1 OPTIONS GRAHAM O’BRIEN

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3 What are options? Exchange Traded Options Calls v Puts Options pricing Three common strategies

What are options?

Exchange Traded Options create unique payoffs Prior to the creation of options, only three choices existed: Options give you options! Cash Long a position B Short a position S

6 Share price Pay-off diagram Loss Profit Current share price Long stock

7 Share price Pay-off diagram Current share price Loss Profit Short stock

8 Share price Pay-off diagram Cash Loss Profit

9 Share price Pay-off diagram Loss Profit Earn income (Premium) Protect losses Current share price

What are Exchange Traded Options? A contract between two parties conveying a right, but not an obligation, to buy (call) or sell (put) an underlying security at a specified price within a specified time for an agreed premium BS

Components of an Option Loss Profit An expiration date December, January 2015 etc. An underlying security ANZ, BHP, RIO, TLS, XJO Premium or Price Strike price Every option contract has: Type Put or Call Pay-off diagram for a call

75 stocks and 1 index AGLBSLGMGNCMSGMWES AIOBXBGPTNWSSGPWFD AMCCBAHVNORGSHLWOR AMPCCLIAGORISTOWOW ANNCIMIFLOSHSUNWPL ANZCPUILUOZLSYDXJO ARICSLIPLQANTAH ASXCSRJHXQBETCL AWCCTXLLCRIOTEN AZJCWNMPLRMDTLS BENEGPMQGRRLTOL BHPFLTMTSS32TTS BLDFMGMYRSCGTWE BOQFXJNABSEKWBC

13 Calls v puts

B CallPut Calls vs Puts (rights vs obligations) The right (but not the obligation) to buy The right (but not the obligation) to sell The option buyer (holder of a long position) has the right to purchase or sell the underlying instrument at a: Specified time (until the expiration date) The option buyer pays a premium for this right Specific price (the strike price) B

B CallPut Calls vs Puts (rights vs obligations) Once you have purchased an option (established a long position) you can: Sell it Exercise your right Let it expire The right (but not the obligation) to buy The right (but not the obligation) to sell

S Calls vs Puts (rights vs obligations) The potential obligation to buy The potential obligation to sell The option seller (creator of a short position) is obligated to sell or purchase the underlying instrument at a: CallPut Specified time (until the expiration date) The option seller receives a premium for assuming this obligation Specific price (the strike price) S

Calls vs Puts (rights vs obligations) Once you have sold an option (established a short position) you can: Buy it back Let it expire Be assigned to fulfill your obligation S The potential obligation to buy The potential obligation to sell CallPut

18 Calls vs Puts (rights vs obligations) S The potential obligation to buy The potential obligation to sell CallPut B CallPut The right (but not the obligation) to buy The right (but not the obligation) to sell B

Call options – Recap Share price Loss Profit Strike price Long call Premium

Call options – Recap Share price Loss Profit Short call Strike price Premium

Call options – Recap Gives the buyer the right, but not the obligation, to buy a standard quantity of shares at the exercise price, on or before the expiry date Seller obligated to deliver

Put options – Recap Share price Loss Profit Strike price Long put Premium

Put options – Recap Share price Loss Profit Short put Premium Strike price

Put options – Recap Gives the buyer the right, but not the obligation, to sell a standard quantity of shares for the exercise price on, or before, the expiry date Seller obligated to buy

ASX options – key points Equity options Contract size: 100 shares Expiry day: Last Thursday of the month American style (some Euro style) Physically settled Index options Contract value: $10 per point Expiry day: Third Thursday of the month European style Cash settled

What are Options? Exchange Traded Options (ETOs) Calls v Puts Options Pricing? Top 3 Strategies Options pricing

27 Major pricing factors $4.00 $3.50 Share price Exercise price

28 Major pricing factors $4.00 $ c Intrinsic value Share price Exercise price Share price Exercise price

29 Major pricing factors $4.00 $3.5050c 22c Intrinsic value Share price Exercise priceTime value Time to expiry Dividends Interest rates Volatility Supply and demand

50c 30 Major pricing factors $4.00 $3.50 Share price Exercise price 22c 72c Premium

Out of the moneyIn the money $4.00 $4.50 $5.00 $3.50 In, at or out of the money – calls $3.00 Series At the money

32 The Greeks ThetaDelta

Theta The change in an option’s price given a change in the time to expiration: Is not constant Accelerates as expiry approaches

Theta – time decay Lose 1/3 time value Lose 2/3 time value Option life First halfSecond half

35 The Greeks ThetaDelta

The change in an option’s price given a change in the price of the underlying stock or index: For a $1 change in the price of the underlying stock Is not constant Calls have positive deltas Puts have negative deltas Is highest for “In-the-money” options Expressed as 50 delta =.50 delta

Delta – Call options Out of the money Option moves 1/5 as much as share

Delta – Call options At the money Option moves 1/2 as much as share

Delta – Call options In the money Option moves 1 for 1 with share

Options Pricing Options have value for two reasons: Cost of carry Volatility

Option premiums: Calculated similar to insurance premiums I Stock price Strike Time until expiration Cost of money Volatility Value of car Deductible Time span of policy Cost of money Risk Insurance agentOptions trader T

Option Pricing To calculate an option’s theoretical value, you need: = Theoretical value of the Option The Price of the underlying The Strike Price of the option The Time until the option expires The Cost of Money (Interest Rates less dividends, if any) The Volatility of the underlying

Option Pricing $1 Call Put 84c ValueTheoretical StockExerciseTimeVolatilityInterestDividend $50 30 days16%4%0

Option Pricing StockExerciseTimeVolatilityInterestDividend $50 30 days16%4%0 9c$1 Call Put $ c 84c 8% Double the interest rate ValueOriginal -8c

Option Pricing StockExerciseTimeVolatilityInterestDividend $50 30 days16%4%0 47c $1 Call Put $1.47 $ c30c 60 days Double the time ValueOriginal

Option Pricing StockExerciseTimeVolatilityInterestDividend $50 30 days16%4%0 32% Double the volatility 91c$1 Call Put $1.91 $ c91c ValueOriginal

Statistical Reality of Volatility Implied Volatility30 Days60 Days90 Days 15%4.35%6.13%7.50% 20%5.75%8.17%10.00% 25%7.25%10.21%12.50% 30%8.65%12.26%15.00% 35%10.15%14.30%17.50% 40%11.55%16.34%20.00% 45%13.00%18.38%22.50% 50%14.45%20.43%25.00% 55%15.90%22.47%27.50% 60%17.35%24.51%30.00%

Statistical Reality of Volatility Implied Volatility30 Days60 Days90 Days 15%4.35%6.13%7.50% 20%5.75%8.17%10.00% 25%7.25%10.21%12.50% 30%8.65%12.26%15.00% 35%10.15%14.30%17.50% 40%11.55%16.34%20.00% 45%13.00%18.38%22.50% 50%14.45%20.43%25.00% 55%15.90%22.47%27.50% 60%17.35%24.51%30.00%

Options Pricing Call Value 16% Volatility $2.79 $1.00 $47.50 $50.00 $52.50 Strike Price 20c StockExerciseTimeVolatilityInterestDividend $50 30 days16%4%0 StockExerciseTimeVolatilityInterestDividend $50 30 days16%4%0

Options Pricing 74c 91c $2.79 $1.00 $ c $3.42 Call Value 32% Volatility +91% 370% +22.6% % Change $47.50 $50.00 $52.50 Strike Price 63c Call Value 16% Volatility StockExerciseTimeVolatilityInterestDividend $50 30 days16%4%0 20c

Types of Volatility Based on past performance Historical Implied Actual 3:59pm Eastern Forecast “Embedded” in option’s price Occurs over the life of an option Effective volatility of activity/ when hedging is difficult Option user’s opinion of future stock/index volatility

52 Option terminology Taker/writer Exchange traded options Call/put options Exercise price Expiry month Expiry date Premium Intrinsic value Time value In-the-money At-the-money Out-of-the-money

What are Options? Exchange Traded Options (ETOs) Calls v Puts Options Pricing? Top 3 Strategies Three common strategies

54 Three common strategies Selling Calls Buy-write Generating income Buying Puts Protecting shares Buying Calls Leverage or low-risk?

Three common strategies 1. Bought Call Market view: Bullish

Buying Calls Is buying calls risky?

57 Buying Calls Buying Calls ensures you only buy stock after the market confirms your decision Buys leverage up(calls) So you only buy stocks when the market confirms your decisions Go long with limited risk You don’t get closed out before expiry!

58 Example – AML MAR/400/CALL Call Option Buyer has the right to buy a standard quantity of shares Shares AML Exercise price $4.00 Expiry dateJune Contracts10 If the buyer/taker exercises the option, on or before the September expiry date, the writer/seller must sell those shares at $4.00 The writer receives the premium SB

Exercise price The life cycle of a call option Share price ($) Shares Options Time value Intrinsic value Months Option price ($)

First rule of call buying You would not consider buying call options as a sole strategy unless you are bullish about the underlying stock B

Payoff example $4.00 AML shares Exercise price $ c Premium AML/Jun/350 calls $ c AML/Jun/450 calls $4.00 AML/Jun/400 calls 38c

50c $1.50 Expiry value $4.00 $1.00 Payoff example $5.00 Exercise price $3.50 $4.00 $4.50 AML shares on expiry AML/Jun/350 calls AML/Jun/400 calls AML/Jun/450 calls $620 $340 $780 Profit % Return

50c $1.50 $1.00 Breakeven points – Bought Call $4.00 Exercise price $3.50 $4.00 $4.50 AML shares AML/Jun/350 calls AML/Jun/400 calls AML/Jun/450 calls 72c Premium 16c 38c $5.00

$4.38 P.S. $4.66 P.S. Breakeven points – Bought Call $4.00 $4.22 P.S. Breakeven price AML shares AML/Jun/350 calls AML/Jun/400 calls AML/Jun/450 calls

66c 38c Increase over current 22c Breakeven points – Bought Call $4.00 AML shares AML/Jun/350 calls AML/Jun/400 calls AML/Jun/450 calls

Second rule of call buying The more bullish you are the more you will consider out-of-the money series

Leverage $380 $670 $4,000 $4,500 Bought October Sold December

68 Leverage $ %* 12.5%* Return on investment $500 SharesOptions *Not Including Transaction Charges *Not Annualised

Leverage $380 $0 $4,000 $3,500 Bought October Sold December

70 Leverage -$ %* -12.5%* Return on Investment -$500 SharesOptions *Not Including Transaction Charges *Not Annualised

Bought call Share price Loss Profit $4.00 B C A $4.38 Call at expiry

Bought call – summary Break even Exercise price plus premium Position Pay premium in full Risk/reward Limited risk Unlimited reward Market view Bullish

Three common strategies 2. Portfolio protection Market view: Bearish

Put Options/Protective Puts Assume bullish on the market S&P/ASX 200 index worth $59,500 at 5,950 points Share

Put Options/Protective Puts S&P/ASX 200 index worth $59,500 at 5,950 points Nervous about another market correction Put Options can hedge the portfolio against market hiccups Share

Put Options/Protective Puts S&P/ASX 200 index worth $59,500 at 5,950 points 1 S&P/ASX 200 September 5950 Puts Assume price is 160 points each or $1,600 per contract Share Consider buying

Protective Put Purchase $59,500 Own shares $1, put $61,100 Position investment (b/e) Share

Protective Put Purchase $61,100 Raise break-even level from $59,500 to $61,100 Incur cost to purchase puts Limit downside risk to $1,600 $1,600 $59,500 $61,100 Position investment (b/e)

Protective Put Purchase Puts expire worthless Lose $1,600 (may be offset by stock gain) Receive cash ($10) for every point below 5,950 Loss is limited to $1,600 (premium paid for put) Loss Profit 5,950 XJO at expiration

Protective Put Purchase 4,950 Stock Option Total P&L XJO at expiration Loss Profit ($10,000) ($8,400) ($1,600) $10,000

Protective Put Purchase 5,450 Stock Option Total P&L Loss Profit ($5,000) ($3,400) ($1,600) $5,000 XJO at expiration

Protective Put Purchase 5,950 Stock Option Total P&L Loss Profit ($0) ($1,600) $0 XJO at expiration

Protective Put Purchase 6,450 Stock Option Total P&L Loss Profit ($5,000) ($1,600) ($3,400) $5,000 XJO at expiration

Protective Put Purchase 6,950 Stock Option Total P&L Loss Profit ($10,000) ($1,600) ($8,400) $10,000 XJO at expiration

The Protective Put Strategy Acts like insurance Maximum risk/loss in this example is the “cost of insurance” $1,600 or 3% Insurance expires in September

Benefits – Protective Put Purchase BenefitsRisks Implement protection only if you need it Simplicity Expensive when volatility is high Premium paid for flexibility can result in under-performance Limit risk to a pre- determined amount

Three common strategies 3. Buy-write covered call Market view: Neutral

Buy-Write or Covered Calls Share price Loss Profit By a certain date (the expiration date) Receives premium Call seller agrees to sell shares at an agreed upon price (the strike price) A call is covered if the investor owns the underlying shares

89 Selling Calls Reasons for selling calls against shares currently owned: Enhance returns from investment Pre-set sale price for shares Provide limited downside protection When to use: Neutral to moderately bullish on the shares

Buy-Write Selecting the opportunity

Selling Calls

Buy-Write Placing the trade

Selling Calls Buy 2,000 XYZ shares trading at $39.81/share Share Outlook is neutral to moderately bullish on XYZ

Selling Calls Buy 2,000 XYZ shares trading at $39.81/share Share Want to increase stock return if market is level

Selling Calls Sell 20 XYZ December $41.00 Calls at $1.00 each B S Share

Selling Calls Short 20 XYZ December $41.00 Call at $1.00 Long 2,000 shares in XYZ at $39.81

Selling Calls Loss Profit Share price Own 2,000 shares at $39.81 Sell 20 December $41.00 call at $1.00 Overall Position investment (break-even) $38.81 Maximum profit $4,380 ($2.19 per share)

Selling Calls Break-even lowered from $39.81 to $38.81 Limited downside protection Maximum gain = Premium + Gain on stock ($2.19 = $ $1.19) There is no further profit participation above $41.00 Called away return $2.19 or 4.5% in 90 days

Loss Profit $41.00 XYZ at expiration At expiry Option is assigned Investor must sell shares at $41.00 Seller keeps call premium $1.00

$41.00 Loss Profit XYZ at expiration At expiry Call expires worthless Seller keeps shares and call premium $1.00

Loss Profit XYZ at expiration At expiry Option premium provides limited downside protection Losses will occur below break-even point of $38.81 $37.81

Selling Covered Calls Benefits Risks Income from selling call Partial hedge Downside risk if stock falls Caps upside

Exchange Traded Options Graham O’Brien February OPTIONS Thank you …………………………………… ……………………………………