Academy 5
Basic Option Trading
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How big is the worldwide exchange-traded
derivative market?
A. $70 billion
B. $700 billion
C. $7 trillion
D. $70 trillion
NL GDP: €600 billion (600,000,000,000
US GDP: $14 trillion (14,000,000,000,000)
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Banks and institutional investors
Size: ~ $600 trillion
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Right, but not obligation, to buy or sell
◦ Right to buy with a call; right to sell with a put
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At a pre-defined price
◦ The strike price
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At a pre-defined date
◦ Expiration date: usually the 3rd Friday of the month
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A specified amount
◦ Regular size is 100
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 Call
– right to BUY
 Put
– right to SELL
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Speculation (leveraged)
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Risk management (hedging)
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Interesting payoff structure
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ING Groep Call dec-2013 6,40
Underlying: ING Groep
Option type: Call
Expiration date: dec-2013
Strike price: 6,40
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Derivatives
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Indices
Commodities
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European style options
◦ Cannot be exercised before expiry
◦ Expires Thursday before 3rd Friday of the month
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American style options
◦ May be exercised before expiry
◦ Expires 3rd Friday of the month
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In Europe we trade American style options
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Called “writing” an option
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You do not have a right to buy or sell;
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You have the obligation to sell or buy
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If you own stocks you do not need a margin
for a call option (Covered short selling)
Otherwise you need a margin
◦ A portion of your account is set aside as a safety
that guarantees you will be able to meet your
obligation
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Buy 100 stocks
Write 100 call options
(1 contract)
You receive the
premium!
Limits profits, but reduces losses
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1) You buy a put option. Stock goes down
Profit or loss?
2) You buy a call option. The stock goes up.
Profit or loss?
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Underlying
value
Time value
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Other
Current stock price-strike
price. (Intrinsical value)
The longer away the higer
the price
Volatility, risk free rate,
dividend yield.
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Premium = Time Value + Intrinsic Value
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Time Value:
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Brokerage fees:
◦ 2,95 or 1,95 per
contract
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Bid-Ask spread
◦ This may vary over the
lifetime of the option
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• Spread
• Absolute
• Relative
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So, nice to know..
but how does it work??
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Long
Strike price
Short
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Long
Strike price
Short
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Stock price 30
Buy 1 call 32
Write 1 call 34
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Careful:
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◦ Before expiry
you gain on low
call and lose
on high call
◦ Net effect?
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Buy 1 call 26
Buy 1 put 26
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Strangle
Long strangle
Butterfly spread
Iron Butterfly spread
Iron Condor
Protective collar
Etc.
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“Options involve risks and are not suitable for
everyone. Option trading can be speculative
in nature and carry substantial risk of loss.
Only invest with risk capital”
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About 90% of private traders lose money on
options.
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You can be correct and still lose money
◦ for example: you lose more time value than you
gain on a stock increase
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You can lose more than your initial
investment when you sell an option
◦ Shorting a call can lead to inifinite amount of loss
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Markets can become VERY illiquid when you
are deep into the money
◦ Bid-Ask spread widens for example
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Suppose we buy 1 Nov 15’ 26 Call
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On Nov 15 Philips is at 27.5
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Profit: 100 ∗ (€27.5 − €26 − €0.43) = €107
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Profit: −€43! As you do not exercise your option
ii. On Nov 15 Philips is at 25
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Suppose we expect Aegon to move up or
down by a significant amount
◦ Buy Nov 15’ 6 Call and Put (“long straddle”)
◦ Why is the put more expensive than the call option?
 The put option is “in-the-money” by 6 − 5.828 = 0.172
◦ How much does Aegon’s stock price need to move?
 Premia paid: 0.07 (Call) + 0.23 (Put) = 0.30
 Either 0.472 up (6.3) or 0.128 (5.7) down for a profit of
€0
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Suppose we expect Aegon to move up or
down by a significant amount
◦ What is the worst case scenario for a long straddle?
 Stock price goes to 6 for a loss of €30
◦ Suppose we went short the straddle, how would
this change the aforementioned question?
 Ideal case: stock price goes to 6, profit of €26 (don’t
forget, we sell at the bid!)
 Horrible case: stock goes to infinity
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Construct a covered call for Arcelor Mittal
◦ Long 100 shares MT, short 1 call Nov 15 11.5 Call
◦ What is the collected premium?
 Bid: 100 ∗ €0.37 = €37
◦ For which stock price(s) at expiration is the profit 0?
 11.58 − 0.37 = 11.21
◦ What is the upper profit bound?
 Gain on shares is offset by the short option
position, thus 100 ∗ (0.37 − 0.08) = €29
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We hope you have enjoyed
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