Options

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Options

• Topic 9

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I. Options

• A. Definition The right to buy or sell a
  specific issue at a specified price (the exercise
  price) on or before a specified date regardless
  of what the market price of the security is on
  the date the option is exercised.
• B. Call The right to buy a security.
• C. Put The right to sell a security.

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I. Options (continued)

• D. Option Writer
• The person who writes the call or put and
  receives a premium
• E. Option Buyer
• The person who buys the call or put and pays the
  premium

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I. Options (continued)

• F. Relation of Options to Stock

Stock Market
Option Market
Option Investor
Company
Investor

• Stock and Option Markets are unrelated
• except for the market price of a stock in
• the stock market and the exercise price
• of the stock option.

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II. Investor Profit Profiles

• Assume you bought 1 share of T.I. at 40. This is
  your profit profile given various assumptions
  about T.I.s future market price.

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II. Investor Profit Profiles

• A. Call Option Profit Graph of Buyer and Seller
• Situation Investor thinks a security will
  increase in price -- can buy security or a call
  option. If price declines, Investor has a
  capital loss in long position or loses his option
  premium when expired.

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1. Profit Graph of Call Buyer

• Note Upside potential is unlimited, Downside
  risk is limited

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2. Profit Graph of a Call Seller

• Note Upside potential is limited to the premium
  received. Downside risk is unlimited.

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B. Put Option Profit Graph of Buyer and Seller

• Situation Investor thinks a security will
  decrease in price -- can short sell or buy a PUT
  option. If the security increases in price, the
  short position produces a capital loss and the
  option position produces a premium loss.

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1. Profit Graph of Put Buyer

• Note Upside potential is limited to the price
  of the security. Downside risk is limited to the
  premium.

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2. Profit Graph of Put Seller

• Note Upside potential is limited to the
  premium. Downside risk is limited to the price
  of the security.

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C. Listed Options Quotes

• Option Strike Calls Price May Aug Nov
• Mobil 20 8 8 3/4 9
• 27 1/8 25 3 3 5/8 4
• 27 1/8 30 1/2 1 1/4 1 5/8

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C. Listed Options Quotes (continued)

• Option Strike Puts Price May Aug
  Nov
• Mobil 40 1/8 5/16 5/8
• 40 45 11/16 1 1/8 1 1/4
• 50 50 3 3/8 3 3/8 r
• Mobil common stock closed at 27 1/8 per share on
  February 25, 2004.

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D. Option Premiums

• 1. Option premium is the price an option buyer
  must pay for the right and the price an option
  writer receives for selling the right.

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D. Option Premiums (continued)

• 2. Effected by
• a. The Security Price
• Premiums are directly related to the relative
  magnitude of the security price since the risk of
  price change is a function of the price.
• Example Stock A P 100
• Stock B P 10
• Loss potential as a result of changes in security
  price is greater for Stock A, and hence, the
  option writer will require a greater premium.

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D. Option Premiums (continued)

• b. Length of Option Life
• 3, 6, 9 months
• Longer term options on the same security are
  riskier since the probability of adverse price
  changes increases with time. Higher premiums
  compensate the seller for this greater risk.

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D. Option Premiums (continued)

• c. Variability of Returns
• The greater the past variability of return on the
  security the more likely that the option will be
  exercised. Greater return variability translates
  into greater option risk, for which, the writer
  wants to be compensated for.

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D. Option Premiums (continued)

• d. Exercise Price
• 1. In-the-Money Call exercise price is below
  the current market price.
• 2. At-the-Money Call exercise price is equal
  to the current market price.
• 3. Out-the-Money Call exercise price is above
  the current market price.
• Relation between Call Premium and Exercise Price

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E. Option Trading Strategies

• 1. Buying Call Options
• a. Buying to achieve leverage
• The price of a call of 100 shares is
  significantly lower than buying the shares
  outright.
• Example Stock XYZ sells at 50/share and a 50
  call costs 5/share. The Investor can buy the
  call for 500 instead of the 100 shares for
  5,000. If XYZ goes to 60, the value of the
  option is 1000.
• Return on option 500/500 100
• Return on stock purchase 1000/5000 20

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E. Option Trading Strategies (continued)

• b. Buying call options to limit risk
• Investor dislikes the risk of buying XYZ and
  watching it go down in value. Therefore,
  Investor purchases XYZ 50 call at 5 and puts
  remaining in risk-free securities. Hence,
  given the same 5,000, the Investor buys call and
  puts 4,500 into Rf securities.
• Example If XYZ goes to 60, the Investor can
  buy or exercise the option to net 500 plus
  interest from Rf investment. If XYZ stays at 50
  or falls below, the investor has lost his option
  premium which is partly offset by interest income.

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E. Option Trading Strategies (continued)

• c. Buying call option to hedge short stock
  position
• Investor believes XYZ will decline. Investor
  sells XYZ short to obtain total profit potential
  but he is exposed to unlimited loss from stock
  price increase. The Investor buys a call to
  eliminate loss.

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E. Option Trading Strategies (continued)

• 2. Put Option Strategies
• a. Buying Put options for leverage and limited
  risk
• Investor anticipates significant decrease in the
  stock price but does not have the margin money
  for a short sale, and does not want to be exposed
  to unlimited risk of stock price increases.
  Investor buys a put.
• NOTE Stock price must decline enough to break
  even.

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E. Option Trading Strategies (continued)

• b. Buying Put options to hedge against a stock
  price decline
• Investor holds IBM and has already taken a paper
  profit. Investor believes IBM will go higher and
  would like to participate in upside without
  risking a loss on paper profit. So he buys a
  put. If price goes up, the potential is only
  diminished by the cost of the put, whereas the
  paper profits are protected by the put and
  decreased only by the put price.

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Buying Put Options
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E. Option Trading Strategies (continued)

• 3. Option Writing Strategies
• Definition An investor holds 100 shares of IBM.
  Writes 2 calls and receives the option call
  premiums. One option is covered and the other is
  naked.

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E. Option Trading Strategies

• 4. Writing Call Options Strategies
• a. Writing covered calls
• Investor owns 100 shares of IBM (50) and writes
  a call at 55 to earn a greater return than the
  stock alone. Investor earns D 1.00 plus 5.00
  on the call. Return is 6.00 plus any capital
  gains.
• Disadvantage if price goes above 55, the
  upside is limited to 6.00.
• Note Covered call also provides limited
  protection to writer against price decline.
  Price can decline to 45 (50-Premium) before
  writer experiences paper loss.

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E. Option Trading Strategies

• b. Writing naked calls
• Investor writes a call on IBM and receives a
  premium income without owning the security.

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Writing Naked Calls

• Gain is limited to the value of the premium.
  Loss is unlimited because the investor must go to
  the market to buy at a higher price to deliver
  50/share stock at the exercise price.

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E. Option Trading Strategies (continued)

• 5. Writing Put Option Strategies
• a. Writing Puts for Premium Income
• Investor expects the price of the stock he holds
  to increase. Therefore, he can write a covered
  put to increase income. The only risk is that
  the stock falls below current market price.

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Profit Profile
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E. Option Trading Strategies (continued)

• 6. Buying or Writing an Option Straddle
• An Option Straddle is the purchase or the writing
  of both a put and a call on the same security.
• a. Buying a Straddle Price of underlying
  security is expected to move SHARPLY up or down
  before option expiration date. Buy a put and a
  call. Say you pay for a put and a call premium
  of 3.00 each. If the stock moves from 50 to
  above 56 or below 44, a profit is made.

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Profit Profile

• b. Writing a Straddle Price of the underlying
  security is expected to stay at its current
  market value until the option expires. Write a
  put and write a call at 3.00 each and receive a
  total premium of 6.00.
• As long as the stock price remains between 44
  and 56, the option straddle writer makes a
  profit.

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F. Other Option Strategies

• 1. Bull Spread
• Buying a call and selling a call with a higher
  strike price
• Examples
• 1. Buy call with 90 SP
• Premium 5
• 2. Sell a call with 95 SP
• Premium 2

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Profit Profile

• Question If stock price goes to 97, what is
  the net profit to the investor?
• Assignment Determine profits from a range of
  85 to 110 profit profile.

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F. Other Option Strategies (continued)

• 2. Bear Spread
• Buy a put option and sell a put with a lower
  strike price
• Examples
• 1. Buy a put with 110 SP
• Premium 5
• 2. Sell put with 105 SP
• Premium 2

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Profit Profile

• Assignment Determine net profits from a range
  of prices of 85-115.
• Also generate a graph or profile.

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F. Other Option Strategies (continued)

• 3. BUTTERFLY SPREAD
• The butterfly spread is a neutral position that
  is a combination of both a bull and bear spread.
• Example P 60
• July 50 call 12July 60 call 6July 70
  call 3
• Butterfly spread
• Buy 1 July 50 call (1200)Sell 2 July 60
  calls 1200Buy 1 July 70 call
  (300) (300)

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Profit Profile (Bicycle)

• Assignment Determine net profits from a range
  of 40-80. Profit profile.

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F. Other Option Strategies (continued)

• 4. Calendar or Time Spread
• Involves the sale of one option and the
  simultaneous purchase of a more distant option,
  both with the same strike price.

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Calendar or Time Spread

• Example
• JAN. APR50s JUL50s OCT50s
• XYZ 5 8 10 50
• Neutral Spread investor should have the initial
  intent of closing the spread by the time the
  near-term option expires.

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Calendar or Time Spread (continued)

• Assume the following
• Call Options
• APRIL 50 JULY 50 OCT 50
• JAN(3 mo.) (6 mo.) (9 mo.)
• 50 5 8 10
• APR
• 50 0 5 8

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Calendar or Time Spread (continued)

• In January the investor sells the APR 50 call and
  buys the July 50. His debit position is-3
  points.
• In April the price is unchanged and the 3 month
  call (July) should be worth 5. The spread
  between the April 50 and the July 50 has now
  widened to 5. Since the spread cost 3, a 2 pt.
  profit exists. Investor should now close his
  long position by selling his July 50 call and
  reaping a 2 pt. profit.

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Bullish Calendar Spread

• Investor sells the near-term call and buys a
  longer-term call when the underlying stock is
  some distance below the SP of the calls.
• Feature of low dollar investment and large
  potential profit.
• Example XYZ 45 in Jan.
• Sell April 50 for 1
• Buy July 50 for 1 1/2

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Bullish Calendar Spread (continued)

• Investor wants 2 things to happen
• 1. Near-term call expires worthless
• 2. Stock price must rise by the time July call
  expires
• Assume price goes to 52 b/w April July.
  Investor nets 1 1/2 pts. How?