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Chapter 15
Options Markets-The
applications
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outline
• Features of options
– Call vs., put, Long vs. short
– In the money, out of the money and at the money
• Profit and payoff at expiration (examples and
calculations)
– for calls
• Call buyer
• Call seller
• Graph
– For Puts
• Put buyer
• Put seller
• Graph
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Outline
• Option strategy
– The risk return trade off
– Basic Strategies
• Buy Call: the dangerous one
• Sell Call (covered call): Cap your gain
• Buy Put (protective put): Do you really need the
protection?
• Sell Put: Get paid for a limit order
– Advanced Strategies
• Straddle: bet the price would have huge move
• Spread: betting on the price pattern
• Collar: bracket your profit
– Index options and options on index futures
I. Features and payoff of options
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Define option
• Option is the right to buy or sell an
asset at a specified exercise price on
or before a specified expiration date.
• Call Option:
• Put Option:
• Check:
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American vs. European Options
American - the option can be exercised at
any time before expiration or maturity
European - the option can only be
exercised on the expiration or maturity
date
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Option Terminology
•
•
•
•
•
Buy - Long
Sell - Short
Call
Put
Key Elements
– Exercise or Strike Price
– Premium or Option Price
– Maturity or Expiration
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Market and Exercise Price
Relationships
In the Money - exercise of the option would be
profitable (without considering the
cost/premium of the option)
Call: market price>exercise price
Put: exercise price>market price
Out of the Money - exercise of the option would
not be profitable
Call: market price>exercise price
Put: exercise price>market price
At the Money - exercise price and asset price
are equal
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Payoffs and Profits on Options at Expiration Calls
Notation
Stock Price = ST Exercise Price = X Premium=P
Payoff: value of option at expiration
ST<X
(Out)
ST=X
(At)
ST>X
(In)
Payoff
0
0
ST-X
Profit
-P
-P
(ST-X)-P
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Payoffs and Profits on Options at
Expiration - Calls
Payoff to Call Writer
- (ST - X)
if ST >X
0
if ST < X
Profit to Call Writer
Payoff + Premium
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Profit Profiles for Calls
Profit
Call Holder
0
Call Writer
Stock Price
at expiration
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Payoffs and Profits at Expiration Puts
Payoffs to Put Holder
0
if ST > X
(X - ST)
if ST < X
Profit to Put Holder
Payoff - Premium
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Payoffs and Profits at Expiration Puts
Payoffs to Put Writer
0
if ST > X
-(X - ST)
if ST < X
Profits to Put Writer
Payoff + Premium
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Profit Profiles for Puts
Profits
Put Writer
0
Put Holder
Stock Price
at expiration
II. option strategy
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Equity and Options-risk and return
Investment
Strategy
Investment
Equity only
Buy stock @ 80
100 shares
$8,000
Options only
Buy calls @ 10
800 options
$8,000
Option exercise price: $80, expire in one year
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Equity and Options
Apple Price
$75
$80
$100
All Stock
$7,500
$8,000
$10,000
All Options
$0
$0
$16,000
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Equity and Options
Apple Price
$75
$80
$100
All Stock
-6.25%
0%
25%
All Options
-100%
-100%
100%
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Option Strategies-Long Call
• Long call: bullish
–
–
–
–
Leap Call
Calls that will expire soon
Out of the money call: a gamble
Deep in the money call: a replacement of stock
investing
• The downside
– 90% of the time, you lose 100% of your
investment (out of the money call)
– You lose money even you are right about the
stock
– You often pay short term capital gain
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Option Strategies-Long Put
Protective Put (you stock hold is protected by put
option)
Goal: Buy insurance for your stock, protect it from
falling price.
Tax reason: ST tax v. LT tax
Execution:
buy Stock and buy Put
Critics:
why pay for unnecessary insurance
You need to continue to roll over
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Option Strategies
Covered Call (potential obligation to deliver
the stock is covered by the stock held,
compared with naked option writing)
Execution:
Long Stock, Short Call
Critics: Why cap the gain when sky is the
limit
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Option Strategies-Short Put
• The Process: Sell a put secured by
cash
• The payoff:
– Keep Premium when price above Ex.
– Exercised when price below Ex.
• The idea: a limit order with upfront pay
• The view: bullish, flat
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Option Strategies-Short Put
• Buy stock vs. Sell put: a risk return
trade off
• Short In-the-Money vs. Out-of-theMoney
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Advanced Option Strategies
• Straddles
• Spreads
• Collar
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Option Strategies
Straddle (Same Exercise Price)
•
Bet price will move a lot
– Long Call
– Long Put
• Short straddle
– Short SPX (S&P 500 index) Puts and Calls,
2 year leap, both out of the money
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Option Strategies
• Spread: A combination of two or more call options
(or put options) on the same stock with differing
exercise prices or time to maturity
– Money spread: buy one and sell another with same maturity,
but different exercising price (betting on price range)
• Bullish call spread
–
–
–
–
–
Buy AAPL call ex $400 @$35, with maturity Jan 2015
Sell AAPL call ex $500 @$15, with maturity Jan 2015
Cost: 35-15=$20
Bet: stock go up above $400, but not high enough to touch $500
Idea: Use premium from selling calls (with higher ex price) to lower the cost
of buying call (with lower ex price)
• Bearish Call spread
– Sell NFLX call ex$330 @$25. with maturity Jan 2013 (bet NFLX
won’t go above $330)
– Buy NFLX call ex$370 @$17 (protect unlimited loss)
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Spread (continued)
– Money spread (continued)
• Bullish Put
– Sell AAPL put , ex $300 (bet price won’t go below $300)
– Buy AAPL put, ex $250 (protect it stock drops below $250)
– Idea: bet stock price won’t fall below $300, but cap the loss
if stock does fall below $250.
• Bearish Put spread:
– Buy E-Mini S&P put, ex 1300 @$40
– Sell E-mini S&P put, ex 1200 @$15
– Bet index might fall below 1300, but above 1200
– Time spread (price timing)
• Short AAPL call ex $900 Jan 2014, buy call ex$900 Jan
2015
• Bet price will be much higher than $900 by Jan 2015, but
not by Jan 2014.
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Option Strategies
• Collar
– Goal: Brackets the value of your portfolio between
two bounds. (so you can keep the profit without
selling the stock, for tax reasons)
– Execution: buy a protective put (to protect the very
possible downside) and sell a covered call (to
offset the cost of put)
– Example:
•
•
•
•
You hold 100 shares of Dell, current price $14
Buy a put : Expiration-Jan 2014, Ex-$13, premium$0.46
Sell a call: Expiration-Jan 2014, Ex-$15, premium$0.36
Cost: 0.46-0.36=$0.1