Presentation on theme: "A Primer on Call and Put Options"— Presentation transcript:
1A Primer on Call and Put Options OLLI ClassFall, 2011
2Call optionsA listed call option on an individual stock is a contract that allows the call buyer tobuy from the call option seller (or writer)100 shares of a specified stockat a specified price (striking price)any time before the date of expirationby paying a premium to the option seller
3Put optionsA listed put option is a contract which allows the put buyer to:sell to the put option seller (writer)100 shares of a specified stockat a specified price (striking price)any time before the date of expirationby paying a premium to the option seller
4Essential termsThe buyer of a put or call has a long position in the option and the right of exercise.The call seller has a short position and has the obligation to sell the stock if assigned.The put seller is short the put and must buy the stock if assigned.
5American or European Style All listed options can be traded prior to expiration, but:American options can be exercised anytime prior to expiration. All listed equity options and the OEX (S&P100) are American options.European options can be exercised only at expiration. Most index options are European style options.All else equal, an American option will have a higher premium than the identical European option
6Types of Options Available Individual equity/stock optionsIndex OptionsBroad Based (S&P 500, DJIA, S&P 100)Sector indexesLEAPS (long term options up to 2 years)FLEX options (customized contracts)Interest Rate optionsForeign Currency options
8Creating a call payoff diagram Exercise price = days to expirationInterest rate = Stock price = $70Premium = $ 5.25Stock and call payoff at expirationstock call payoff stock payoff= == == == =
9Risk Management Strategies: Long stock compared to buying callProfitlong stock7075.25stock price atexpirationbuy call5.25Market outlook: bullishLoss
10Risk Management Strategies: Short the call: (i.e. sell the call)Profitsell call5.2570stock priceat expirationMarket outlook: bearishLoss
11Risk Management Strategies: Covered Call: long stock - sell calllong stockProfitsell call5.25long stock - short call64.7570stock priceat expirationLossMarket outlook:long term bullish but short term neutral
12Risk Management Strategies: Buy Put compared to shorting stockProfitshort stockstock price atexpiration7065.375buy put4.625Market outlook: bearishLoss
13Risk Management Strategies: Short put: (sell the put)Profitsell put4.625stock price atexpiration7065.375Market outlook: bullishLoss
15The Costless Collar: long stock + put - call Buy $70 buysell net cost of $69.375Profit+stock-call5.62565703.25752.654.375+putstock priceat expirationLossMarket outlook: neutral but nervously bearish
16Trading Volatility: The Straddle Long straddle: buy the call and put with same characteristics. Exercise price is $70:profit/loss profit/lossStock portfolio
17Risk Management Strategies: Long straddle: buy call + buy putProfitbuy putbuy call70stock price atexpiration9.875Market outlook: volatility will increaseLoss
18Risk Management Strategies: Sell the straddle: short call + short put9.875Profitsell callsell put70stock price atexpirationMarket outlook: volatility will decreaseLoss
19Creating a Synthetic Forward Sell the 70 put for $4.625 and buy the 70 call for $5.25 for a debit of $ .625.-put + callprofit4.625-put70Stock priceAt expiration+call5.25loss
20Strategies for Today’s Market It Depends on Your Market View
21Just the fact, ma’am:The S&P 500 (SPY) is at having varied between 135 and 125 since January 2011.Volatility is relatively low, about 17 on the VIXYou own 1,000 shares of SPY stock.
22SPY Option Premiums:June 17, 2011 SPY 128 Strike Aug Sep Dec Price Calls Puts Calls Puts Calls Puts Aug: 63 days Sep: 105 days Dec: 182 days
23Case 1: You are neutral to bearish between now and October You could sell all your stock, but … what if you’re wrong. Let’s consider some option strategies:
24Conservative Strategies to Manage Downside Risk Covered call strategy: Sell Aug calls with strike of 130 (neutral to slightly bearish)Protective put strategy: Buy Sep puts with strike of 125 (bearish, but don’t want to be out of the market).Collar strategy: Sell Aug 130 calls and buy Aug 120 puts (very bearish).
26Covered Call: long stock - sell call Own Stock at 128; Sell 130 Aug Call $2.65Profit4.65long stock - short call125.35130stock priceat expirationLossMarket outlook:long term bullish but short term neutralMax Return = (4.65/128) = 3.6% for 63 days; max loss unlimited less $2.65
28Protective put: long stock + buy put Profitlong stock+ buy put125stock price atexpirationMax loss price134.407.40Market outlook: nervously bullishLossMax loss = 7.40/128 = 5.8% over 105 days; Max gain = unlimited
30The Costless Collar: long stock + put - call Profit$2.30120130$7.30stock priceat expirationLossMarket outlook: neutral but nervously bearishMax loss = 5.7%; Max gain = 1.8%; over 105 days
31Instead of a limit order below the market, sell a “cash secured” put Case 2: You have cash and are neutral to bearish between now and December but willing to buy if market goes down another 5+%.Instead of a limit order below the market, sell a “cash secured” put
32Payoff table “Cash Secured Put”: Sell Dec 120 put @4 Payoff table “Cash Secured Put”: Sell Dec 120 Invest cash (T-bills) of $120-$4.95 = $115.05Stock Cash of portfolio1Would include 182 days of interest, which today is close to 0%2This is a return of 4.95/ = 4.3% for 182 days (8.6% annualized)if the market stays above 120.
33Case 3: The Bullish Case by year end You think the market will be flat until early fall then will rally above 140 by December.Split Strike Synthetic:Buy the Dec 135 call for $3.25Sell the Dec 120 put for $4.95
34Payoff table Split Strike Synthetic: Sell Dec 120 put @4 Payoff table Split Strike Synthetic: Sell Dec 120 Buy Dec 135Stock portfolio
35Synthetic Forward: Long Call + Short Put profit1.70-put120135Stock priceAt expirationlossYou are out of the market between 120 and 135 with a return of $1.70 over 182 days
36Case 4: You are neutral to bearish between now and December, but … You are willing to buy stock if the market goes below 120 and sell what you have above 135
37Sell a “Strangle” – sell a put and call with same expirations but different strikes. Sell the Dec 135 Call for $3.25 and sell the Dec 120 put for $4.95, you own the stock at 128:Stock call 120 put stock portfolio
38Sell a strangle and own the stock: Sell 120 put; sell 135 call; own the stock Profit15.20.20115120135stock price atexpirationLossSell you stock at $ if market goes above 135;Buy more stock at $11.80 if market goes below 120.