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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 pricePut: exercise price>market price

Out of the Money - exercise of the option would not be profitableCall: market price>exercise pricePut: 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=PPayoff: 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 < XProfit to Call Writer

Payoff + Premium

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ProfitProfit

Stock Price Stock Price at expirationat expiration

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Call WriterCall Writer

Call HolderCall Holder

Profit Profiles for CallsProfit Profiles for Calls

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Payoffs and Profits at Expiration - Puts

Payoffs to Put Holder0 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 Writer0 if ST > X

-(X - ST) if ST < X

Profits to Put WriterPayoff + Premium

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Profit Profiles for PutsProfit Profiles for Puts

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Profits

Stock Price at expiration

Put Writer

Put Holder

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 PriceApple Price

$75$75 $80$80 $100$100

All StockAll Stock $7,500$7,500 $8,000$8,000 $10,000$10,000

All OptionsAll Options $0$0 $0$0 $16,000$16,000

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Equity and Options

Apple PriceApple Price

$75$75 $80 $80 $100$100

All StockAll Stock -6.25%-6.25% 0% 0% 25% 25%

All OptionsAll Options -100% -100%-100% -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 taxExecution:

buy Stock and buy Put

Critics: why pay for unnecessary insuranceYou 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-the-Money

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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