Options basics and trading strategies for FRM/CFA level 1
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Options basics and trading strategies for FRM/CFA level 1

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A presentation on the basics of options and the trading strategies using options. Very useful for CFA and FRM level 1 preparation candidates.

A presentation on the basics of options and the trading strategies using options. Very useful for CFA and FRM level 1 preparation candidates.

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Options basics and trading strategies for FRM/CFA level 1 Options basics and trading strategies for FRM/CFA level 1 Presentation Transcript

  • Options: Basics and TradingStrategies
  • 2
  • Session Agenda• Part I- Introduction to Options– What are Options?– Intrinsic Value of Options– Returns to Option buyers and sellers– Put Call Parity– Bounds and Option Values– Determinants of Option Values– Some special cases3• Trading Strategies– Covered Call– Protective Put– Spread Strategies– Combination StrategiesPart II- Options Trading Strategies View slide
  • Part-I: Introduction toOptions View slide
  • • Options are contracts that give its buyer the right to buy or sell a particular asset– In future– At a pre-decided price (i.e. exercise or strike price)– Without any obligations• The seller of the option collects a payment (Option Premium) from the buyer for providing theoption• Types of options:– Call or Put Options• Call Option: gives option holder the right to buy the asset at an agreed price• Put Options: gives option holder the right to sell the asset at an agreed price– European or American Options• European options are those that can only be exercised on expiration.• American options may be exercised on any trading day on or before expiration• Positions:• Long position: An option buyer is said to be in a long position• Short Position: An option writer (or seller) is said to be in a short position5What are Options?
  • 6Factors that affect Options value
  • 1. Assuming the stock price and all other variables remain the same what will be the impact of anincrease in the risk-free interest rate on the price of an American put option?A. No impact.B. Negative.C. Positive.D. Cannot be determined.Solution: B7Example Question
  • 8Intrinsic Value of Options• Intrinsic value: is the maximum of zero and the value of the option if the option were exercisedimmediately.– At the money:• When the price of the underlying is the same as the strike price of the option, the option is termed at themoney and exercising it carries a nil pay-off.– In the money:• When the price of the underlying is greater than the strike price carried by a call option, the call option istermed in the money, as exercising it results in a positive pay off.• When the price of the underlying is less than the strike price carried by a put option, the put option is termed inthe money, as exercising it results in a positive pay off.– Out of the money:• When the price of the underlying is less than the strike price carried by a call option, the call option is termedout of the money, as exercising it will result in a nil pay off.• When the price of the underlying is greater than the strike price carried by a put option, the put option is termedout of the money, as exercising it will result in a nil pay off.
  • 9Intrinsic Value of Options• Illustration: Pay-offs from buying a Call– Call option is written on the stock of XYZ Corporation with a strike price of 5. Consider options on a stockwhose price is expected to range from 0 - 10 at the time of expiration.– If share price is less than 5, then the pay off to the option buyer is nil.– If the price is more than 5, the pay-off moves upward linearly with the share price.01234560 2 4 6 8 10 12Call-PayoffStock PriceCall ValueStockPriceCallValuePut Value StrikePrice0 0 5 51 0 4 52 0 3 53 0 2 54 0 1 55 0 0 56 1 0 57 2 0 58 3 0 59 4 0 510 5 0 5
  • 10Intrinsic Value of Options• Illustration: Pay-offs from buying a Put– Put option is written on the stock of XYZ Corporation with a strike price of 5. Consider options on astock whose price is expected to range from 0 - 10 at the time of expiration.– If share price is more than 5, then the pay off to the option buyer is nil.– If the price is less than 5, the pay-off moves linearly with the share price.01234560 2 4 6 8 10 12Put-PayoffStock PricePut ValueStockPriceCallValuePut Value StrikePrice0 0 5 51 0 4 52 0 3 53 0 2 54 0 1 55 0 0 56 1 0 57 2 0 58 3 0 59 4 0 510 5 0 5
  • 11Payoffs from Options
  • 12Returns to Option Sellers• Returns to Option sellers:– The price that the option writer gets for underwriting the contract is called premium.– If the option is not exercised, the option writer makes profit from the premium.– If the option is exercised, the option writer may make profit or loss depending on the spot price of theunderlying asset at the time.• Example: A Call option writer gets premium of 1 for an option with strike price of 5.– He makes a profit if:• The option is not exercised when spot price is less than 5. The profit is 1 (i.e. premium);• The option is exercised and spot price is more than 5 but less than 6.• The profit to the call writer is less than 1.• If the spot price is 6, the writer has no profit and no loss.• For all spot prices more than 6, the call writer makes losses, which increase linearly with increase in spotprices.
  • 13-5-4-3-2-10120 2 4 6 8 10 12Short-PutPayoffStock PriceShort-Put Payoffwith Premium-5-4-3-2-10120 2 4 6 8 10 12ShortCallPayoffStock PriceShort-Call Payoffwith PremiumReturns to Option SellersStockPriceOptionPremiumShort-CallValuePut Value StrikePrice0 1 1 -4 51 1 1 -3 52 1 1 -2 53 1 1 -1 54 1 1 0 55 1 1 1 56 1 0 1 57 1 -1 1 58 1 -2 1 59 1 -3 1 510 1 -4 1 5
  • 14Returns to Option Buyers• Profit to Option buyers:– The pay-off are distinct from the profit (or loss) to the option holder.– To estimate the profit, the premium (price of option) is to be subtracted from the pay-off.• Illustration: In continuation to above, further consider options which carries a premium of 1.-2-10123450 2 4 6 8 10 12LongCallPayoffStock PriceLong-Call Payoff with Premium-2-10123450 2 4 6 8 10 12Long-PutPayoffStock PriceLong-Put Payoffwith PremiumStockPriceOptionPremiumCall Value Put Value StrikePrice0 1 -1 4 51 1 -1 3 52 1 -1 2 53 1 -1 1 54 1 -1 0 55 1 -1 -1 56 1 0 -1 57 1 1 -1 58 1 2 -1 59 1 3 -1 510 1 4 -1 5
  • 15Put Call parity• Consider the Pay-off of a trader who has the following position:– A Call Option with a Strike Price of 5 and,– A Bond with a maturity value of 5.Share Price atExpirationCallPay-Off Strike PriceBond Value atMaturity Bond + Call0 - 5 0 5 5 56 1 5 5 67 2 5 5 78 3 5 5 89 4 5 5 910 5 5 5 10
  • 16Put Call parity• Consider, now, the Pay-off of a trader who has :– A Put Option with a Strike Price of 5 and,– An equivalent unit of the underlying assetShare Price atExpirationPut Pay-Off (ExercisePrice 5)StockPay-offStock+Put0 5 0 51 4 1 52 3 2 53 2 3 54 1 4 55-10 0 5-10 5-10
  • 17Put Call parity• The Pay-offs are exactly the same0246810120 2 4 6 8 10 12Share PriceTotalPay-off
  • 18Put Call parity• Put Call parity provides an equivalence relationship between the Put and Call options of acommon underlying and carrying the same strike price:• It can be expressed as:– Value of call + Present value of strike price = value of put + share price.• If value of put is not available, it can be derived as:– Value of put = Value of call + present value of strike price - share price.• Put-call parity relationship, assumes that the options are not exercised before expiration day, i.e. itfollows European options.• This holds true for American options only if they are not exercised early.• In case of dividend-paying stocks, either the amount of dividend paid should be known in advance or itis assumed that the strike price factors the future dividend payment.• The mathematical representation of Put Call Parity is:= Initial stock price (S) + Put premium (P)Put Call Parity is valid only for European options, for American Options thisrelationship turns into an inequalitytt rddividendsofPVrXpricestrikeofPVCemium11)(Pr
  • 19Question: Put Call parity1. According to Put Call parity for European options, purchasing a put option on ABC stock will beequivalent toA. Buying a call, buying ABC stock and buying a Zero Coupon bond.B. Buying a call, selling ABC stock and buying a Zero Coupon bond.C. Selling a call, selling ABC stock and buying a Zero Coupon bond.D. Buying a call, selling ABC stock and selling a Zero Coupon bondSolution: B: p + S0 = c + Ke-rT
  • 20Question: Put Call parity1. Consider a 1-year European call option with a strike price of $27.50 that is currently valued at $4.10on a $25 stock. The 1-year risk-free rate is 6%.What is the value of the corresponding put option?A. 4.1B. 5C. 6D. 25Solution: p + S0 = c + D + Xe -rt
  • 21Bounds and Option Values• The value of an option changes over its life.• Consider the earlier illustration of the call.– If the share price of is below 5 on the exercise date, the call will be worthless.– If the stock price is above 5, the call will be worth 5 less than the value of the stock.– Even before maturity of the option, its value can never remain below this lower-bound line.– For options that still have some time to run, the heavy lower line is thus the lower-bound limit on themarket price of the option.– The diagonal line in the plot is the upper bound limit to the option price, because the stock gives a higherultimate pay-off than the option.01234560 1 2 3 4 5 6 7 8 9 10 11CallPay-offShare Price
  • 22Bounds and Option Values• The value of an option changes over its life.• Consider the earlier illustration of the call.– If at the option’s expiration, stock price > exercise price, the option is worth the stock price minus theexercise price.– If the stock price < exercise price, the option is worthless. But the share owners still have a valuablefinancial asset in the form of stock of ABC Corporation.– The value of the option would lie between these two bounds throughout the option’s life.01234560 1 2 3 4 5 6 7 8 9 10 11CallPay-offShare Price
  • 23Option Minimum Value MaximumValueEuropean call (c) ct ≥ Max(0,St-(X/(1+RFR)t) StAmerican Call(C)Ct ≥ Max(0, St-(X/(1+RFR)t) StEuropean put (p) pt ≥Max(0,(X/(1+RFR)t)-St) X/(1+RFR)tAmerican put (P) Pt ≥ Max(0, (X-St)) XWhere t is the time to expirationBounds and Option Values
  • Part-II: Options TradingStrategies
  • 25Trading Strategies• Traders may create positions using different kinds of strategies depending on the:– Expectations regarding the movement of the price of the underlying– Risk appetite– Availability of contracts
  • 26Covered Call• Involves selling call options of stocks already owned or simultaneously bought• Motivation– Earning a return from the underlying that is already owned– Lowering the cost of acquisition of the underlying asset• Expectation`– Moderate rise in the price of the underlying• Profit Potential– Maximum Profits when the options are exercised by the buyer• Premium received + Strike Price – Spot Price– If the options are not exercised the trader gets to keep the premium, thus lowering the cost of acquiring theasset• More conservative than buying the stock onlyStock priceat expirationNetprofit/lossComparison tosimple stockpurchase$30 (200) (300)$32 0 (100)$33 100 0$35 300 200$37 300 400If MyCompany (MC) trades at Rs33 and Rs35 calls are priced at Rs1, thenan investor can purchase 100 shares of MC for Rs3300 and sell one (100-share) call option for Rs100, for a net cost of only Rs3200. The Rs100premium received for the call will cover a Rs1 decline in stock price. Thebreak-even point of the transaction is Rs32/share. Upside potential islimited to $300, but this amounts to a return of almost 10%. (If the stockprice rises to Rs35 or more, the call option holder will exercise his optionand the investors profit will be Rs35-Rs32 = Rs3). If the stock price atexpiry is below Rs35 but above Rs32, the call option will be allowed toexpire, but the investor can still profit by selling his shares. Only if the priceis below Rs32/share will the investor experience a loss.
  • 27Protective Put• Involves buying put options of stocks already owned or simultaneously bought• Motivation– Protection against loss in the value of stocks owned• Expectation– Rise in the price of the underlying• Advantage– Trader profits from the rise in price of the underlying albeit the amount of profit is reduced by the premiumpaid to purchase the put– In case the price of the underlying goes down, the trader is still able to sell the underlying at the strikeprice, thus insuring her profit
  • 28Spread StrategiesBull Call Spread• Involves purchase of Call options at a particular strike price and selling Call options for the sameunderlying and carrying the same maturity but having a higher strike price.– A vertical spread• Motivation– Downside protection by agreeing to a limit to the upside profits• Expectation– Moderate rise in the price of the underlying• Profit Potential– Maximum Profits when the trader is able to exercise the option purchased, i.e. the spot price is greaterthan the strike price of the option written• Difference in Strike Prices + Premium Received – Premium Paid– Loss is limited to• Premium Paid – Premium Received, when the options expire unexercised
  • 29Spread Strategies (Cont...)• Bull Call Spread-4-20246895 100 105 110 115 120 125Share Price
  • 30Bear Spread• Involves purchase of put options at a particular strike price and the sale of the same put options at alower strike price.– A vertical spread• Motivation– Downside protection by agreeing to a limit to the upside profits• Expectation– Moderate fall in the price of the underlying• Profit Potential– Maximum Profits when the trader is able to exercise the option purchased, i.e. the spot price is lower thanthe strike price of the option written• Difference in Strike Prices + Premium Received – Premium Paid– Loss is limited to• Premium Paid – Premium Received, when the options expire unexercised`Spread Strategies (Cont...)
  • 31• Bear Spread-4-20246895 100 105 110 115 120 125Share PriceTotalProfitsSpread Strategies (Cont...)
  • 32Butterfly Spread• Involves sale and purchase of two calls (or puts) of the same underlying carrying the same maturity. ALong Call Butterfly can be established by selling two at the money calls with strike price say P, buyingone out of money call at price say P+X and buying another in the money call at price say P-X.• Motivation– To profit even when the price of the underlying is range bound and limit losses in case it moves beyond theexpected bound• Expectation– Not much change in the price of the underlying.• Profit Potential– Profits translate when the stock price remains within the bounds indicated by the purchased calls. Profitsare maximized when the price of the underlying remains unchanged– Loss is limited to• Premium Paid – Premium Received, when the options expire unexercisedSpread Strategies (Cont...)
  • 33• Butterfly Spread-4-20246810100 105 110 115 120 125 130SharePriceTotalProfitsSpread Strategies (Cont...)
  • 34Combination Strategies• Combination Strategy: Positions taken in both the call as well as the put options of the sameunderlying stocks.Straddle• Involves purchasing same quantity of at the money call and put options carrying the same strike priceand same maturity.• Motivation– To profit from wide variations in the price of the underlying, even though the direction of the movement inprice is uncertain.• Expectation– Large change in the price of the underlying.• Profit Potential– Profits translate when any one of the options can be exercised and the resultant pay-off is greater than thepremium paid for establishing the position. Profit potential is unlimited.– Loss is limited to• Premium Paid
  • 35• Straddle-2.5-2-1.5-1-0.500.511.522.50 2 4 6 8 10Straddle ProfitsSharePriceTotalProfitsCombination Strategies (Cont...)
  • 36Strap• Involves purchasing two at the money calls for every one at the money put purchased. Both put andcall options carry the same strike price and same maturity. More bullish version of the straddle• Motivation– To profit from wide variations in the price of the underlying, even though the direction of the movement inprice is uncertain.• Expectation– Large change in the price of the underlying, price expected to increase more than decrease• Profit Potential– Profits translate when any one of the options can be exercised and the resultant pay-off is greater than thepremium paid for establishing the position. Profit potential is unlimited although the rise profit is steeper incase the underlying price increases more than the call strike price.– Loss is limited to• Premium PaidCombination Strategies (Cont...)
  • 37• Strap-4-3-2-101234560 2 4 6 8 10Strap ProfitsSharePriceTotalProfitsCombination Strategies (Cont...)
  • 38Strip• Involves purchasing two at the money puts for every one at the money call purchased. Both put andcall options carry the same strike price and same maturity. Bearish version of the straddle• Motivation– To profit from wide variations in the price of the underlying, even though the direction of the movement inprice is uncertain.• Expectation– Large change in the price of the underlying, price expected to decrease more than increase• Profit Potential– Profits translate when any one of the options can be exercised and the resultant pay-off is greater than thepremium paid for establishing the position. Profit potential is unlimited although the rise profit is steeper incase the underlying price decreases more than the put strike price.– Loss is limited to• Premium PaidCombination Strategies (Cont...)
  • 39• Strip-4-3-2-101234560 2 4 6 8 10Strip ProfitsSharePriceTotalProfitsCombination Strategies (Cont...)
  • 40Long Strangle• Involves purchasing slightly out of money calls and puts of the same underlying carrying the samematurity.• Motivation– To profit from wide variations in the price of the underlying, even though the direction of the movement inprice is uncertain.• Expectation– Large change in the price of the underlying• Profit Potential– Profits translate when any one of the options can be exercised and the resultant pay-off is greater than thepremium paid for establishing the position.– Loss is limited to• Premium PaidCombination Strategies (Cont...)
  • 41• Long Strangle-1.5-1-0.500.511.522.50 2 4 6 8 10Strangle ProfitsTotalProfitsSharePriceCombination Strategies (Cont...)
  • 42• Box Spread• Involves purchasing a Bull Call Spread and one Bear Put Spread. Box Spread yields us Risk-free rateCombination Strategies (Cont...)
  • 43Questions1. The S&P March 2005 index futures contract is trading at 280. The associated American 260 calloption is at 16 and the associated 260 American put option is at 3. Which of the following strategieswould you select to lock in a profit?A. No strategy would result in a risk-free profit.B. Buy the put, sell the call and buy the futures contract.C. Buy and exercise the put and buy the futures contract.D. Buy and exercise the call and sell the futures contract.2. An investor sells a June 2008 call of ABC Limited with a strike price of USD 45 for USD 3 and buys aJune 2008 call of ABC Limited with a strike price of USD 40 for USD 5. What is the name of thisstrategy and the maximum profit and loss the investor could incur?A. Bear Spread, Maximum Loss USD 2, Maximum Profit USD 3B. Bull Spread, Maximum Loss Unlimited, Maximum Profit USD 3C. Bear Spread, Maximum Loss USD 2, Maximum Profit UnlimitedD. Bull Spread, Maximum Loss USD 2, Maximum Profit USD 3
  • 44Solution1. D2. D
  • Five Minute Recap45-4-20246895 100 105 110 115 120 125Share Price-4-20246895 100 105 110 115 120 125Share PriceTotalProfitsBull Call SpreadBear Spread-4-20246810100 105 110 115 120 125 130SharePriceTotalProfitsButterfly Spread-2.5-2-1.5-1-0.500.511.522.50 2 4 6 8 10Straddle ProfitsSharePriceTotalProfits-4-3-2-101234560 2 4 6 8 10Strap ProfitsSharePriceTotalProfits-4-3-2-101234560 2 4 6 8 10Strip ProfitsSharePriceTotalProfits-1.5-1-0.500.511.522.50 2 4 6 8 10Strangle ProfitsTotalProfitsSharePriceOption Trading Strategies:•Covered Call•Protective Put•Combination Strategy
  • Other WebinarsHere are the links for the blogs of the other recent webinars on our website tohelp you with CFA/FRM preparationLinear regression analysis (11/04/2013)Blog: http://www.edupristine.com/blog/demystifying-linear-regression-analysis-for-frm-level-1-exam/Understanding Income statement (12/04/2013)Blog: http://www.edupristine.com/blog/cfa-tutorial-understanding-income-statement-from-cfa-perspective/Hedging strategies using futures (13/04/2013)Blog: http://www.edupristine.com/blog/frm-tutorial-hedging-strategies-using-futures-for-frm-level-1-exam/46
  • Upcoming WebinarsFixed Income Securities : Analysis and Valuation (18/04/2013)Registration link: https://attendee.gotowebinar.com/register/2624315802346425600Hypothesis Testing using Various Tests (20/04/2013)Registration link: https://attendee.gotowebinar.com/register/7324338783972653056Look forward to more webinars from our side on the topics of your choice!! Justdrop a mail to us to suggest a topic!CLASSROOM TRAINING IN NEWYORK, US47
  • THANK YOU FOR YOUR PATIENCE!! 48