Yazann Romahi 2 nd May 2002 Options Strategies

Synopsis What is an option? Work through an example Call Option What determines the price of an option? Intrinsic Value Option Delta Time Value Volatility Option Strategies Covered Call Bull Spread, Bear Spread Straddles and Strangles Married Put

What is an option? An “option” is a contract that gives you the right but not the obligation to buy (call option) or to sell (put option) an underlying asset at (a European option) or before (American option) some future date (expiry) at some predetermined price (the strike) It is important to note that an option contract controls 100 units of the underlying asset

A Call Option GE is currently trading at $38 If you are bullish, buy “GE $40 June Call” Premium = $140 Option Chain: Range influenced by volatility Expiration dates in 3 month increments Expire on 3 rd Sat of month

Call Option Continued GE reaches $42.50 You exercise your in-the-money option at $40 (making a profit of $2.50 per stock) This gives you a 79% gain while the stock appreciated only 12%. This is called gearing (or leverage). GE closes below the $40 strike Option expires out-of-the-money Entire investment is lost

Ticker Symbol The Ticker Symbols Option ticker symbols have a specified format and are composed of four parts: CCCES.X CCC: The first three symbols refer to the company so above GE referred to General Electric E: This character refers to the expiry month. A-L refer to January through to December respectively for Calls while M-X refer to January-December for Puts S: Strike. A to T are used from 5 to 100 in increments of 5 at which point, it starts again at A for 105 and so on every hundred. X: X refers to the exchange on which this option is traded. This is optional and does not always appear.

The Option Price What determines the price of an option? Intrinsic Value Time Value Volatility of underlying

Intrinsic Value Intrinsic value is extent to which stock is in-the-money GE $35 June call for example is trading at $4.10 With the underlying at $37.87, the intrinsic value is $2.87 Out-of-the-money options do not have intrinsic value What about the sensitivity of option price to underlying? How much the price of an option changes with the underlying depends on how far in or out of the money the option is

How much an option increases in price for moves in underlying Deep-in-the-money options approach a 1-1 relationship “June 30 Call” trading at $2.40 more than “June Call”. That’s a $2.40 difference for a $2.50 difference in the strike. June 30 vs June 32.50: $2.40/$2.50 = 96% June vs June 35: $1.80/$2.50=72% The further in-the-money, the higher the delta! (approaching a 1-1 relationship for deep-in-the-money options) Volatility is a further factor affecting a stock’s delta. Option Delta

Time Value The greater the amount of time to expiry, the higher the time value As expiry date approaches, time value decreases The closer an option gets to expiration, the faster it’s time value declines! The rapid decline in time value during the last month of an option’s life can be so rapid that it often offsets any gain in intrinsic value due to an increase in the underlying stock’s price.

Volatility Considering the following two options roughly 15% away from market price both expiring in the same month

Put Options You think GE will fall to $35 (currently at $37.87) Buy $37.50 April Put at $1.10 If GE falls below $37.50, the option expires in-the-money. Break even point= $37.50-$1.10 = $ If GE falls to $35, the profit earned will be $1.40 on a $1.10 investment, ie. 127% gain.

Writing Options Taking the opposite position of the previously mentioned strategies Receive premium in exchange for risk Unlimited potential loss with a short call Potential loss with a short put is the price of underlying

Covered Call What is a covered call? Buy stock-write call (buy-write) Write call; Buy call with lower strike price in same month Write call; Buy call with same strike price in different month Write call; Cover with LEAPS (covered later, if you’ll excuse the pun) Covered vs. Naked calls Covered call writer is never exposed to unlimited loss

Standard Covered Call You own Nokia ADR at $ Write a $22.50 November October Call Receive $2.40 premium Basis lowered to $ $2.40 = $18.34 But you have limited your upside to 20% gain

Covering with LEAPS Standard options go forward a year, LEAPS go from 9 months up to 2 years At a fraction of the underlying security, often used to cover written calls ABC is at $50, APR-55 call is $4 and JUN LEAP is at $17. Want to sell 10 APR-55 calls collecting $4000 To cover, spend $50/share costing $50,000 Or spend $17 for 10 of the $50 LEAPS at $17000 Buy back call, and sell the LEAP

Options as a cover – Bull Call Spreads Traditional Covered Call: Buy 100 shares of ELNK at 70 for $7000; sell MAY- for $6 depositing $600 in your account Return =16% over 4 weeks Spread: Buy at-the-money MAY-70 call for $8 and sell MAY- 75 for $6. Outlay=$200 If ELNK>75, profit =$5 per share - $2 outlay, ie.150% return If ELNK<70, Loss=100%!

Bull Spreads Max Profit = Difference between strikes – net premia paid Max Loss = Net Premia Paid Break-even-point: Strike of purchased call + net premia paid Bear Put Spread (buying a put option and writing another put with lower strike but same expiration)

Long Straddles Long Staddle Investor anticipates a large move but is not sure of direction Buy call and put with the same strike price and month –EGRP trading at 45; Straddle stock by buying APR-45 call at $4 and buying APR-45 put at $3 giving a basis of $7 –To recoup, stock must move above $52 or below £38

Short Straddles & Strangles Short straddles exist as well where you do not believe there to be a big movement in the market. However, it is not a capped strategy and leaves you open to unlimited loss. A Long Strangle is the same idea as the straddle except that the two strikes are not the same. This means that the investor can purchase two out-of-the-money options which would cost less requiring a lower initial outlay but potentially a larger upward or downward move in the price to attain profitability

Married Put Benefits of stock ownership without downside risk Buy protective put to cover potential losses

Collar Investor wants to protect profits using a married put but does not want to pay the full premium associated with married put Willing to sell stock at a higher price than the current so an out- of-the money call option is written to lower his basis

Other Strategies The Strap The Butterfly Spread The Condor The Seagull Etc. etc. etc.

Tying Up the Loose Ends Commission Typically fixed amount + % of principal Due to high commissions, do not trade options (hold them till expiry) Taxes

Further information Online Tutorials: CUIC Introduction to Options booklet coming out soon…