RM1 04 v5 Intro To Options

RM1 Chapter 4: Introduction to Options
Version 5
2008 FH-Doz. Mag. Donald Baillie, FRM
Options: Forward Transactions, Derivatives
Options are a type of derivative, meaning that it is a right to some kind of reference asset (the underlying)
Options are forward transactions: the value date of the contract lies some time in the future
An option entitles the buyer to a right: the right to buy or sell the underlying asset at an agreed price at some agreed future date
A call option entitles the buyer of the option to buy the underlying asset at the agreed conditions
A put option entitles the buyer of the option to sell the underlying asset at the agreed conditions
RM1 04 Introduction to Options, v.5, 2008, FH-Doz. Mag. Donald Baillie, FRM
Page 2
Options: English & German terminology

Basiswert Kontraktgre Laufzeit Ausbungspreis Optionstyp Underlying Size Expiration Strike Price Type
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Call and Put Options

Call Options
A call option gives its owner the right to buy; it is not a promise to buy
For example, a store holding an item for you for a fee is a call option
Put Options
A put option gives its owner the right to sell; it is not a promise to sell
For example, a lifetime money back guarantee policy on items sold by a company is an embedded put option
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
Page 4
Categories of Options
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
Cash-settled
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Standardized 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
The option premium is the amount you pay for the option Exchange-traded options are fungible
For a given company, all options of the same type with the same expiration and striking price are identical
RM1 04 Introduction to Options, v.5, 2008, FH-Doz. Mag. Donald Baillie, FRM Page 6
Identifying An Option
Expiration (3rd Friday in October)
Type of option
Microsoft OCT 80 Call
Underlying asset (Microsoft common stock)
Strike price ($80 per share)
Page 7
Opening and Closing Transactions

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
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The Basic Options Positions

The buyer of a call option is long a call option. He or she pays the premium and purchases the right to buy the underlying asset at an agreed price. A profit is made if the market value of the underlying (S) > strike price (X) + the premium (P)
A long put entitles the buyer to the right to sell the underlying at an agred price in return for paying the premium. A profit is made if S < X +P A short call entitles the seller of the option (writer) to receive the premium. In return, he or she must deliver the underlying at the exercise price if the option is exercised. A short put entitles the seller of the option to receive the premium. In return, he or she must buy the underlying at the agreed price if the otion is exercised. RM1 04 Introduction to Options, v.5, 2008, FH-Doz. Mag. Donald Baillie, FRM Page 9
Intrinsic Value and 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 = stock price striking price (S X) For a put option, intrinsic value = striking price stock price (X S) Intrinsic value cannot be < zero
Intrinsic value (contd)

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
Page 10
Intrinsic Value and Time Value (contd)

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) An option is a wasting asset
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Profit and Loss Diagrams

Vertical axis reflects profits or losses on the expiration day resulting from a particular strategy Horizontal axis reflects the stock price on the expiration day Any bend in the diagram occurs at the striking price By convention, diagrams ignore the effect of commissions that must be paid
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Intrinsic Value of a CALL: S - X
S: underlying 90
X: strike 100
Intrinsic Value 0
95
100 105 110
100
100 100 100
0
0 5 10
Quelle: FTCI Financialtraining GmbH
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In-the-Money CALL
Call: the strike price X is lower than the current price of the underlying S: SX>0
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At-the-Money CALL
Call: the strike price X is equal to the current price of the underlying S: S=X
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Out-of-the-Money CALL
Call: the strike price X is higher than the current price of the underlying S: SX<0
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Intrinsic Value of a PUT: X - S

S: underlying 90 95 X: strike 100 100 Inrinsic Value 10 5
100
105 110
100
100 100
0
0 0
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In-the-Money PUT
Put: the strike price X is higher than the current price of the underlying S: X-S>0
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At-the-Money PUT
Put: the strike price X is equal to the current price of the underlying S: X=S
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Out-of-the-Money PUT
Put: the strike price X is lower than the current price of the underlying S: X-S<0
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Buying a Call Option (Going Long)

Example: buy a Microsoft October 25 call for $3.70
Maximum loss is $3.70 Profit potential is unlimited Breakeven is $28.70
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Buying a Call Option (contd)
Breakeven = $28.70
20
40
60
80
100
Maximum
loss = $3.70
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Writing a Call Option (Short Option)

Ignoring commissions, the options market is a zero sum game
Aggregate gains and losses will always net to zero The most an option writer can make is the option premium
Writing a call without owning the underlying shares is called writing a naked (uncovered) call
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Writing a Call Option (contd)
Breakeven = $28.70
Maximum Profit = $3.70

0 20 40 60 80 100
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Buying a Put Option (Going Long)

Example: buy a Microsoft April 25 put for $1.10
Maximum loss is $1.10 Maximum profit is $23.90 Breakeven is $23.90
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Buying a Put Option (contd)

$23.90
Breakeven = $23.90
20
40
60
80
100
$1.10
Page 26
Writing a Put Option
The put option writer has the obligation to buy if the put is exercised by the holder
Breakeven = $23.90
$1.10
0 20 40 60 80 100
$23.90
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Protective Puts
Definition Microsoft example
Logic behind the protective put

Synthetic options
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Definition
A protective put is a descriptive term given to a long stock position combined with a long put position
Investors may anticipate a decline in the value of an investment but cannot conveniently sell
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Microsoft Example
Assume you purchased Microsoft for $28.51
Profit or loss ($)
0 28.51 28.51
Stock price at option expiration
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Microsoft Example (contd)

Assume you purchased a Microsoft APR 25 put for $1.10
23.90
23.90 0 25 Stock price at option expiration
1.10
Page 31

Construct a profit and loss worksheet to form the protective put:
Stock Price at Option Expiration 0 Long stock @ $28.51 Long $25 put
23.90 18.90 8.90 -1.10 -1.10 -1.10 -28.51
5
-23.51
15
-13.51
25
-3.51
30
1.49
40
11.49
@ $1.10
Net
-4.61 -4.61 -4.61 -4.61 0.39 10.39
Page 32

The worksheet shows that
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
Page 33

Protective put
25 0 29.61 4.61
Page 34
Writing Covered Calls to Protect Against Market Downturns

A call where the investor owns the stock and writes a call against it is called a covered call
The call premium cushions the loss Useful for investors anticipating a drop in the market but unwilling to sell the shares now
Page 35
Writing Covered Calls to Protect Against Market Downturns

A JAN 30 covered call on Microsoft @ $1.20; buy stock @ 28.51
2.69
27.31
27.31
30
Page 36
Combined Strategies
Straddles
A straddle is the best-known option combination
You are long a straddle if you own both a put and a call with the same
Striking price Expiration date Underlying security
You are short a straddle if you are short both a put and a call with the same
Striking price Expiration date Underlying security
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Buying a Straddle
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
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Buying a Straddle (contd)

Suppose a speculator
Buys a JAN 30 call on MSFT @ $1.20 Buys a JAN 30 put on MSFT @ $2.75
Page 40

Construct a profit and loss worksheet to form the long straddle:
Stock Price at Option Expiration 0 Long 30 call @ $1.20 Long 30 put @ $2.75 Net 26.05 11.05 -1.05 -3.95 11.05 21.05 27.25 12.25 2.25 -2.75 -2.75 -2.75 -1.20 15 -1.20 25 -1.20 30 -1.20 45 13.80 55 23.80
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Long straddle
Two breakeven points
26.05
30 26.05 3.95 33.95 Stock price at option expiration
Page 42

The worst outcome for the straddle buyer is when both options expire worthless
Occurs when the stock price is at-the-money
The straddle buyer will lose money if MSFT closes near the striking price
The stock must rise or fall to recover the cost of the initial position
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Buying Straddles:
If the stock rises, the put expires worthless, but the call is valuable If the stock falls, the put is valuable, but the call expires worthless
Writing Straddles:
Popular with speculators The straddle writer wants little movement in the stock price Losses are potentially unlimited on the upside because the short call is uncovered
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Writing a Straddle (contd)

Short straddle
3.95
30 0
26.05 26.05 33.95 Stock price at option expiration
Page 45
Strangles
A strangle is similar to a straddle, except the puts and calls have different striking prices Strangles are very popular with professional option traders 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
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Buying a Strangle (contd)

Suppose a speculator:
Buys a MSFT JAN 25 put @ $0.70 Buys a MSFT JAN 30 call @ $1.20
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Buying a Strangle (contd)

Long strangle
23.10 25 0 30 Stock price at option expiration
23.10
1.90
31.90
The maximum gains for the strangle writer occurs if both option expire worthless
Occurs in the price range between the two exercise prices
Writing a Strangle (contd)

Short strangle
1.90 25 0 23.10 31.90 30 Stock price at option expiration
23.10
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Condors
A condor is a less risky version of the strangle, with four different striking prices There are various ways to construct a long condor The condor buyer hopes that stock prices remain in the range between the middle two striking prices
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Buying a Condor (contd)

Suppose a speculator:
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
Page 51

Construct a profit and loss worksheet to form the long condor:
Stock Price at Option Expiration 0
Buy 25 call @ $4.20 Write 27.50 call @ $2.40 Write 30 put @ $2.75 Buy 32.50 put @ $4.60 Net -1.15 -1.15 1.35 1.35 -1.15 -1.15 27.90 2.90 0.40 -2.10 -4.60 -4.60 -27.25 -2.25 0.25 2.75 2.75 2.75 2.40 2.40 2.40 -0.10 -2.60 -5.10 -4.20
25
-4.20
27.50
-1.70
30
0.80
32.50
3.30
35
5.80
Page 52

Long condor
1.35
25 27.50 26.15 30 31.35 32.50
1.15
The condor writer makes money when prices move sharply in either direction The maximum gain is limited to the premium
Page 53
Writing a Condor (contd)

Short condor
1.35
27.50 30 32.50 31.35
0
25
1.15
26.15
Page 54
Spreads
Introduction Vertical spreads
Vertical spreads with calls

Vertical spreads with puts Calendar spreads
Diagonal spreads
Butterfly spreads
Page 55
Spreads: Introduction
Option spreads are strategies in which the player is simultaneously long and short options of the same type, but with different
Striking prices or Expiration dates
Page 56
Vertical Spreads
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
Page 57
Bullspread
Assume a person believes MSFT stock will appreciate soon A possible strategy is to construct a vertical call bullspread and:
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
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Bullspread (contd)
Construct a profit and loss worksheet to form the bullspread:
Stock Price at Option Expiration 0 Long 27.50 call @ $3 Short 32.50 call @ $1 Net -3 1 -2 27.50 -3 1 -2 28.50 -2 1 -1 30.50 0 1 1 32.50 2 1 3 50 19.50 -16.50 3
Page 59
Bullspread (contd)
Bullspread
3
27.50 0 32.50 2 29.50 Stock price at option expiration
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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
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 spreaders account (credit spread) The call spread results in a debit to the spreaders account (debit spread)
Bullspread (contd)
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
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Time Value of a CALL
Page 63
Time Value of a PUT
Page 64
Determinants of the price of an option
Strike (exercise) price of the option X Current price of the underlying S
Remaining time to maturity of the option t

Volatility of the underlying Riskless interest rate r
Page 65

RM1 04 v5 Intro To Options

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RM1 04 v5 Intro To Options

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RM1 Chapter 4: Introduction to Options

Options: Forward Transactions, Derivatives

Options: English & German terminology

Call and Put Options

Standardized Option Characteristics

Expiration (3rd Friday in October)

Microsoft OCT 80 Call

Underlying asset (Microsoft common stock)

Strike price ($80 per share)

Opening and Closing Transactions

The Basic Options Positions

Intrinsic Value and Time Value

Intrinsic value (contd)

Intrinsic Value and Time Value (contd)

Profit and Loss Diagrams

Intrinsic Value of a CALL: S - X

Quelle: FTCI Financialtraining GmbH

Quelle: FTCI Financialtraining GmbH

Quelle: FTCI Financialtraining GmbH

Quelle: FTCI Financialtraining GmbH

Intrinsic Value of a PUT: X - S

Quelle: FTCI Financialtraining GmbH

Quelle: FTCI Financialtraining GmbH

Quelle: FTCI Financialtraining GmbH

Quelle: FTCI Financialtraining GmbH

Buying a Call Option (Going Long)

Buying a Call Option (contd)

Writing a Call Option (Short Option)

Writing a Call Option (contd)

Maximum Profit = $3.70

Buying a Put Option (Going Long)

Buying a Put Option (contd)

Writing a Put Option

Logic behind the protective put

Profit or loss ($)

Stock price at option expiration

Microsoft Example (contd)

Microsoft Example (contd)

Microsoft Example (contd)

Microsoft Example (contd)

Stock price at option expiration

Writing Covered Calls to Protect Against Market Downturns

Writing Covered Calls to Protect Against Market Downturns

Stock price at option expiration

Buying a Straddle (contd)

Buying a Straddle (contd)

Buying a Straddle (contd)

Two breakeven points

Buying a Straddle (contd)

Buying a Straddle (contd)

Writing a Straddle (contd)

Buying a Strangle (contd)

Buying a Strangle (contd)

Writing a Strangle (contd)

1.90 25 0 23.10 31.90 30 Stock price at option expiration

Buying a Condor (contd)

Buying a Condor (contd)

Buying a Condor (contd)

Stock price at option expiration

Writing a Condor (contd)

Stock price at option expiration

Vertical spreads with calls