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A simplistic presentation explaining the basics of options and various strategies.

A simplistic presentation explaining the basics of options and various strategies.

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    Options strategies Options strategies Presentation Transcript

    • - Pavan Makhija
    • Options are derivative products which, if you buy, give you certainrightsInvestors use options for two primary reasons -- to speculate and tohedge their riskCall Options give you a right to buy a share (at a certain specificprice)Put Options give you a right to sell (again at a predefined price)The cost you pay for obtaining such rights is the premium (alsocalled price or option value)Options will (like Futures) expire on the last Thursday of everymonth
    • Option Buyer (Option Holder)Party that purchases and holds the options contractOption SellerParty that writes, or creates, the options contract.Strike PriceThe price at which the option seller agrees to buy or sell a certain stockin the futureExpiration MonthThe month in which the option will expireExpiration DateThis is always the third Friday of the month in which the option isscheduled to expire
    • Option ContractEach options contract represents an interest in 100 shares of a certainunderlying stockPut OptionThis type of option gives the option holder the right, but not theobligation, to sellCall OptionThis type of option gives the option holder the right, but not theobligation, to purchaseIn the moneySituation in which an options strike price is below the current marketprice of the underlier (for a call option) or above the current marketprice of the underlier (for a put option)
    • Out of the moneyA call option whose strike price is higher than the market price of theunderlying security, or a put option whose strike price is lower thanthe market price of the underlying securityNaked Option WritingWhen an investor writes an option on a stock he/she does not own, it isreferred to as writing a “naked” options contract
    • European optionAn option that may only be exercised on expirationAmerican optionAn option that may be exercised on any trading day on or beforeexpirationBermudan optionAn option that may be exercised only on specified dates on or beforeexpirationBarrier optionAny option with the general characteristic that the underlyingsecuritys price must reach some trigger level before the exercise canoccur.
    • Strategy: Buy a Call OptionStrategy View (Bullish)Investor thinks that the market will rise significantly in the short-term. .Strategy ImplementationCall options are bought with a strike price of a. The more bullish the investor is, thehigher the strike price should be.Upside PotentialProfit potential is unlimited and rises as the market rises.Downside RiskLimited to the premium paid - incurred if the market at expiry is at, or below, the strikea.CommentIf the market does little then the value of the position will decrease as the option timevalue falls.
    • (Payoff Table)Market Profit/ Price Premium Call Loss 100 -5 -5 a 110 -5 -5 120 -5 -5 125 -5 5 0 130 -5 10 5 140 -5 20 15 Strike Price (Call Option): 120 Premium: 5Strike Price: Break-Even:
    • Strategy: Buy a Put OptionStrategy View (Bearish)Investor thinks that the market will fall significantly in the short-term. .Strategy ImplementationPut option is bought with a strike price of a. The more bearish the investor is, the lowerthe strike price should be.Upside PotentialProfit potential is unlimited (well, not really unlimited of course as the market can notfall below zero).Downside RiskLimited to the premium paid - incurred if at expiry the market is at or above the strike a.CommentIf the market does little then the value of the position will decrease as the option timevalue falls.
    • (Payoff Table)Market Profit/ Price Premium Put Loss 100 -5 30 25 a 110 -5 20 15 120 -5 10 5 125 -5 5 0 130 -5 -5 140 -5 -5 Strike Price (Put Option): 130 Premium: 5 Strike Price: Break-Even:
    • Strategy: Hold the stock and buy call options.Strategy View (Bearish)An investor holds stock but does not think the stock will rise in the short term, or that thestock will be neutral, income can be gained by selling call options against the stockholding.Strategy ImplementationCall options are sold. The number of call options sold will be determined by the investorsmarket view and the size of the stock holding.Upside PotentialLimited - by selling calls, the investor is writing off the potential prfit of the stockposition. Maximum profit is the strike minus the market price plus the premium received.Downside RiskLarge: Similar to that incurred with ordinary stock ownership, only off-set partially bythe (fixed) option premium received. Main loss could be the opportunity loss if themarket rises strongly.
    • (Payoff Table)Market Short Profit/ Price Premium Call Stock Loss 100 30 -20 10 110 30 -10 20 120 30 0 30 a 125 30 -5 5 30 130 30 -10 10 30 140 30 -20 20 30 Strike Price (Short Call): 120 Stock Price: 120 Premium: 30 Strike Price: Break-Even:
    • Strategy: Buy and sell Call Options with different strike prices.Strategy View (Bullish)Investor thinks that the market will not fall, but wants to cap the risk. Conservativestrategy for one who thinks that the market is more likely to rise than fall.Strategy ImplementationCall option is bought with a strike price of a and another call option sold with a strike of b,producing a net initial debit,Upside PotentialCalls: difference between strikes minus initial debitMaximum profit if market at expiry is above the higher strike.Downside RiskCalls: net initial debitMaximum loss if at expiry market is below the lower strike.CommentTime value erosion not too significant due to the balanced position. .
    • (Payoff Table)Market Call Call Profit/ Price Premium (120) (150) Loss 100 -11 -11 110 -11 -11 a 120 -11 -11 b 125 -11 5 -6 131 -11 11 0 140 -11 20 9 150 -11 30 19 Strike Price (Long)-a: 120 160 -11 40 -10 19 Strike Price (Short)-b: 150 Premium long call: 16 Strike Price: Break-Even: Premium short call: 5
    • Strategy: Buy a call option and a put option with the same strike prices.Strategy View (Neutral)Investor thinks that the market will be very volatile in the short-term.Strategy ImplementationCall option and put option are bought with the same strike price a - usually at-the-money.Upside PotentialUnlimited Breakeven Point at ExpiryLower point is the strike minus the two premiums paid, and the upper is the strike plusthe two premiums.Downside RiskLimited to the two premiums paid. [If the investor would like to decrease the premiumpaid, a buy strangle might be interesting]CommentPosition loses value with passage of time as time value decreases on options.
    • (Payoff Table)Market Profit/ Price Premium Call Put Loss 100 -11 30 19 a 110 -11 20 9 119 -11 11 0 130 -11 0 -11 141 -11 11 0 150 -11 20 9 160 -11 30 19 Strike Price (Long Call): 130 Strike Price (Long Put): 130 Premium long call: 5 Strike Price: Break-Even: Premium short call: 6
    • Strategy: Buy a call option and a put option with the different strike prices.Strategy View (Neutral)Investor thinks that the market will be very volatile in the short-term [this is similar to thebuy straddle but the premium paid here is less]Strategy ImplementationPut option is bought with a strike a and a call option is bought with a strike b.Upside PotentialUnlimited - should the market fall or rise greatly.Downside RiskLimited to the two premiums paid. [If the investor would like to reduce the premiums paidstill further, a short butterfly might be interesting].CommentPosition loses value with passage of time as time value decreases on options.
    • (Payoff Table)Market Profit/ Price Premium Call Put Loss 100 -11 20 9 109 -11 11 0 a b 120 -11 -11 130 -11 -11 140 -11 -11 151 -11 11 0 160 -11 20 9 Strike Price (Long Call): 140 Strike Price (Long Put): 120 Premium long call: 5 Strike Price: Break-Even: Premium long put: 6
    • Strategy: Buy a call option with lower strike price and a higher strike price. Also sella call and a put option with a medium (same) strike price.Strategy View (Neutral)Investor thinks that the market will not be volatile, but wants to cap the downside risk. .Strategy ImplementationPut option with low strike b bought and a straddle with medium strike a is sold and calloption with high strike c bought.Upside PotentialLimitedDownside RiskLimited.CommentCan be difficult to execute such strategies quickly.
    • (Payoff Table)Market Short Long Long Short Profit Price Premium Call Call Put Put /Loss 100 13 10 -30 -7 b c 110 13 -20 -7 a 117 13 -13 0 130 13 0 0 0 0 13 143 13 -13 0 150 13 -20 -7 Strike Price (Short Call): 130 160 13 -30 10 -7 Strike Price (Short Put): 130 Strike Price (Long Call): 150 Premium short put: 13 Strike Price (Long Put): 110 Strike Price: Break-Even: Premium long put: 5 Premium long call: 6 Premium short call: 11
    • Strategy: Buy a call option and two put options with the same strike prices andexpiration dateStrategy ViewInvestor mildly thinks that the market will be volatile but price is likely to decline.Strategy ImplementationCall option and two put options with strike price „a‟ are boughtUpside PotentialUnlimited.Downside RiskLimited.CommentMay be difficult to execute this strategy quickly.
    • (Payoff Table)Market Profit Price Premium Call Puts /Loss 120 -50 180 130 a 160 -50 100 50 190 -50 40 -10 210 -50 0 0 -50 230 -50 20 -30 260 -50 50 0 300 -50 90 40 Strike Price (Long Call): 210 Strike Price (Long Puts): 210 Premium long call: 10 Strike Price: Break-Even: Premium long put: 20
    • Strategy: Buy two call options and a put option with the same strike prices andexpiration dateStrategy ViewInvestor mildly thinks that the market will be volatile but price is likely to decline.Strategy ImplementationCall options and a put option with strike price „a‟ are boughtUpside PotentialUnlimited.Downside RiskLimited.CommentMay be difficult to execute this strategy quickly.
    • (Payoff Table)Market Profit Price Premium Call Puts /Loss 150 -30 60 30 a 180 -30 30 0 190 -30 20 -10 210 -30 0 0 -30 230 -30 40 10 250 -30 80 50 280 -30 140 110 Strike Price (Long Calls): 210 Strike Price (Long Put): 210 Premium long call: 5 Strike Price: Break-Even: Premium long put: 20
    • Strategy: Sell a Call Option.Strategy View (Bearish)Investor is certain that the market will not rise and and is unsure/unconcerned whether itwill fall.Strategy ImplementationCall option is sold with a strike price of a. If the investor is very certain of his view then at-the-money options should be sold, if less certain, then out-of-the-money ones should besold.Upside PotentialLimited to the premium received - received if the market at expiry is at, or below, theoption strike.Downside RiskUnlimited. Losses on the position will worsen as the market rises. [If the investor likes theidea of the strategy, but not the downside risk, they might be interested in a bear spread].CommentIf the market does little, and time passes, this helps as the short position gains when thetime value erodes
    • (Payoff Table)Market Profit/ Price Premium Call Loss 100 5 5 110 5 5 120 5 5 a 125 5 0 130 5 -10 -5 140 5 -20 -15 150 5 -30 -25 Strike Price (Call Option): 120 Premium: 5 Strike Price: Break-Even:
    • Strategy: Sell a Put OptionStrategy View (Bullish)Investor is certain that the market will not go down, but unsure about whether it will rise.Strategy ImplementationPut options are sold with a strike price a. If an investor is very bullish, then in-the-moneyputs would be sold.Upside PotentialProfit potential is limited to the premium received. The more the option is in-the-money,the greater the premium received.Downside RiskLoss is almost unlimited ("almost"!). High risk strategy. Potential huge losses incurred ifthe market crashes.CommentIf the market does little, and time passes, this helps as the short position gains when thetime value erodes.
    • (Payoff Table)Market Profit/ Price Premium Call Put Loss 100 5 -30 -25 110 5 -20 -15 a 120 5 -10 -5 125 5 -5 0 130 5 5 140 5 5 Strike Price (Put Option)-a: 130 Premium: 5 Strike Price: Break-Even:
    • Strategy: Hold Stock and buy put options.Strategy View (Bearish)Investor holds stock and is worried about a market fall. Put options can be bought toprotect the value of the stock position, while not preventing the position to benefit in theevent of a market rise.Strategy ImplementationPut options are bought with a strike price of a.The number of put options bought willdepend on the bearishness of the investor and the size of the stock holding.Upside PotentialProfit potential is unlimited, being the ordinary return on the stock minus the fixedpremium paid for the put option.Downside RiskPotentially limited, (depending on the hedge ratio initially applied). The gains on the putoptions - as the market falls - will off-set the stock losses.CommentStrategy characteristics are similar to a buy call.
    • (Payoff Table)Market Long Profit Price Premium Put Stock /Loss 100 -5 20 -20 15 110 -5 10 -10 5 a 120 -5 0 0 -5 125 -5 5 0 130 -5 10 5 140 -5 20 15 Strike Price (Long Put): 120 Stock Price: 120 Strike Price: Break-Even: Premium: 5
    • Strategy: Buy and sell Put Options with different strike prices.Strategy View (Bearish)Investor thinks that the market will not rise, but wants to cap the risk. Conservativestrategy for one who thinks that the market is more likely to fall than rise.Strategy ImplementationPut option is sold with a stike of a and another put bought with a strike of b, producing anet initial debit.Upside PotentialPuts: difference between strikes minus initial debitMaximum profit if market at expiry is below the lower strike.Downside RiskPuts: net initial debitMaximum loss if at expiry market is above the higher strike.CommentTime value erosion not too significant due to the balanced position. .
    • (Payoff Table)Market Put Put Profit/ Price Premium (120) (150) Loss 100 -11 -20 50 19 110 -11 -10 40 19 b 120 -11 30 19 a 125 -11 25 14 139 -11 11 0 145 -11 5 -6 150 -11 -11 Strike Price (Short)-a: 120 160 -11 -11 Strike Price (Long)-b: 150 Premium long put: 16Strike Price: Break-Even: Premium short put: 5
    • Strategy: Sell a call option and put option with the same strike price.Strategy View (Neutral)Investor is certain that the market will not be very volatile (will neither go up nor downvery much).Strategy ImplementationA call option and a put option are sold with the same strike price a.Upside PotentialLimited to the two premiums received - will be realized if market at expiry is exactly at thestrike price level.Downside RiskUnlimited - should the market fall or rise greatly.CommentIf the market does little then the value of the position will benefit as the short positions gainwhen the option time value falls.
    • (Payoff Table)Market Profit/ Price Premium Call Put Loss 100 11 - 110 11 130 -110 - a 119 11 130 -119 130 11 0 0 11 - 141 11 130 - 150 11 130 Strike Price (Short Call): 130 160 11 Strike Price (Short Put): 130 Premium long call: 5 Strike Price: Break-Even: Premium short call: 6
    • Strategy: Sell a put option at a given strike price and a call option with higher strikeprice.Strategy View (Bearish)The investor thinks that the market will not be volatile within a broad band.Strategy ImplementationPut option is sold with a strike price of a and a call option is sold with the higher strikeprice bUpside PotentialLimited to the two premiums received.Downside RiskUnlimited - should the market fall or rise greatly. [If the investor likes the strategy, but notthe downside risk, a long butterfly might be interesting].CommentIf the market does little then the value of the position will benefit as the short positions gainwhen the option time value falls.
    • (Payoff Table)Market Profit Price Premium Call Put /Loss 100 11 -20 -9 109 11 -11 0 a b 120 11 11 130 11 11 140 11 11 151 11 -11 0 160 11 -20 -9 Strike Price (Short Call): 140 Strike Price (Short Put): 120 Premium long call: 5 Strike Price: Break-Even: Premium short call: 6
    • Strategy: Buy a call option and a put option with the different strike prices.Strategy ViewInvestor mildly thinks that the market will be volatile.Strategy ImplementationPut option is sold with strike b, a straddle is bought with strike a and a call option is soldwith strike cUpside PotentialLimited.Downside RiskLimited.CommentMay be difficult to execute this strategy quickly.
    • (Payoff Table)Market Short Long Long Short Profit Price Premium Call Call Put Put /Loss 100 -13 30 -10 7 a 110 -13 20 7 b c 117 -13 13 0 130 -13 0 0 0 0 -13 143 -13 13 0 150 -13 20 -7 160 -13 -10 30 7 Premium short put: 5 Strike Price: Break-Even: Premium long put: 13
    • Strategy: Sell a call option and put options with the same strike price and expirationdate.Strategy ViewInvestor is certain that the market will not be very volatile but price is likely to riseStrategy ImplementationA call option and put options are sold with the same strike price „a‟.Upside PotentialLimited to the three premiums received - will be realized if market at expiry is exactly at thestrike price level.Downside RiskUnlimited - should the market fall or rise greatly.CommentIf the market does little then the value of the position will benefit as the short positions gainwhen the option time value falls.
    • (Payoff Table)Market Profit Price Premium Call Put /Loss 120 50 -180 -130 160 50 -100 -50 190 50 -40 10 a 210 50 0 0 50 230 50 -20 30 260 50 -50 0 300 50 -90 -40 Strike Price (Short Call): 210 Strike Price (Short Puts): 210 Premium long call: 10 Strike Price: Break-Even: Premium short call: 20
    • Strategy: Sell two call options and put option with the same strike price and expirationdate.Strategy ViewInvestor is certain that the market will not be very volatile but price is likely to declineStrategy ImplementationA call option and put options are sold with the same strike price „a‟.Upside PotentialLimited to the three premiums received - will be realized if market at expiry is exactly at thestrike price level.Downside RiskUnlimited - should the market fall or rise greatly.CommentIf the market does little then the value of the position will benefit as the short positions gainwhen the option time value falls.
    • (Payoff Table)Market Profit Price Premium Call Put /Loss 150 30 -60 -30 180 30 -30 0 190 30 -20 10 a 210 30 0 0 30 230 30 -20 10 250 30 -40 -10 280 30 -70 -40 Strike Price (Short Calls): 210 Strike Price (Short Put): 210 Premium long call: 5 Strike Price: Break-Even: Premium short call: 20