Academy 5Basic 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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How important are options?

Banks and institutional investors Size: ~ $600 trillion

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Over the counter market

Right, but not obligation, to buy or sell◦ Right to buy with a call; right to sell with a put

At a pre-defined price◦ The strike price

At a pre-defined date◦ Expiration date: usually the 3rd Friday of the

month A specified amount

◦ Regular size is 100

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What are options?

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Call – right to BUY

Put – right to SELL

Call - Put

Speculation (leveraged)

Risk management (hedging)

Interesting payoff structure

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Why should you use options?

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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

Example

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Underlyings

Commodities

Indices Derivatives

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European style options◦ Cannot be exercised before expiry◦ Expires Thursday before 3rd Friday of the month

American style options◦ May be exercised before expiry◦ Expires 3rd Friday of the month

In Europe we trade American style options

Styles of options

Called “writing” an option

You do not have a right to buy or sell;

You have the obligation to sell or buy

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Selling options

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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Covered vs. Uncovered Shorts

Buy 100 stocks Write 100 call options (1 contract)

You receive the premium!

Limits profits, but reduces losses

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Covered call

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1) You buy a put option. Stock goes downProfit or loss?

2) You buy a call option. The stock goes up.Profit or loss?

Scenario’s

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Black and Scholes

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Option pricing

Underlying value

Time value

Other

Current stock price-strike price. (Intrinsical value)

The longer away the higer the price

Volatility, risk free rate, dividend yield.

Break

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Premium = Time Value + Intrinsic Value

Time Value:

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Importance of time value

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Brokerage fees:◦ 2,95 or 1,95 per

contract

Bid-Ask spread◦ This may vary over

the lifetime of the option

Trading Costs:

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Bid-Ask Reality: Equity

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Bid-Ask Reality: Options• Spread• Absolute• Relative

So, nice to know..

but how does it work??

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Long Short Strike price

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Quizz

Long Short Strike price

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Quizz

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Hedging

Stock price 30 Buy 1 call 32 Write 1 call 34

Careful:◦ Before expiry

you gain on low call and lose on high call

◦ Net effect?

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Call spread

Buy 1 call 26 Buy 1 put 26

Straddle

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Strangle Long strangle Butterfly spread Iron Butterfly spread Iron Condor Protective collar Etc.

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More option strategies

“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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Warning

About 90% of private traders lose money on options.

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Private traders

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Dangers of options You can be correct and still lose money

◦ for example: you lose more time value than you gain on a stock increase

You can lose more than your initial investment when you sell an option◦ Shorting a call can lead to inifinite amount of loss

Markets can become VERY illiquid when you are deep into the money◦ Bid-Ask spread widens for example

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Enough info! Let’s exercise!

Suppose we buy 1 Nov 15’ 26 Calli. On Nov 15 Philips is at 27.5

i. Profit: ii. On Nov 15 Philips is at 25

i. Profit: ! As you do not exercise your option

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Case 1: Philips

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

◦ 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

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Case 2: Aegon

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

◦ Suppose we went short the straddle, how would this change the aforementioned question? Ideal case: stock price goes to 6, profit of (don’t

forget, we sell at the bid!) Horrible case: stock goes to infinity

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Case 2: Aegon

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: ◦ For which stock price(s) at expiration is the profit

0?

◦ What is the upper profit bound? Gain on shares is offset by the short option

position, thus 36

Case 3: Arcelor Mittal

See you this evening!We hope you have enjoyed

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