RM1 04 v5 Intro to Options

7/30/2019 RM1 04 v5 Intro to Options

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RM1Chapter 4: Introduction to Options

Version 5

2008

FH-Doz. Mag. Donald Baillie, FRM


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RM1 04 Introduction to Options, v.5, 2008, FH-Doz. Mag. Donald Baillie, FRM Page 2

Options: Forward Transactions, Derivatives

Options are a type ofderivative, meaning that it is a right to some kindof reference asset (the underlying)

Options are forward transactions: the value date of the contract liessome time in the future

An option entitles the buyer to a right: the right to buy or sell theunderlying asset at an agreed price at some agreed future date

A call option entitles the buyer of the option to buy the underlying assetat the agreed conditions

A put option entitles the buyer of the option to sell the underlying assetat the agreed conditions


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Options: English & German terminology

Basiswert Underlying

Kontraktgre Size

Laufzeit Expiration

Ausbungspreis Strike Price

Optionstyp 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 Aput 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 acompany is an embedded put option

AnAmerican option gives its owner the right to exercise the option anytimeprior to option expiration

A European option may only be exercised at expiration


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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 formost 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 optionpremium 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


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Identifying An Option

Microsoft OCT 80 Call

Expiration (3rd Friday in October) Type of option

Underlying asset(Microsoft common stock)

Strike price($80 per share)


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Opening and Closing Transactions

When someone sells an option as an opening transaction, this is calledwriting 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 anagreed price. A profit is made if the market value of the underlying (S)> strike price (X) + the premium (P)

A longput 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 shortcall entitles the seller of the option (writer) to receive thepremium. In return, he or she must deliver the underlying at the

exercise price if the option is exercised.

A shortput entitles the seller of the option to receive the premium. Inreturn, he or she must buy the underlying at the agreed price if theotion is exercised.


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Intrinsic Value and Time Value

Intrinsic value is the amount that an option is immediately worth giventhe 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


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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 aparticular 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 X: strike Intrinsic Value

90 100 0

95 100 0

100 100 0

105 100 5

110 100 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:

S X > 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:

S X < 0



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Intrinsic Value of a PUT: X - S

S: underlying X: strike Inrinsic Value

90 100 10

95 100 5

100 100 0

105 100 0

110 100 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

0 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 anaked (uncovered) call


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Writing a Call Option (contd)

Breakeven = $28.70

Maximum

Profit = $3.700 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

B i P t O ti ( td)


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Buying a Put Option (contd)

$23.90Breakeven = $23.90

0 20 40 60 80 100

$1.10

W iti P t O ti


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Writing a Put Option

Breakeven = $23.90

$1.10

0 20 40 60 80 100

$23.90

The put option writer has the obligation to buy if the put is exercised by th

holder

P t ti P t


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Protective Puts

Definition

Microsoft example

Logic behind the protective put

Synthetic options

D fi iti


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Definition

Aprotective putis a descriptive term given to a longstock positioncombined with a longput position Investors may anticipate a decline in the value of an investment but cannot

conveniently sell

Mi ft E l


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Microsoft Example

Assume you purchased Microsoft for $28.51

Stock price at

option expiration

Profit or loss ($)

0

28.51

28.51

Microsoft Example (contd)


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Assume you purchased a Microsoft APR 25 put for $1.10

Stock price at

option expiration

0

1.10

23.90

23.90 25



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Construct a profit and loss worksheet to form the protective put:

Stock Price at Option Expiration

0 5 15 25 30 40

Long stock

@ $28.51

-28.51 -23.51 -13.51 -3.51 1.49 11.49

Long $25 put

@ $1.10

23.90 18.90 8.90 -1.10 -1.10 -1.10

Net -4.61 -4.61 -4.61 -4.61 0.39 10.39



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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



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Microsoft Example (cont d)

Protective put

Stock price at

option expiration

0

4.61

25

29.61

Writing Covered Calls to Protect Against


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Writing Covered Calls to Protect AgainstMarket Downturns

A call where the investor owns the stock and writes a call against it iscalled a covered call The call premium cushions the loss

Useful for investors anticipating a drop in the market but unwilling to sell theshares now

Writing Covered Calls to Protect Against


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Writing Covered Calls to Protect AgainstMarket Downturns

A JAN 30 covered call on Microsoft @ $1.20; buy stock @ 28.51

Stock price at

option expiration

0

27.31

30

2.69

27.31


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Combined Strategies

Straddles


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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 thesame Striking price

Expiration date Underlying security

Buying a Straddle


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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

Buying a Straddle (contd)


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Buying a Straddle (cont d)

Suppose a speculator Buys a JAN 30 call on MSFT @ $1.20

Buys a JAN 30 put on MSFT @ $2.75



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Construct a profit and loss worksheet to form the long straddle:


0 15 25 30 45 55

Long 30 call

@ $1.20

-1.20 -1.20 -1.20 -1.20 13.80 23.80

Long 30 put

@ $2.75

27.25 12.25 2.25 -2.75 -2.75 -2.75

Net 26.05 11.05 -1.05 -3.95 11.05 21.05



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Long straddle

Stock price at

option expiration

0

3.95

30

26.05

26.05 33.95

Two breakeven points



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The worst outcome for the straddle buyer is when both options expireworthless 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 isuncovered

Writing a Straddle (contd)


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g ( )

Short straddle

Stock price at

option expiration

0

26.05

30

3.95

26.05 33.95

Strangles


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g

A strangle is similar to a straddle, except the puts and calls havedifferent striking prices

Strangles are very popular with professional option traders

The speculator long a strangle expects a sharp price movement eitherup or down in the underlying security

With a long strangle, the most popular version involves buying a putwith a lower striking price than the call

Buying a Strangle (contd)


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y g g ( )

Suppose a speculator: Buys a MSFT JAN 25 put @ $0.70

Buys a MSFT JAN 30 call @ $1.20

Buying a Strangle (contd)


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y g g ( )

Long strangle

The maximum gains for the strangle writer occurs if both option expireworthless Occurs in the price range between the two exercise prices

Stock price at

option expiration0

1.90

25

23.10

23.10 31.90

30

Writing a Strangle (contd)


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g g ( )

Short strangle

Stock price atoption expiration0

23.10

25

1.90

23.10 31.90

30

Condors


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A condoris a less risky version of the strangle, with four differentstriking prices

There are various ways to construct a long condor

The condor buyer hopes that stock prices remain in the range betweenthe middle two striking prices

Buying a Condor (contd)


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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



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Construct a profit and loss worksheet to form the long condor:


0 25 27.50 30 32.50 35

Buy 25 call

@ $4.20

-4.20 -4.20 -1.70 0.80 3.30 5.80

Write 27.50 call

@ $2.40

2.40 2.40 2.40 -0.10 -2.60 -5.10

Write 30 put

@ $2.75

-27.25 -2.25 0.25 2.75 2.75 2.75

Buy 32.50 put

@ $4.60

27.90 2.90 0.40 -2.10 -4.60 -4.60

Net -1.15 -1.15 1.35 1.35 -1.15 -1.15



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Long condor

The condorwritermakes money when prices move sharply in eitherdirection

The maximum gain is limited to the premium

Stock price at

option expiration0

1.15

25

1.35

26.15

30

31.35

27.50 32.50

Writing a Condor (contd)


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Short condor


1.15

25

1.35

26.15

30

31.35

27.50

32.50

Spreads


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Introduction

Vertical spreads

Vertical spreads with calls

Vertical spreads with puts

Calendar spreads

Diagonal spreads

Butterfly spreads

Spreads: Introduction


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Option spreads are strategies in which the player is simultaneously longand short options of the same type, but with different Striking prices or

Expiration dates

Vertical Spreads


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In a vertical spread, options are selected vertically from the financialpages The options have the same expiration date

The spreader will long one option and short the other

Vertical spreads with calls

Bullspread Bearspread

Bullspread


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Assume a person believes MSFT stock will appreciate soon

A possible strategy is to construct a vertical call bullspreadand: 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 theposition.

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 (contd)


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Construct a profit and loss worksheet to form the bullspread:


0 27.50 28.50 30.50 32.50 50

Long 27.50 call

@ $3

-3 -3 -2 0 2 19.50

Short 32.50 call@ $1

1 1 1 1 1 -16.50

Net -2 -2 -1 1 3 3

Bullspread (contd)


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Bullspread


2

3

32.50

29.50

27.50

Bearspread


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A bearspreadis 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 thehigher 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)


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A general characteristic of the call and put bullspreads is that the profitand 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

Time Value of a CALL


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Time Value of a PUT


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Determinants of the price of an option


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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

Documents

RM1 04 v5 Intro to Options