Options Price and trading

Agenda Useful terminology Option types Underlying assets Options trading Bull call/put, bear and butterfly spread Straddle, strip, strangle

Useful terminology holders – the buyers of the options, which are also the owners of those options writers – sellers of the options premium - money paid by the buyer to the writer at the beginning of the options contract strike price- price at which a derivative can be exercised expiration date - in derivatives is the last day that an options or future contract is valid exercising - means to put into effect the right specified in a contract

What are the options? Options gives a buyer the right, but not the obligation, to buy or sell a specified quantity of an underlying asset at a pre-agreed exercise price

Option types call option is where the buyer has the right to buy the asset at the exercise price, if they choose to. put option is where the buyer has the right to sell the underlying asset at the exercise price.

Example Suppose shares in ABC company are trading at $3.24 and an investor buys a $3.50 call for three months. The investor, Jack, has the right to buy ABC shares from the writer(seller) of the option (another investor –Bill) at $3.50 if he chooses, at any stage over the next three months. ABC shares are below 3,5$ three months later, Jack will abandon the option if they rise to 6$ buy the share at $3.50 and keep it, or sell it at $6.00 persuade Bill to give him $6.00 – $3.50 = $2.50 to settle the transaction

Example If Jack paid a premium of 42 cents to Bill, what is Jack’s maximum loss and what level does A company have to reach for Jack to make a profit? The most Jack can lose is 42 centsABC shares: 1)rise above $3.92, so then Jack makes a profit 2)If the shares rose to $3.51 then Jack would exercise his right to naked covered

Exercise styles – when, how and under what circumstances? European - styleAmerican - style Bermudan – style May only be exercised at the option’s expiration date Can be exercised at any time up to the option’s expiration May only be exercised on specified dates

Whether and when to exercise an option? options should not be exercised before expiration options should only be exercised if it is in the money American - style Early exercise is a possibility whenever the benefits of being long, outweigh the cost of surrendering the option early

Short selling vs. purchasing a put option Short sale transactions Borrowing shares from a broker Selling them on the market in the hope that the share price will decrease Purchase of a put option Limits the amount of loss

Net payoffs The profit (or loss) from the sale of an item after the costs of selling it and any accounting losses have been subtracted. net payoff = market price of underlying - (strike price+ premium) net payoff = strike price - (market price of underlying + premium) Call option Put option

In,at,out of money options AT THE MONEYIN THE MONEY OUT THE MONEY  an option's strike price is identical to the price of the underlying security  Both call and put options will be simultaneously "at the money”  out of the money is a call option with a strike price that is higher than the market price of the underlying asset, or  put option with a strike price that is lower than the market price of the underlying asset  stock option is worth money and you can turn around and sell or exercise it  For a call option, when the option's strike price is below the market price of the underlying asset  For a put option, when the strike price is above the market price of the underlying asset.

Underlying assets The underlying of a derivative is an asset, basket of assets, index, or even another derivative, such that the cash flows of the (former) derivative depend on the value of this underlying. interest rate security price commodity price foreign exchange rate index of prices or rates other variable

Options trading There are two main forms of trading options Exchange-trading Over-the-counter trading

Options trading Exchange - traded options that are also called (''listed options'') as they have standarized contracts and are settled through a clearing house with fulfillment guaranteed by the Options Clearing Corporation (OCC) Options are described in following scheme: 1. Root symbol of the underlying stock or ETF, padded with spaces to 6 characters 2. Expiration date, 6 digits in the format yymmdd 3. Option type, either P or C, for put or call 4. Strike price, as the price x 1000, front padded with 0s to 8 digits

Example of stock options GOOG P Stock ticker symbol Exp. Date YY/MM/DD Put Or Call Strike price x1000 This is put option for Google shares with expiration date 2014/11/20 with strike price $19.50

Over-the-counter options These are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, the option writer is a well-capitalized institution (in order to prevent the credit risk).

Counterparty risk Risk that a counterparty in a derivatives transaction will default prior to expiration of the trade and will not make the current and future payments required by the contract. OTC counterparties must establish credit lines with each other, and conform to each other's clearing and settlement procedures.

Put-Call Parity States that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. Since American style options allow early exercise, put-call parity will not hold for them.

If these two portfolios have same expiration value, then they must have the same present value. If the put-call parity is not achieved, arbitrage trader can go long on the undervalued portfolio and short on the overvalued portfolio to make a riskfree profit on expiration day!

Some trading strategies explanation Covered call Protective put Bullish strategies Bearish strategies Butterfly

Covered call A covered call is an options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset. This is often employed when an investor has a short-term neutral view on the asset and for this reason hold the asset long and simultaneously have a short position via the option to generate income from the option premium.

Protective put The put option acts like an insurance policy - it costs money, which reduces the investor's potential gains from owning the security, but it also reduces his risk of losing money if the security declines in value EXAMPLE If an investor purchased a stock for $10 that is now worth $20 but he has not sold it, he has unrealized gains of $10. If he doesn't want to sell the stock yet (perhaps because he thinks it will appreciate further) but he wants to make sure he doesn't lose the $10 in unrealized gains, he can purchase a put option for that same stock that will protect him for as long as the option contract is in force. If the stock continues to increase in price, say, going up to $30, the investor can benefit from the increase. If the stock declines from $20 to $15 or even to $1, the investor is able to limit his losses because of the protective put.

Bull call spread A bull call spread is used when a moderate rise in the price of the underlying asset is expected. The maximum profit in this strategy is the difference between the strike prices of the long and short options, less the net cost of options. A bull call spread is an options strategy that involves purchasing call options at a specific strike price while also selling the same number of calls of the same asset and expiration date but at a higher strike.

Example of bull call spread Let's assume that a stock is trading at $18 and an investor has purchased one call option with a strike price of $20 and sold one call option with a strike price of $25. If the price of the stock jumps up to $35, the investor must provide 100 shares to the buyer of the short call at $25. This is where the purchased call option allows the trader to buy the shares at $20 and sell them for $25, rather than buying the shares at the market price of $35 and selling them for a loss.

Bull put spread We have to purchase one put option while simultaneously selling another put option with a higher strike price Goal of this strategy is realized when the price of the underlying stays above the higher strike price, Short option to expire worthless, resulting in the trader keeping the premium. This type of strategy (buying one option and selling another with a higher strike price) is known as a credit spread because the amount received by selling the put option with a higher strike is more than enough to cover the cost of purchasing the put with the lower strike.

Bear call spread A bear call spread is a limited profit, limited risk options trading strategy that can be used when the options trader is moderately bearish on the underlying security. It is entered by buying call options of a certain strike price and selling the same number of call options of lower strike price (in the money) on the same underlying security with the same expiration month.

Bear call spread example Let's assume that a stock is trading at $30. An option investor has purchased one call option with a strike price of $35 for a premium of $0.50 and sold one call option with a strike price of $30 for a premium of $2.50. If the price of the underlying asset closes below $30 upon expiration, then the investor collects: $200 (($ $0.50) * 100 shares/contract)

Butterfly spread In finance, a butterfly is a limited risk, non-directional options strategy that is designed to have a large probability of earning a limited profit when the future volatility of the underlying asset is expected to be lower than the current volatility.

Long butterfly The spread is created by buying a call with a relatively low strike (x1), buying a call with a relatively high strike (x3), and shorting two calls with a strike in between (x2)

Examples of combined strategies Straddle Strip Strap Strangle

Straddle A straddle is an options strategy with which the investor holds a position in both a call and put with the same strike price and expiration date. This allows the investor to make a profit regardless of whether the price of the security goes up or down, assuming the stock price changes dramatically.

Strip The strip is a modified, more bearish version of the common straddle It involves buying a number of at-the-money calls and twice the number of puts of the same underlying stock, striking price and expiration date.

Strangle The strategy involves buying an out-of-the- money call and an out-of- the-money put option. A strangle is generally less expensive than a straddle as the contracts are purchased out of the money.

Strap Same as strip but here we find more probably to rise in price

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