Options MU Investment Club Spring 2013

Basics MU Investment Club Spring 2013

What is an Option? An option is a contract that gives Party A to buy or sell something to Party B at a predetermined price. Stock Options are contracts that allow Party A to buy or sell 100 shares of a certain stock at a specified price per share, or strike price. Call Option is the right to Buy the stock Put Option is the right to Sell the stock MU Investment Club Spring 2013

Ancient History 350 B.C. Thales bought options on olive presses Romans bought/sold options on cargoes European Options Exchange opened in Amsterdam in April of 1978 Prior to 1963 all options were sold over the counter MU Investment Club Spring 2013

Modern History In late 1960 Joseph W. Sullivan, Vice President of Planning for the CBOT proposed: standardizing the strike price, expiration, size, and other relevant contract terms create a mediator to issue contracts and guarantee settlement and performance (Options Clearing Corporation ) April 26, 1973 CBOE began trading on standardized, listed options. the first day of trading: only call option 911 contracts traded on 16 underlying stocks. By the end of 1974, average daily volume exceeded 200,000 contracts MU Investment Club Spring 2013

Features of Stock Options Strike Price (X): the price at which a the underlying stock can be bought or sold Stock Price (S): the price of a share of the underlying stock Expiration Date: day option expires; generally the third Friday of the month; options in or at the money will be automatically exercised Value of Call/Put (C/P): the cost to buy or price to sell an option MU Investment Club Spring 2013

Terminology Long: Buy Short: Sell In the Money (ITM): an option with intrinsic value and extrinsic value At the Money (ATM): an option at the strike price Out of the Money (OTM): an option with only extrinsic value

Terminology Exercise: going through with an option If you bought a Put option and want to sell your shares at that strike price, you can exercise your option and someone will have to buy your shares for that price. Assigned: having to make good on an option contract If you sold a contract and someone on the other end wants to exercise her right you are obligated to sell that person your shares at the strike price.

Intrinsic and Extrinsic Value MU Investment Club Spring 2013

Definitions Intrinsic Value: the value of the difference between the strike price and stock price that you would receive if you exercised the option today ( zero if at or out of the money) Extrinsic Value: the difference between the value of the option and the intrinsic value MU Investment Club Spring 2013

Examples Example 1: A call option is selling for $4. It has a strike price of $50 and the stock is trading at $53. $53-$50 = $3 of Intrinsic Value $4-$3= $1 of Extrinsic Value Example 2: A call option is selling for $2. It has a strike price of $50 and the stock is trading at $49. $50 > $49 = $0 of Intrinsic Value $2-$0= $2 of Extrinsic Value MU Investment Club Spring 2013

Why does Extrinsic Value Exist? Time is money. Extrinsic value is a measure of how likely the stock price is to meet or exceed the strike price before the expiration date. MU Investment Club Spring 2013

Extrinsic Value Decay Chart MU Investment Club Spring 2013

Option Strategies MU Investment Club Spring 2013

Long Call or Long Put Level of Risk: cost of the option Long Call: buy a call option Long Put: buy a put option

Naked Call or Naked Put Level of Risk: theoretically infinite Naked Call: selling a call Naked Put: selling a put Naked Calls are more risky than Naked Puts because whereas a stock price can theoretically increase to infinity, a stock price can only sink down to $0 MU Investment Club Spring 2013

Covered Call Covered Call: sell a call option on the shares you own For example, if you owned 100 shares of AAPL you could sell a call option against those shares, so if the option was assigned you would have to sell those shares and not have to buy shares at market price Strategy: good way to make extra money on your holdings that are mostly flat or going through gradual appreciation, would have to be okay with selling the stock at the set target price MU Investment Club Spring 2013

Covered Call Profits Bought the Stock at $30, Strike Price of $35, Sold Call for $3 In short, selling a covered call will make you: price of the option * 100 * number of contracts sold- commission If the option is assigned, you will make: price of the option * 100 * number of contracts sold – commission & assignment fees + difference between purchasing price of stock and strike MU Investment Club Spring 2013

Covered Put Sell a put option, but hold enough money to buy all the stock in reserve For example, if you sold a put option on AAPL with a strike price of $450, if the option was assigned, you would have the $450*100, or $45,000 set aside to buy all 100 shares Strategy: could use to buy a stock you think is overvalued at the price you would like to while making cash premiums while you wait for it to hit your price, works well for fundamentally strong stocks when you have a large amount of cash sitting in your portfolio MU Investment Club Spring 2013

Spreads Buy and Sell a Call or a Put option Can differ in strike price (vertical), expiration date (horizontal), or both (diagonal) Profits and losses are capped MU Investment Club Spring 2013

Straddles Buy or Sell a Call and a Put Can differ in strike prices Long Straddles-losses capped, profit infinite Short Straddles – profits capped, losses infinite MU Investment Club Spring 2013

Other Strategies All other strategies are some combination of Spreads, Straddles, and the underlying stock The Options Guide has a pretty extensive list of other strategies: strategies.aspx strategies.aspx MU Investment Club Spring 2013

Other Areas of Interest Black-Scholes Option Pricing: Option Greeks: introduction/option-greeks/ introduction/option-greeks/ MU Investment Club Spring 2013