10 with a strike at $100

Illustration 4: Assume that you sold a put option 3 months ago at $10 with a strike at $100

Expiration Date Payoffs to Long and Short Put Positions

Portfolio Risk Management Rational How: Narrowing the distribution –Diversification between classes –Beta positioning “Skewing” the distribution to the left with Options –Covered call –Escrowed puts –90/10 –Protective puts

Put-Call-Spot Parity

S + P - C = X(1 + Rf) -T where: Rf = the annualized risk-free rate T = the time to maturity in years Let X(1 + Rf) -T = the proceed of a T-bill with a face value of X Then (long stock) + (long put) - (short call) = (long T-bill) Put-Call-Spot Parity

Creating Synthetic Securities Using Put-Call Parity T-bill=S + P - C Put= X(1 + Rf) -T - S + C Call = S + P - X(1 + Rf) -T Stock = X(1 + Rf) -T - P + C

Questions How can the put-call parity be used in the risk management framework? Determine the “payoff” of a position that consists of a long position in a put and a futures contract and a short position in a call (same exercise and maturity for the options; same underlying asset for the futures) How can you use this information for risk management purpose?

Combinations of Options Hedging: –Protective put –Covered call –Covering a Short position

Protecting Portfolio Value with Put Options Protective puts –Hedges downside losses –Protective put=S+P=C+T-bill Example: –Portfolio value = $100 million –3-month put quote on Nasdaq100=52.96 (spot=4000, strike=4000) –1 Nasdaq contract is based on a price of $400,000 (index price x 100=$400,000); the premium costs $5,296 for 1 contract(100 x 52.6) –you need 250 contracts ($ to hedge/$ of 1 contract = 100M/0.4M) –3-month put premium 1.324 million (250 x 52.96 X100)

Expiration Date Value of a Protective Put Position

Simulated Portfolio Return Distributions

Questions What would happen to our “protected” position, if we bought: OTM puts? ITM puts?

Another Example: Protective Put RATIONAL: Investors may anticipate a decline in the value of an Investment but cannot conveniently sell. OPERATION: LONG PUT & LONG STOCK  INITIALLY, -So-Po  AT MATURITY: S(T)+MAX(X-S(T),0)  PROFIT (AT MATURITY)= S(T)+MAX(X-S(T),0)-So-Po EXAMPLE: purchased Microsoft for $28.51 and a Microsoft APR 25 put for $1.10 BREAKEVEN: IF S(T)<X, S(T)+X-S(T)-So-Po=0  NO SOLUTIONS FOR S(T) IF S(T)>X, S(T)-So- Po=0  S(T)=So+Po=28.51+1.1=29.61 IN SUM: -The maximum loss is $4.61 -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) -The maximum gain is unlimited S(T)  Stock Price at Option Expiration 0515253040 S(T)-So- 28.51 -23.51-13.51-3.511.4911.49 MAX(X- S(T),0)-Co 23.9018.908.90-1.10 PROFIT-4.61 0.3910.39

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 A protective put is an example of a synthetic call

Altering Portfolio Payoffs with Call Options Covered calls –Call writer owns the stock: S-C=T-bill - P Benefits –If you wish, the cash received from the sell of the calls shifts the downside potential up; this is a dangerous strategy that may be used to profit in a “neutral- bearish” and low volatility market Danger –Prices could fall very very badly.

Example A fund manager writes covered calls against the $100 million fund and receives the premium of $2.813 million, The calls have been chosen so that the strike is 100 million (ATM) if your portfolio follows the NASDAQ100, which is quoted at 4000, a 3-month “at-the money” option (strike is 4000) is priced at 112.52. 1 contract is 100 times the index, so a call with a strike at 4000 correspond to $400,000 and is priced at $11,252. You need to cover $100,000,000; thus, you need 250 contracts (100m/0.4), which cost in total $2.813 M (11,252 x 250)..

Altering Portfolio Payoffs with Call Options

Questions What are the advantages of a covered call strategy? Under what circumstance(s) would you use a covered call strategy Vs. a protective put strategy? Your portfolio is not traded in the option market; only index options are traded. How would set the number of puts to buy or calls to sell in practice?

HEDGING: Covered Calls Rational: Useful for investors anticipating a drop in the market but unwilling to sell the shares now Operation: Long stock and short call Initially: -So+Co At maturity: S(T)-Max(S(T)-X,0) Profit at maturity: -So+Co+S(T)-Max(S(T)-X,0) Example: Write a JAN 30 covered call on Microsoft @ $1.20; buy stock @ 28.51 Break-even: -So+Co+S(T)-Max(S(T)-X,0)=0 If S<X, -So+Co+S(T)=0  S(T)=So-C0=28.51-1.20=27.31 If S>X, -So+Co+S(T)-S(T)+X=0  No solution In sum: The call premium cushions the loss. This is a synthetic short put.

HEDGING: Covering a short position Rational: Call options can be used to provide a hedge against losses resulting from rising security prices  The potential for unlimited losses is eliminated Operation: Short stock and long call Initially: So-Co At maturity: -S(T)+Max(S(T)-X,0) Profit at maturity: So-Co -S(T)+Max(S(T)- X,0) Example: Assume you short sold Microsoft for $28.51and purchased an APR 35 call at $0.50 in addition to the short sale Breakeven: So-Co -S(T)+Max(S(T)- X,0)=0 If S<X, So-Co -S(T)=0  S(T)=So-Co=28.51- 0.5=28.01 If S>X, So-Co -S(T)+S(T)-X=0  No Solution In sum: This is a synthetic put; Many investors prefer the put –The loss is limited to the option premium –Buying a put requires less capital than margin requirements

Bottom-line E scrowed puts - writing put options and investing in Treasury bills an amount equal to the discounted strike price of the puts.  (X-P) 90/10 strategy- A method of investment in which one places approximately 90% of his funds in risk-free, interest-bearing assets such as Treasury bills, and buys options with the remainder 10%.  X+C BearishNeutral-BearishNeutralNeutral- Bullish Bullish Protective put (ITM) M Protective put Protective put (ATM) Covered call (ITM) Protective put (OTM) 90/10 (ITM) Escrowed puts (OTM) Covered Call (ATM) 90/10 (ATM) Escrowed puts (ATM) M 90/10 (OTM) M Escrowed puts (ITM)

Why Options Are a Good Idea Increased risk Instantaneous information Portfolio risk management Risk transfer Financial leverage Income generation

Generate income with options: Writing Calls Attractive way to generate income with foundations, pension funds, and other portfolios. Also, very popular activity with individual investors. Writing calls may not be appropriate when option premiums are very low (duh!) and the option is very long-term. Example of Covered calls: You bought 300 shares of Microsoft at $22. You write three JAN 30 calls @ $1.20, or $120.00 on 100 shares. Profit Equation: -So+Co+S(T)-Max(S(T)-X,0) Breakeven: -So+Co+S(T)-Max(S(T)-X,0)=0  Solution when S(T)<X, that is S(T)=So-Co=22-1.2=20.8 Observation: same as short put  If prices advance above the striking price of $30, your stock will be called away and you must sell it to the owner of the call option for $30 per share, despite the current stock price. If Microsoft trades for $30, you will have made a good profit, since the stock price has risen substantially. Additionally, you retain the option premium. Writing Naked Calls are very risky due to the potential for unlimited losses Example of naked calls: It is now September 15; a SEP 35 MSFT call exists with a premium of $0.05; the SEP 35 MSFT call expires on September 19; Microsoft currently trades at $28.51.A brokerage firm feels it is extremely unlikely that MSFT stock will rise to $35 per share in ten days. The firm decides to write 100 SEP 35 calls. The firm receives $0.05 x 10,000 = $500 now. If the stock price stays below $35, nothing else happens. If the stock were to rise dramatically, the firm could sustain a large loss. Profit Equation:Co-Max(S(T)-X,0) Breakeven: Co-Max(S(T)-X,0)=0, when S(T)>X,S(T)=X+Co=35+0.05=35.05

Generate income with Puts A naked put means a short put by itself. A covered put means the combination of a short put and a short stock position  A short stock position would cushion losses from a short put: Short stock + short put ≈ short call Put overwriting involves owning shares of stock and simultaneously writing put options against these shares. –Both positions are bullish –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 Example: investor simultaneously buys shares of MSFT at $28.51 and writes an OCT 30 MSFT put for $2 Stock Price at Option Expiration 0152528.25 5 3035 Buy stock @ $28.51 -28.51-13.51-3.51-0.2551.496.49 Write 30 put @ $2 -28.00-13.00-3.000.2552.00 Net-56.51-26.51-6.510.003.498.49

Adding A Put to an Existing Stock Position Stock Price at Option Expiration 01025303540 Long stock @ $22-22-12+3+8+13+18 Long 25 put @ $1.10+23.90+13.90-1.10 Net1.90 6.9011.9016.90 Assume an investor: Bought MSFT @ $22 and Buys an APR 25 MSFT put @ $1.10;The stock price is currently $28.51

Writing A Call Against an Existing Stock Position Stock price at option expiration 0 20.80 30 9.20 20.80 Assume an investor Bought MSFT @ $22 and Writes a JAN 30 call @ $1.20;The stock price is currently $28.51

Writing Calls to Improve on the Market Writing Deep-in-the-Money Microsoft Calls Example Assume an institution holds 10,000 shares of MSFT. The current market price is $28.51. OCT 20 call options are available @ $8.62. 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. Though, there is risk associated with writing deep-in-the-money calls –It is possible that Microsoft could fall deep below the striking price –It may not be possible to actually trade the options listed 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 Puts to Improve on the Market 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

Speculating with options Playing with expected volatility and expected changes in market conditions. LONGSHORT STRADDLE (Same X,M) C+P-C-P STRANGLE (≠ X, same M) C(ITM)+P(OTM)-C(ITM)-P(OTM) STRAP (Same X,M) 2C+P-C-2P SPREAD (≠ X, same M) C(ITM)-P(OTM)P(ITM)-C(OTM) C-BUTTERFLY (≠ X, same M) C(OTM)-2C(ATM)+C(ITM)-C(OTM)+2C(ATM)- C(ITM)

Sample of quoted options with 6 months maturity

Terminal payoff for Long straddle (C+P) and short straddle (-C-P): same maturity and strike price (call 2 and Put 2)

Buying a Straddle: an other example A long call is bullish; A long put is bearish Why buy a long straddle? –Whenever a situation exists when it is likely that a stock will move sharply one way or the other Suppose a speculator –Buys a JAN 30 call on MSFT @ $1.20 –Buys a JAN 30 put on MSFT @ $2.75 Equation: Max(S(T)-X,0)-Co+Max(X-S(T),0)-Po Breakeven:Max(S(T)-X,0)-Co+Max(X-S(T),0)-Po=0 2 cases: (1) S<X, then -Co+X-S(T)-Po=0  S(T)=-Co+X-Po=-1.2+30-2.75=26.05 (2) S>X, then S(T)-X-Co-Po=0  S(T)=X+Co+Po=30+1.2+2.75=33.95 The worst outcome for the straddle buyer is when both options expire worthless. It occurs when the stock price is at-the-money. So the straddle buyer will lose money if stock closes near the striking price Stock Price at Option Expiration 01525304555 Long 30 call-1.20 13.8023.80 Long 30 put27.2512.252.25-2.75 Net26.0511.05-1.05-3.9511.0521.05

Writing a Straddle The straddle writer wants little movement in the stock price. Losses are potentially unlimited on the upside because the short call is uncovered

Strangles A strangle is similar to a straddle, except the puts and calls have different striking prices.The speculator long a strangle expects a sharp price movement either up or down in the underlying security With a long strangle, the most popular version involves buying a put with a lower striking price than the call Suppose a speculator: –Buys a MSFT JAN 25 put @ $0.70 –Buys a MSFT JAN 30 call @ $1.20

Writing a Strangle The maximum gains for the strangle writer occurs if both option expire worthless. It occurs in the price range between the two exercise prices.

Condors A condor is a less risky version of the strangle, with four different striking prices The condor buyer hopes that stock prices remain in the range between the middle two striking prices Buyer: –Buys MSFT 25 calls @ $4.20 –Writes MSFT 27.50 calls @ $2.40 –Writes MSFT 30 puts @ $2.75 –Buys MSFT 32.50 puts @ $4.60 Seller: –writes MSFT 25 calls @ $4.20 –buys MSFT 27.50 calls @ $2.40 –buys MSFT 30 puts @ $2.75 –writess MSFT 32.50 puts @ $4.60 Long Condor Short Condor

Long Strap: 2 C + P (same maturity and strike)

Spreads Option spreads are strategies in which the player is simultaneously long and short options of the same type, but with different –Striking prices or possibly expiration dates In a vertical spread, options are selected vertically from the financial pages –The options have the same expiration date –The spreader will long one option and short the other Vertical spreads with calls –Bullspread –Bearspread

“Bull spread”: buy call no 1 (in-the money) and sell call no 3 (out-the money)

Comparing the Bull Money Spread and Long Call Positions

“Bear Spread”:buy put no 3 (in-the money) and sell put no l (out-the money).

Bullspread another example Assume a person believes MSFT stock will appreciate soon  A possible strategy is to construct a vertical call bullspread : –Buy an APR 27.50 MSFT call –Write an APR 32.50 MSFT call The spreader trades part of the profit potential for a reduced cost of the position. With all spreads the maximum gain and loss occur at the striking prices –It is not necessary to consider prices outside this range –With a 27.50/32.50 spread, you only need to look at the stock prices from $27.50 to $32.50

Bullspread (cont’d) Construct a profit and loss worksheet to form the bullspread: Stock Price at Option Expiration 027.5028.5030.5032.5050 Long 27.50 call @ $3 -3 -20219.50 Short 32.50 call @ $1 11111-16.50 Net-2 133

Bearspread A bearspread is the reverse of a bullspread –The maximum profit occurs with falling prices –The investor buys the option with the lower striking price and writes the option with the higher striking price

Vertical Spreads With Puts: Bullspread Involves using puts instead of calls. Buy the option with the lower striking price and write the option with the higher one The put spread results in a credit to the spreader’s account (credit spread) The call spread results in a debit to the spreader’s account (debit spread) A general characteristic of the call and put bullspreads is that the profit and loss payoffs for the two spreads are approximately the same –The maximum profit occurs at all stock prices above the higher striking price –The maximum loss occurs at stock prices below the lower striking price

Calendar Spreads In a calendar spread, options are chosen horizontally from a given row in the financial pages –They have the same striking price –The spreader will long one option and short the other Calendar spreads are either bullspreads or bearspreads –In a bullspread, the spreader will buy a call with a distant expiration and write a call that is near expiration –In a bearspread, the spreader will buy a call that is near expiration and write a call with a distant expiration Calendar spreaders are concerned with time decay –Options are worth more the longer they have until expiration

Diagonal Spreads A diagonal spread involves options from different expiration months and with different striking prices –They are chosen diagonally from the option listing in the financial pages Diagonal spreads can be bullish or bearish

Butterfly Spreads A butterfly spread can be constructed for very little cost beyond commissions A butterfly spread can be constructed using puts and calls Stock price at option expiration 0

Nonstandard Spreads: Ratio Spreads A ratio spread is a variation on bullspreads and bearspreads –Instead of “long one, short one,” ratio spreads involve an unequal number of long and short options –E.g., a call bullspread is a call ratio spread if it involves writing more than one call at a higher striking price

Nonstandard Spreads: Ratio Backspreads A ratio backspread is constructed the opposite of ratio spreads –Call bearspreads are transformed into call ratio backspreads by adding to the long call position –Put bullspreads are transformed into put ratio backspreads by adding more long puts

Nonstandard Spreads:Hedge Wrapper A hedge wrapper involves writing a covered call and buying a put –Useful if a stock you own has appreciated and is expected to appreciate further with a temporary decline –An alternative to selling the stock or creating a protective put The maximum profit occurs once the stock price rises to the striking price of the call The lowest return occurs if the stock falls to the striking price of the put or below The profitable stock position is transformed into a certain winner The potential for further gain is reduced

Combined Call Writing In combined call writing, the investor writes calls using more than one striking price An alternative to other covered call strategies The combined write is a compromise between income and potential for further price appreciation

Margin Considerations: Necessity to post margin is an important consideration in spreading: The speculator in short options must have sufficient equity in his or her brokerage account before the option positions can be assumed There is no requirement to advance any sum of money - other than the option premium and the commission required - to long calls or puts Can borrow up to 25% of the cost of the option position from a brokerage firm if the option has at least nine months until expiration For uncovered calls on common stock, the initial margin requirement is the greater of Premium + 0.10(Stock Price) For uncovered puts on common stock, the initial margin requirement is 10% of the exercise price

Margin Requirements on Spreads All spreads must be done in a margin account More lenient than those for uncovered options You must pay for the long side in full You must deposit the amount by which the long put (or short call) exercise price is below the short put (or long call) exercise price A general spread margin rule: –For a debit spread, deposit the net cost of the spread –For a credit spread, deposit the different between the option striking prices

Margin Requirements on Covered Calls There is no margin requirement when writing covered calls Brokerage firms may restrict clients’ ability to sell shares of the underlying stock

Evaluating Spreads: Introduction Spreads and combinations are –Bullish, –Bearish, or –Neutral You must decide on your outlook for the market before deciding on a strategy

Evaluating Spreads: The Debit/Credit Issue An outlay requires a debit An inflow generates a credit There are several strategies that may serve a particular end, and some will involve a debt and others a credit

Evaluating Spreads: The Reward/Risk Ratio Examine the maximum gain relative to the maximum loss E.g., if a call bullspread has a maximum gain of $300.00 and a maximum loss of $200.00, the reward/risk ratio is 1.50

Evaluating Spreads: The “Movement to Loss” Issue The magnitude of stock price movement necessary for a position to become unprofitable can be used to evaluate spreads

Evaluating Spreads: Specify A Limit Price In spreads: –You want to obtain a high price for the options you sell –You want to pay a low price for the options you buy Specify a dollar amount for the debit or credit at which you are willing to trade

Determining the Appropriate Strategy: Some Final Thoughts The basic steps involved in any decision making process: –Learn the fundamentals –Gather information –Evaluate alternatives –Make a decision

Introduction A derivative is a financial instrument whose return is derived from the return on another instrument. Size of the derivatives market at year-end.

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Introduction A derivative is a financial instrument whose return is derived from the return on another instrument. Size of the derivatives market at year-end.

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