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Why Options? Why Bother?
Without options,
there are three strategy choices.
Short Stock T-BillLong Stock
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Options Give You Options!
Ratio Call Spread Call Volatility Spread Split-strike Synthetic Put Volatility Spread
Long Straddle Short Straddle Long Strangle Short Strangle
Long Call Short Call Long Put Short Put
Options offer many strategy choices.
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Possible Portfolio Objectives
Generate income
Limit risk Reduce variability of returns
Lower the cost of protection Increase exposure to equities
without increasing risk
Buy equities during the next sixmonths at lower prices
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What are Options?WHAT ARE OPTIONS?
Options are _________
Option buyers get ______
Option sellers get __________
contracts
rights
obligations
Options Basics
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Contract Terms
Buyers of calls get the __________
Sellers of calls get the _______________
Buyers of puts get the __________
Sellers of puts get the _______________
right to buy
obligation to buy
right to sell
obligation to sell
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LONG PUT
Bearish
Protect a stock or portfolio
SHORT PUT
Collect premium (income)Establish a purchase price
LONG CALL
Bullish
Buy stock and limit risk
SHORT CALL
Collect premium (income)Establish a selling price
Basic Strategies at Expiration
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Rule 1 for Pricing Options
At expiration, an option is worth its
intrinsic value or zeroCall = Max (0, Stock Price Strike Price)
Put = Max (0, Strike Price Stock Price)
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Rule 2 for Pricing Options
Prior to expiration, there are no rules
Prices reflect the balancing of supply anddemand
Yet, there are tendencies in options pricesthat we can generally rely upon
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3 Option Pricing Concepts
Time Decay: Option prices decrease asexpiration approaches.
Delta: Options prices change to a lesserdegree than changes in the underlyingstock or index price; Delta measures thedegree.
Volatility: Options prices increase as themarkets expectations of underlyingvolatility increase.
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Time Decay is Complicated
At-the-money (ATM) options decay lessinitially and more as expirationapproaches.
Out-of-the-money (OTM) options decay in a
more linear fashion (least erosion nearexpiration).
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Time Decay ATM vs. OTM
0.00
5.00
10.00
15.00
20.00
25.00
35 Days 28 Days 21 Days 14 Days 7 Days Exp.
1300 Call (ATM)
1350 Call (OTM)
SPX @ 1,300
Assumes SPX remains @1,300, and volatility expectations remain constant .
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Call Prices vs. Index Prices
Option
Value
X = 1300 Index Price
Long 1300 Call
* Stylistic presentation; drawing is not to scale
Several days prior to expiration
At expiration
Intrinsic Value
Time Value
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Put Prices vs. Index Prices
Option
Value
X = 1300 Index Price
Long 1300 Put
* Stylistic presentation; drawing is not to scale
Several days prior to expiration
At expiration
Intrinsic
Value
Time Value
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Delta: A Measure of Exposure
Option
Value
X = 1300
Index PriceS = 1200 S = 1300 S = 1400
= .10
= .50
= .95
OTM
ATM
ITM
* Stylistic presentation; drawing is not to scale & deltas are approximated
Long 1300 Call, several days before expiration
Call value several days
before expiration
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Delta vs. Moneyness
In-the-Money Calls Delta > 50%At-the-Money Calls Delta 50%
Out-of-the-Money Calls Delta < 50%
When index
moves up 1 point
Call price moves up
less than 1 point
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Deltas change as time passes
Option
Value
Index Price
Long 1300 Call: At expiration, delta is either 0.00 or 1.00
* Stylistic presentation; drawing is not to scale
Several days prior to expiration
At expiration
S = 1200 S = 1300 S = 1400
= 0.0
= 1.00
OTM
ITM
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Volatility Defined
Volatility means __________movementprice fluctuation
uncertainty
risk (like in insurance)
Types of volatility: Name:
Past stock price movement _____________
Reflected in option prices _____________
Future stock price movement _____________
Historical volatility
Implied volatility
Realized volatility
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Volatility Uncertainty
Five primary factors that influencean options value:
1. Underlying Price (today)
2. Strike Price
3. Expiration Date4. Interest Rate (for $1 invested
today through expiration)
5. Volatility of the Underlying Price(from today until expiration)
Assuming no dividends
Where do
we find
these inputs?
#1 - #4
are easy!
#5???
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Imply Volatility from Option Prices
SPX 1,300 1,350 1,350
Days to Exp. 28 21 14
1300 Call 20.00 52.00 51.00
1350 Call 5.00 18.50 15.00
Implied Volatility 14% 14% 14%
What if implied volatility drops to 11%?
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SPX 1,300 1,350 1,350
Days to Exp. 28 21 14
1300 Call @ 14% 20.00 52.00 51.00
Volatility @ 11% 50.50 50.00
1350 Call @ 14% 5.00 18.50 15.00
Volatility @ 11% 14.63 12.20
Prices are sensitive to Volatility
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The Risk of Changing Volatility
Changing volatility can have a
significant impact on option prices!- A profit might become a loss.
- The best option may change.- Another strategy might be better.
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Option Pricing - Summary
Time Decay impacts everyoption; the degreeof impact depends moneyness.
Delta concept: Option prices change to alesser degree than index prices.
Volatility expectations directly impact optionsprices. Options prices can be used to implythat expectation. Expectations change daily!
Option strategy construction involvescontemplating the effects of all three
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