OPTIONS
GRAHAM O’BRIEN
1
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2
What are options?
Exchange Traded Options
Calls v Puts
Options pricing
Three common strategies
3
What are options?
Exchange Traded Options create unique payoffs
Prior to the creation of options, only three choices existed:
B
S
Long a position
Short a position
Options give you options!
Cash
Pay-off diagram
Profit
Long stock
Share price
Current
share price
Loss
6
Pay-off diagram
Profit
Short stock
Share price
Current
share price
Loss
7
Pay-off diagram
Profit
Cash
Share price
Loss
8
Pay-off diagram
Profit
Earn income (Premium)
Share price
Protect losses
Current
share price
Loss
9
What are Exchange Traded Options?
B
S
A contract between two parties
conveying a right, but not an obligation,
to buy (call) or sell (put) an underlying
security at a specified price within a
specified time for an agreed premium
Components of an Option
Every option contract has:
Profit
An underlying security
ANZ, BHP, RIO, TLS, XJO
An expiration date
December, January 2015 etc.
Type
Put or Call
Premium or Price
Strike price
Loss
Pay-off diagram for a call
75 stocks and 1 index
AGL
BSL
GMG
NCM
SGM
WES
AIO
BXB
GPT
NWS
SGP
WFD
AMC
CBA
HVN
ORG
SHL
WOR
AMP
CCL
IAG
ORI
STO
WOW
ANN
CIM
IFL
OSH
SUN
WPL
ANZ
CPU
ILU
OZL
SYD
XJO
ARI
CSL
IPL
QAN
TAH
ASX
CSR
JHX
QBE
TCL
AWC
CTX
LLC
RIO
TEN
AZJ
CWN
MPL
RMD
TLS
BEN
EGP
MQG
RRL
TOL
BHP
FLT
MTS
S32
TTS
BLD
FMG
MYR
SCG
TWE
BOQ
FXJ
NAB
SEK
WBC
Calls v puts
13
Calls vs Puts (rights vs obligations)
B
Call
Put
The right
(but not the
obligation)
to buy
The right
(but not the
obligation)
to sell
The option buyer (holder of a long position) has the right
to purchase or sell the underlying instrument at a:
Specific price
(the strike price)
Specified time
(until the
expiration date)
The option buyer
pays a premium
for this right
Calls vs Puts (rights vs obligations)
B
Call
Put
The right
(but not the
obligation)
to buy
The right
(but not the
obligation)
to sell
Once you have purchased an option
(established a long position) you can:
Sell it
Exercise your right
Let it expire
Calls vs Puts (rights vs obligations)
S
Call
Put
The potential
obligation
to sell
The potential
obligation
to buy
The option seller (creator of a short position) is obligated
to sell or purchase the underlying instrument at a:
Specific price
(the strike price)
Specified time
The option seller
(until the
receives a premium
expiration date)
for assuming this
obligation
Calls vs Puts (rights vs obligations)
S
Call
Put
The potential
obligation
to sell
The potential
obligation
to buy
Once you have sold an option
(established a short position) you can:
Buy it back
Let it expire
Be assigned to fulfill your obligation
Calls vs Puts (rights vs obligations)
B
S
Call
Put
The right
(but not the
obligation)
to buy
The right
(but not the
obligation)
to sell
Call
Put
The potential
obligation
to sell
The potential
obligation
to buy
18
Call options – Recap
Profit
Long call
Share price
Premium
Strike price
Loss
Call options – Recap
Profit
Short call
Strike price
Premium
Share price
Loss
Call options – Recap
Gives the buyer the right, but not the
obligation, to buy a standard quantity
of shares at the exercise price, on or
before the expiry date
Seller obligated to deliver
Put options – Recap
Profit
Long put
Share price
Premium
Strike price
Loss
Put options – Recap
Profit
Short put
Strike price
Premium
Share price
Loss
Put options – Recap
Gives the buyer the right, but not the
obligation, to sell a standard quantity
of shares for the exercise price on,
or before, the expiry date
Seller obligated to buy
ASX options – key points
Equity options
Index options
Contract size: 100 shares
Contract value: $10 per point
Expiry day: Last Thursday
of the month
Expiry day: Third Thursday
of the month
American style
(some Euro style)
European style
Physically settled
Cash settled
Options pricing
What are Options?
Exchange Traded Options (ETOs)
Calls v Puts
Options Pricing?
Top 3 Strategies
Major pricing factors
$4.00
Share price
$3.50
Exercise price
27
Major pricing factors
$4.00
50c
Share price
$3.50
Exercise price
Intrinsic
value
Share price
Exercise price
28
Major pricing factors
$4.00
Share price
$3.50
50c
22c
Exercise price
Intrinsic
value
Time
value
Time to expiry
Dividends
Interest rates
Volatility
Supply and demand
29
Major pricing factors
$4.00
Share price
$3.50
Exercise price
50c
72c
22c
Premium
30
In, at or out of the money – calls
$5.00
$4.50
$4.00
Out of the money
At the money
$3.50
In the money
$3.00
Series
The Greeks
Theta
Delta
32
Theta
The change in an option’s price given
a change in the time to expiration:
Is not constant
Accelerates as
expiry approaches
Theta – time decay
Lose 1/3
time value
Lose 2/3
time value
Option life
First half
Second half
The Greeks
Theta
Delta
35
Delta
The change in an option’s price given a change
in the price of the underlying stock or index:
For a $1 change
in the price of the
underlying stock
Expressed as
50 delta = .50 delta
Is highest for
“In-the-money”
options
Is not constant
Calls have
positive deltas
Puts have
negative deltas
Delta – Call options
0.8
0.5
0.1
Out
of the money
Option moves 1/5
as much as share
Delta – Call options
0.8
0.5
0.1
At
the money
Option moves 1/2
as much as share
Delta – Call options
0.8
0.5
0.1
In
the money
Option moves
1 for 1 with share
Option terminology
Taker/writer
Premium
Exchange
traded options
Intrinsic value
Call/put options
Exercise price
Expiry month
Time value
In-the-money
At-the-money
Out-of-the-money
Expiry date
52
Three common strategies
What are Options?
Exchange Traded Options (ETOs)
Calls v Puts
Options Pricing?
Top 3 Strategies
Three common strategies
Buying Calls
Buying Puts
Selling Calls
Leverage or low-risk?
Protecting shares
Buy-write
Generating income
54
Three common strategies
1. Bought Call
Market view:
Bullish
Buying Calls
Is buying calls risky?
Buying Calls
Buying Calls ensures you only buy stock
after the market confirms your decision
1
Buys leverage up(calls)
2
So you only buy stocks when the
market confirms your decisions
3
Go long with limited risk
4
You don’t get closed out before expiry!
57
Example – AML MAR/400/CALL
Call Option
B
S
Buyer has the right to buy a
standard quantity of shares
Shares
AML
Exercise price $4.00
Expiry date
June
Contracts
10
If the buyer/taker exercises the
option, on or before the September
expiry date, the writer/seller
must sell those shares at $4.00
The writer receives the premium
58
The life cycle of a call option
Share price ($)
Option price ($)
1.00
5.00
Options
4.80
0.80
Shares
4.60
0.60
Intrinsic value
4.40
0.40
Time value
0.20
4.20
Exercise price
4.00
Months 1
3.80
3.60
3.40
3.20
3.00
2
3
4
0
5
6
7
8
9
First rule of call buying
B
You would not
consider buying call
options
as a sole strategy
unless
you are bullish about
the underlying stock
Payoff example
AML shares
$4.00
Exercise price
AML/Jun/350 calls
AML/Jun/400 calls
AML/Jun/450 calls
$3.50
$4.00
$4.50
Premium
72c
38c
16c
Payoff example
AML shares on expiry
$4.00
$5.00
Exercise price
AML/Jun/350 calls
AML/Jun/400 calls
AML/Jun/450 calls
$3.50
$4.00
$4.50
Expiry value
$1.50
$1.00
50c
Profit
% Return
$780
108
$620
163
$340
213
Breakeven points – Bought Call
AML shares
$4.00
$5.00
Exercise price
AML/Jun/350 calls
AML/Jun/400 calls
AML/Jun/450 calls
$3.50
$4.00
$4.50
Premium
$1.50
72c
38c
$1.00
50c
16c
Breakeven points – Bought Call
AML shares
$4.00
Breakeven price
AML/Jun/350 calls
$4.22 P.S.
AML/Jun/400 calls
$4.38 P.S.
AML/Jun/450 calls
$4.66 P.S.
Breakeven points – Bought Call
AML shares
$4.00
Increase over current
AML/Jun/350 calls
22c
AML/Jun/400 calls
38c
AML/Jun/450 calls
66c
Second rule of call buying
The more bullish you are
the more you will consider
out-of-the money series
Leverage
$4,500
$4,000
$670
$380
Bought
October
Sold
December
Leverage
76.3%*
$500
$290
12.5%*
Shares
Options
Return on investment
*Not Including Transaction Charges
*Not Annualised
68
Leverage
$4,000
$3,500
$380
$0
Bought
October
Sold
December
Leverage
-100%*
-$500
-12.5%*
-$380
Shares
Options
Return on Investment
*Not Including Transaction Charges
*Not Annualised
70
Bought call
Profit
$4.00
C
-0.38
A
Loss
$4.38
B
Call at
expiry
Share price
Bought call – summary
Position
Risk/reward
Break even
Market view
Pay premium
in full
Limited risk
Unlimited reward
Exercise price
plus premium
Bullish
Three common strategies
2. Portfolio protection
Market view:
Bearish
Put Options/Protective Puts
Assume bullish
on the market
S&P/ASX 200 index
worth $59,500
at 5,950 points
Share
Put Options/Protective Puts
Nervous about another
market correction
S&P/ASX 200 index
worth $59,500
at 5,950 points
Share
Put Options can hedge
the portfolio against
market hiccups
Put Options/Protective Puts
Consider buying
S&P/ASX 200 index
worth $59,500
at 5,950 points
Share
1 S&P/ASX 200 September 5950 Puts
Assume price is 160 points each or
$1,600 per contract
Protective Put Purchase
5950 put
Own
shares
$59,500
$1,600
Share
Position
investment (b/e)
$61,100
Protective Put Purchase
Raise break-even level
from $59,500 to $61,100
$61,100
$59,500
Incur cost to
purchase puts
$1,600
Limit downside
risk to $1,600
$1,600
Position
investment (b/e)
$61,100
Protective Put Purchase
Profit
Puts expire worthless
Lose $1,600 (may be
offset by stock gain)
5,950
XJO at expiration
Receive cash ($10) for
every point below 5,950
Loss
Loss is limited to $1,600
(premium paid for put)
Protective Put Purchase
Profit
4,950
XJO at expiration
$10,000
Loss
Stock
($10,000)
Option
($8,400)
Total P&L ($1,600)
Protective Put Purchase
Profit
5,450
XJO at expiration
$5,000
Loss
Stock
($5,000)
Option
($3,400)
Total P&L ($1,600)
Protective Put Purchase
Profit
5,950
$0
XJO at expiration
Stock
($0)
Option
($1,600)
Total P&L ($1,600)
Loss
Protective Put Purchase
Profit
Stock
($5,000)
Option
($1,600)
Total P&L ($3,400)
$5,000
6,450
Loss
XJO at expiration
Protective Put Purchase
Profit
$10,000
Stock
($10,000)
Option
($1,600)
Total P&L ($8,400)
6,950
Loss
XJO at expiration
The Protective Put Strategy
Acts like
insurance
Maximum risk/loss in
this example is the
“cost of insurance”
$1,600 or 3%
Insurance expires in
September
Benefits – Protective Put Purchase
Benefits
Risks
Simplicity
Expensive when
volatility is high
Limit risk to a predetermined amount
Premium paid for
flexibility can result in
under-performance
Implement protection
only if you need it
Three common strategies
3. Buy-write
covered call
Market view:
Neutral
Buy-Write or Covered Calls
Profit
Call seller agrees to sell
shares at an agreed upon
price (the strike price)
Share price
Receives
premium
By a certain date
(the expiration date)
Loss
A call is covered if the investor
owns the underlying shares
Selling Calls
Reasons for selling calls against
shares currently owned:
Enhance returns from investment
When to use:
Neutral to moderately
bullish on the shares
Pre-set sale price for shares
Provide limited downside protection
89
Buy-Write
Selecting the
opportunity
Selling Calls
Buy-Write
Placing
the trade
Selling Calls
Outlook is neutral
to moderately
bullish on XYZ
Buy 2,000 XYZ shares
trading at $39.81/share
Share
Selling Calls
Want to increase
stock return if
market is level
Buy 2,000 XYZ shares
trading at $39.81/share
Share
Selling Calls
Sell 20 XYZ December
$41.00 Calls at $1.00 each
S
Share
B
Selling Calls
Long 2,000 shares
in XYZ at $39.81
Short 20 XYZ
December $41.00 Call
at $1.00
Selling Calls
Profit
Maximum profit $4,380 ($2.19 per share)
Own 2,000 shares
at $39.81
Sell 20 December
$41.00 call at $1.00
37.81
39.81
41.00
Overall Position
investment (break-even)
$38.81
Loss
Share price
Selling Calls
Called away return
$2.19 or 4.5%
in 90 days
Break-even lowered
from $39.81 to $38.81
Limited downside protection
Maximum gain = Premium + Gain on stock
($2.19 = $1.00 + $1.19)
There is no further profit
participation above $41.00
At expiry
Profit
$41.00
Option is assigned
Investor must sell
shares at $41.00
Seller keeps call
premium $1.00
XYZ at expiration
Loss
At expiry
Profit
$41.00
XYZ at expiration
Call expires worthless
Seller keeps shares
and call premium $1.00
Loss
At expiry
Profit
$37.81
XYZ at expiration
Loss
Option premium provides
limited downside protection
Losses will occur below
break-even point of $38.81
Selling Covered Calls
Benefits
Risks
Income from
selling call
Caps upside
Partial hedge
Downside risk
if stock falls
Exchange Traded Options
OPTIONS
……………………………………
Thank you
……………………………………
Graham O’Brien
February 2014
1
