Options By: Kyle Lau, Matthew Cheung, and Fabian Kwan

Options and Their Characteristics Definition: A contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. A security, similar to a stock or bond Classified under derivatives market Generally, Two Types of Options: Puts Calls Created by investors seeking to trade in claims on a particular stock, stock index, or futures contract Each contract represents the right to buy or sell 100 shares Maturity dates range from several months to several years If not exercised before expiration date, option becomes worthless

Definition of Related Words Strike Price (Exercise Price) - The price at which a specific option can be exercised Expiration Date - The day on which an option is no longer valid and loses all its value Premium - The total cost of an option (sum of the option's intrinsic and time value) Volatility - Used to express the extent to which the return of the underlying asset will fluctuate between the current time and the expiration date Leverage - The use of borrowed capital to increase potential return on an investment Hedge - Making an investment to reduce the risk of adverse price movements on an asset

Differences between Calls and Puts Calls gives holder the right to buy an asset at a certain price buyers hope that the price of the underlying security will increase before option expires (Long position) An increase in security price leads to an increase in call option price Puts gives holder the right to sell an asset at a certain price buyers hope that the price of the underlying security will fall before the option expires (Short Position) An increase in security price leads to a decrease in put option price

Advantages of Options Increase diversity of portfolio Versatility - ability to adjust your position according to market situations Very High Rate of Return Use of leverage, price of 1 contract (100 shares) is relatively low compared to the price of 100 shares of the stock Little price movements of a stock can lead to substantial profits or substantial losses Used for hedging stratergies (Married Puts)

Disadvantages of Options Very High Risk Versatile, but disadvantage is high price fluctuations Investing in Options require a lot of knowledge about how options work and you must correctly predict many factors such as: Direction of a stock's movement Magnitude of the movement Timing of the movement The amount of factors to take into consideration means the odds are stacked against you

How Options Work August 1, the stock price of Fabian’s Dog Corporation is $70 Premium (cost) is $4.00 for a October $73 Call Expiration date is the third Friday of January Total price of the contract is $4.00 x 100 = $ Stock option is the option to buy 100 shares that’s why you multiply the contract price by 100 to get the total price of one contract Have to take commissions into account but will be ignored for this example Strike price is $73 Means the stock price must rise over $73 before the call option can be exercised

How Options Work Because contract is $4.00 per share Break even price would be $77.00 Stock price is currently $70, less than strike price of $73; option is worthless Down by $400, since this amount was paid to purchase one contract A month later, stock price rises to $81, option rises to $8.00 per share. One contract has 100 shares, so option is now worth 8 x 100 = $ Since you paid 400 to purchase contract, profit is 800 – 400 = 400. By expiration date, stock price drops to $65. This is less that 73 strike price, and since there is no time, option contract is worth nothing

How Price of Options are Defined Price is derived from their connected underlying security Affected by many factors Stock Price Strike Price Time Remaining until Expiration Volatility Risk-free interest rate

Option Symbols in the Competition BMOA62 The first part of the symbol represents the symbol of the underlying stock or asset. The length of this depends on the length of the stock symbol The letter that comes before the number represents the expiration month and the type of Option. A-L represents Calls and M-X represents Puts. Each letter from A-L represents one month The last few numbers represent the exercise price in dollars. In some cases, decimals will be represented in the symbol also in the symbol represents $ represents $62.25

Buying and Selling Options in the Competition Possible Actions: o Buy Call o Sell Call o Buy Puts o Sell Puts Maximum contracts to buy or sell: 20 Commission Fees = $20 + $1 x # of contracts

Calculations for Buying and Selling Options in the Competition Buying o Buy 10 contracts of BMOA62 at $1.32/share o 10 contracts = 1000 shares x $1.32 = $1, o Commission Fees = $20 + $10 = $30 o Total: $1, Selling o Selling 10 contracts of BMOA62 at $1.71/share o 10 contracts = 1000 shares x $1.71 = $1, o Commission Fees = $ = $30 o Total: $1,740.00

Exercising Options in the Competition Possible Exercising Actions: o Exercise Call Buy o Exercise Call Buy then Sell o Exercise Put Sell o Exercise Put Sell then Buy

Commissions on Exercising Options in the Competition Commission: Commission of Exercise Call Buy is 1% (Purchase at a strike price of $35 (100 x 35) a share, 1% commission for buying would be $35 (3500 x 0.01)) Commission of Exercise Call Buy then Sell is 1% (Purchase at a strike price of $35 (100 x 35) a share, 1% commission for buying would be $35 (3500 x 0.01), Sell at $45 (100 x 45) a share, 1% commission for selling would be $45 (4500 x 0.01) total commissions would be $80 in commission) The same commission rates apply to put options as well

Calculations for Exercising Call Buy Options Exercise Call Buy (SUA34) –November 8, 2011 Price of Call Option: $2.90 Price of Stock: $36.13 –On November 9, we exercise the option to buy 1000 shares of SU at $ shares x $34 = $34, DateCash# of Options Value of Options # of Stocks Value of Stocks FeesTotal Value Nov 8$97,10010$2,9000$0$100,000 Nov 9$63, $36,130$60$99,170

Calculations for Exercising Call Buy then Sell Options Exercise Call Buy then Sell (SUA34) –November 8, 2011 Price of Call Option: $2.90 Price of Stock: $36.13 –On November 9, we exercise the option to buy 1000 shares of SU at $34 and then sell back at $ shares x $34 = $34, shares x $36.13 = $36, DateCash# of Options Value of Options # of Stocks Value of Stocks FeesTotal Value Nov 8$97,10010$2,9000$0$100,000 Nov 9$63,1000$01000$36,130$60$99,170 Nov 9$99,1100$00 $60$99,110

Sell or Exercise? Generally, it is not profitable to exercise an option early If you exercise early, you lose the extrinsic value of the option. If you wait towards the expiry date of the option, you will not lose the extrinsic value of the option.