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Option
Contracts
Fortuna Favi et Fortus Ltd
Options
- A contract between two parties, a buyer (also known as the long position or
holder) and a seller (also known as the short position or the writer).
-Contract gives certain rights or obligations to buy or sell a specified amount of
an underlying asset, at a specified price (known as the strike price or exercise
price), within a specified period of time.
- Buyer has the right but is not obligated to exercise her contract, whilst seller is
obligated to fulfill his part of the contract, if called upon to do so.
For the right to buy or sell the underlying asset, option buyers must pay sellers
a fee, known as the ‘option price or option premium’.
Upon payment, the option buyer has no further obligation to the writer, unless
the buyer decides to exercise the option. Thus, the most that the buyer of an
option can lose is the premium paid.
Options Writers must always be ready to fulfill their obligation to buy or sell the
underlying asset.
As evidence of constant ability to fulfill their obligations, writers
of exchange-traded options are required to provide and maintain sufficient
margin in their option accounts.
Writers of OTC options typically do not have this requirement.
An option that gives its holder the right to buy and its writer the obligation to
sell the underlying asset is known as a call option.
An option that gives its holder the right to sell and its writer the obligation to
buy the underlying asset is referred to as a put option.
Options
Rights And Obligations Associated With Option Positions
Call
Pays premium to the writer for the right to BUY the
underlying asset.
Receives premium from the buyer and has the obligation to
SELL the underlying asset, if called upon to do so.
Put
Pays premium to the writer for the right to SELL the
underlying asset.
Receives premium from the buyer and has the obligation to
BUY the underlying asset, if called upon to do so.
Buyer or Holder
Writer or Seller
Buyer or Holder
Writer or Seller
Syntax to Describe an Option
- summarizing the option’s most salient features into a phrase:
“{Underlying Asset} + {Expiration Month} + {Strike Price} + {Option Type}”
i.e. investor wants to buy 10 exchange-traded call options on XYZ stock with an
expiration date in December and a strike price of $50, would say that he wanted
to “buy 10 XYZ December 50 calls.”
Same as buying a stock, the investor would also indicate the price at which he is
willing to pay.
He could purchase “at market,” in which case he agrees to accept the best price
currently available, or he could enter a limit order by specifying the highest price
at which he is willing to pay.
An option’s trading unit describes the size or amount of the underlying asset
represented by one option contract.
E.g, all exchange-traded stock options in North America have a trading unit of
100 shares. Thus, a holder of one call option has the right to buy 100 shares of
the underlying stock, while the holder of one put option has the right to sell 100
shares.
Premium of an option is always quoted on a “per unit” basis, i.e. the premium
quote for a stock option is the premium for each share of the underlying stock
calculated by multiplying the premium quote by the option’s trading unit.
E.g., if a stock option is quoted with a premium of $1, it will cost the buyer $100
for each contract.
Options
Options : American and European Style
Options that can be exercised at any time up to and including the expiration date
are referred to as American-style options.
Options that can only be exercised on the expiration date are referred to as
European-style options.
Traditionally, options have been listed with relatively short terms of nine
months or less to expiration but there are exchanges that have listed options
with much longer expirations (2-3yrs) called Long-Term Equity Anticipation
Securities (LEAPS).
LEAPS are long term option contracts and offer the same risks and rewards as
regular options.
Option Transactions
Establishment of a new position in an option contract by an investor is referred
to as an Opening Transaction.
An opening buy transaction results in a long position in the option.
An opening sell transaction results in a short position in the option.
On or before an option’s expiration date, one of three things will happen to long
and short option positions.
• For exchange traded options, positions may be liquidated prior to expiration
by way of an offsetting transaction, which, in effect, cancels the position.
Offsetting a long position involves selling the same type and number of
contracts, while offsetting a short position involves buying the same type and
number of contracts. OTC Contracts can be offset by negotiation
• The party holding the long position can exercise the option. i.e, the party
holding the short position is said to be assigned on the option.
For the owners of call options, the act of exercising involves buying the
underlying asset from the assigned writer at a price equal to the strike price.
For the owners of put options, exercising involves selling the underlying asset
to the assigned put writer at a price equal to the strike price.
• Parties holding a long position can let the option expire. Buyers of options
have rights, not obligations. If they do not want to exercise their options
before they expire, they don’t have to; it’s a right not an obligation.
Owners of options will exercise only if it is in their best financial interest, which
can only occur when an option is in-the-money.
Option Transactions
• A call option is in-the-money when the price of the underlying asset is higher
than the strike price.
If this be the case, the call option holder can exercise the right to buy the
underlying asset at the strike price and then turn around and sell it at the
higher market price.
• A put option is in-the-money when the price of the underlying asset is lower
than the strike price.
If this be the case, the put option holder can exercise the right to sell the
underlying asset at the higher strike price, which would create a short
position, and then cover the short position at the lower market price.
Option Transactions
The in-the-money portion of a call or put option is referred to as the option’s
intrinsic value.
E.g., if XYZ stock is trading at $60, a call option on XYZ stock with a strike
price of $55 has $5 of intrinsic value. Similarly, a put option on XYZ with a
strike price of $65 has $5 of intrinsic value. Thus,
Intrinsic Value of an In-the-Money Call Option = Price of Underlying –
Strike Price; $5 = $60 – $55
Intrinsic Value of an In-the-Money Put Option = Strike Price–Price of
Underlying; $5 = $65 – $60
Option Transactions
If an option is not in-the-money, it has zero intrinsic value.
E.g., a call option on XYZ with a $65 strike price has no intrinsic value, as
does a put option with a strike price of $55.
Option Transactions
Prior to the expiration date, most options trade for more than their intrinsic
value.
The amount by which an option is trading above its intrinsic value is known as
the option’s time value.
E.g., if a call option on XYZ with a strike price of $55 is trading for $6 when
XYZ stock is trading at $60, the option has $1 of time value.
Time Value of an Option = Option Price – Option’s Intrinsic Value
$1 = $6 – $5
Rearranging the equation: Option Price = Intrinsic Value + Time Value
Option Transactions: Time Value
Intrinsic Value is the amount that the owner of an in-the- money option would
earn by immediately exercising the option and offsetting any resulting position
in the underlying asset.
Time Value represents the value of uncertainty.
Option buyers want options to be in-the-money at expiration; option writers
want the reverse.
The greater the uncertainty about where the option will be at expiration, either
in-the-money or out-of-the-money, the greater the option’s time value.
Option Transactions: Intrinsic Value & Time Value
‘Out of’ or ‘At the Money’ Options
Owners of options will definitely not exercise if they are out-of-the-money or
at-the-money.
• A call option is out-of-the-money when the price of the underlying asset is
lower than the strike price.
• A put option is out-of-the-money when the price of the underlying asset is
higher than the strike price.
• Call and put options are at-the-money when the price of the underlying asset
equals the strike price.
If a call option is out-of-the-money, it does not make financial sense for the call
option holder to buy the underlying asset at the strike price (by exercising the
call) when it can be purchased at a lower price in the market.
if a put option is out-of-the-money, it does not make financial sense for the put
option holder to sell the underlying asset at the strike price (by exercising the
put) when it can be sold at a higher price in the market.
There is generally no advantage to exercising an at-the-money option (for which
the strike price equals the market price of the underlying asset), at-the-money
options are normally left to expire worthless.
‘Out of’ or ‘At the Money’ Options
Equity Option Quotation
XYZ Inc. 17 3/4 Bid Ask Last Opt Vol Opt Int
Mar $17.50 3.80 4.05 3.95 50 1595
$17.50P 2.35 2.60 2.40 5 3301
Sept $17.50 1.10 1.35 1.25 41 3403
$17.50P 0.95 1.05 1.00 30 1058
Dec. $20.00P 1.85 2.00 1.90 193 1047
Total 319 10404
Explanation:
XYZ Inc. The underlying equity for the option.,
17 ¾ - The closing market price of the underlying equity.,
Mar. The options’ expiration month (March, September, December).,
Explanation: Equity Option Quotes
XYZ Inc. The underlying equity for the option.,
17 ¾ - The closing market price of the underlying equity.,
Mar. The options’ expiration month (March, September, December).,
$17.50 - The exercise price of each series.,
$17.50P - The option is a put.,
3.80 - closing bid price for each XYZ option expressed as a per share price.,
4.05 - closing asked price for each XYZ option expressed as a per share price.,
3.95 - The last sale price (last premium traded) of an option contract for the
day expressed as a per share price.
E.g., the 3.95 figure for the XYZ March 17.50 calls is the last sale price for this
series on the trading day in question.
Op Int – i.e. open interest – the total
number of option contracts in the series
that are currently outstanding and have
not been closed out or exercised.
E.g., the figure 1595 refers to the open
interest for the XYZ March 17.50 calls.
The figure 10,404 refers to the open
interest of all series of XYZ options,
including the series that did trade as
well as the series that did not trade.
Explanation: Equity Option Quotes
Option Strategies For Individual And Institutional Investors
Range and complexity of trading strategies are practically limitless.
Eight option strategies used by individual and institutional investors will be
discussed involving either a long or short position in an XYZ call or put option.
Strategies will either be a speculative or risk management based on exchange-
traded options.
At times, the option position will be the only part of the strategy, but in other
cases the option position will be combined with a position or expected position
in XYZ stock.
There are other, more complex strategies that are commonly employed.
The strategies assume that it is currently June and that XYZ Inc. stock is
trading at $52.50 per share.
If XYZ Inc. was a real company and it had options listed on its stock, there
would typically be a variety of expiration dates and strike prices to choose
from. –see four options listed in Table.
General assumption: it is currently June and XYZ Inc. stock is trading at $52.50
per share.
Option Strategies For Individual And Institutional Investors
Four Options on XYZ Inc. Stock Trading At $52.50
Option Type Expiration Strike Price Premium
Call September $50 4.55
Call December $55 2.00
Put September $50 1.5
Put December $55 4.85
For simplicity, commissions, margin requirements and dividends are ignored in
all of the examples
XYZ Inc. has options listed on its stock, with a variety of expiration dates and
strike prices to choose from. –see Table.
Buying Call Options
Reasons: to profit from an expected increase in the price of the underlying stock
– a speculative strategy that relies on the fact that call option prices tend to rise
as the price of the stock rises.
Challenge: selecting the appropriate expiration date and strike price to generate
maximum profit given the expected increase in the price of the stock.
Two ways to realize profit on call options when the underlying increases in
price:
• Investors can exercise the option and buy the stock at the lower exercise price
• They can sell the option directly into the market at a profit.
Calls may be bought to establish a maximum purchase price for the stock, or to
limit the potential losses on a short position in the stock. - buying options act
much like insurance, protecting the investor when the stock price moves higher.
Buying Call Options
Strategy #1: Buying Calls to Speculate
An investor buys 5 XYZ December 55 call options at the current price of $2.
Pays a premium of $1,000 ($2 × 100 shares × 5 contracts) to obtain the right to
buy 500 shares of XYZ Inc. at $55 a share on or before the expiration date in
December.
The options are out-of-the-money (the strike price is greater than the stock price
of $52.50), the $2 premium consists entirely of time value.
The options have no intrinsic value.
For the speculative investor - intent of the call purchase is to profit from an
expectation of a higher XYZ stock price.
The call buyer will want to sell the 5 XYZ December 55 calls before they
expire, preferably at a higher price than what was paid for them.
But if the price of XYZ shares rise, the price of the calls will likely rise, and the
call buyer will be able to sell them at a profit.
Of course, the call buyer faces the risk that if the stock price does not rise or,
worse, it falls.
Strategy #1: Buying Calls to Speculate
E.g., if by September the price of XYZ stock is $60, the XYZ December 55 calls
will be trading for at least their intrinsic value, which in this case is $5. Since
there are still three months remaining before the options expire, the premium
will also include some time value.
Assuming the calls have $1.70 of time value, they will be trading at $6.70.
Therefore, the investor could choose to sell the options at $6.70 and realize a
profit of $4.70 a share, equal to the difference between the current premium
minus the premium paid, or $2,350 total ($4.70 × 100 shares × 5 contracts).
Strategy #1: Buying Calls to Speculate
However, XYZ shares are trading at $45 a share in September, the XYZ December 55
calls might be worth only $0.25.
At this time, and indeed, at all other times before expiration, the investor will have to
decide whether to sell the options or hold on in the hope that the stock price (and the
options’ price) recovers.
If the investor sells at this time, a loss equal to $1.75 a share, or $875 total ($1.75 ×
100 shares × 5 contracts) will result.
Selling before expiration allows the call buyer to earn any time value that remains built
into the option premium.
Also, the option buyer gives up any chance of reaping any further increases in the
option’s intrinsic value. The call buyer’s outlook for the stock price plays a crucial role
in the decision.
Strategy #1: Buying Calls to Speculate
Strategy #2: Buying Calls to Manage Risk
Investors buy call options to manage risk.
E.g., a fund manager intends to buy 50,000 shares of XYZ stock, but will not
receive the funds until December.
Buying 500 XYZ December 55 call options will protect the fund manager from
any sharp increase in the price of XYZ above the $55 strike price, because they
will establish a maximum price at which the shares can be purchased.
E.g., if XYZ shares increase to $60 just prior to the expiration date in December,
the options will be trading for their intrinsic value only, in this case $5
= ($60 – $55).
Since the call buyer now has the money to buy the shares, the calls can be
exercised, at which point the call buyer will purchase 50,000 shares of XYZ at
the strike price of $55.
Thus, the call buyer’s net purchase price is actually $57 a share, considering the
$2 paid for the option.
But If, XYZ shares are trading at $45 just prior to the expiration date, the call
buyer will let the options expire and will buy the shares at the going price of $45
each.
The investor’s effective cost is $47, which includes the $2 paid for the calls.
Strategy #2: Buying Calls to Manage Risk
Writing Call Options
Investors write call options primarily for the income they provide. i.e. the
premium, which is the writer’s to keep no matter what happens to the price of the
underlying asset or what the buyer eventually does.
Call-writing strategies are primarily speculative in nature, but it can also be used
to manage risk.
Two classifications of call option writers:
• Covered call writers own the underlying stock, and will use this position to
meet their obligations if they are assigned.
• Naked call writers do not own the underlying stock and if assigned, the
underlying stock must first be purchased in the market before it can be sold to
the call option buyer.
Call option buyers will only exercise if the price of the stock is above the strike
price, assigned naked call writers must buy the stock at one price (the market
price) and sell at a lower price (the strike price).
Naked call writers hope, that this loss is less than the premium they originally
received, so that the overall result for the strategy is a profit.
Since all exchange-traded stock options have an American-style exercise
feature, call writers (and put option writers) face the risk of being assigned at
any time prior to expiration.
Prior to expiration, it is more advantageous for call buyers to sell their options
rather than exercise them - because by selling they receive the option’s time
value as well as its intrinsic value.
Writing Call Options
Only the intrinsic value is captured when an option is exercised.
So the chance of being assigned before expiration is not as great as one might
think.
Though this happens, particularly when the time value is small, and option
writers must be aware of this.
Writing Call Options
Strategy #1: Covered Call Writing
Assume an investor writes 10 XYZ September 50 call options at the current
price of $4.55.
The investor receives a premium of $4,550 ($4.55 × 100 shares × 10 contracts)
to take on the obligation of selling 1,000 shares of XYZ Inc. at $50 a share on
or before the expiration date in September.
Because the options are in-the-money (the strike price is less than the stock
price), the $4.55 premium consists of both intrinsic and time value. Intrinsic
value is equal to $2.50 and time value is equal to $2.05.
If the investor already owned (or purchased at the same time as the options
were written) 1,000 shares of XYZ, the overall position is known as a covered
call. i.e. covered call writer.
At expiration in September, the price of XYZ stock is greater than $50 (i.e., the
options are in-the-money), the covered call writer will be assigned and thus
have to sell the stock to the call buyer at $50 a share.
From the covered call writer’s perspective, however, the effective sale price is
$54.55, because of the initial premium of $4.55.
Strategy #1: Covered Call Writing
But If, the price of the stock at expiration in September is less than $50, the
covered call writer will not be assigned and the options will expire worthless.
Call buyers will not elect to buy stock at $50 when it can be purchased for less
in the market.
The covered call writer will retain the shares and the initial premium. Thus, the
premium reduces the covered call writer’s effective stock purchase price by
$4.55 a share.
i.e., if the covered call writer bought the XYZ stock at, $50, and the options
expired worthless, the covered call writer’s effective purchase price is now
$45.45 ($50 – $4.55).
In this sense, writing the call slightly reduces the risk of owning the stock.
Strategy #1: Covered Call Writing
Strategy # 2: Naked Call Writing
Assume an investor writes 10 XYZ September 50 call options at the current
price of $4.55. if call is not already owned - a naked call writer.
The best the naked call writer could hope for is, that the price of XYZ stock will
be lower than $50 at expiration.
In this instance, the calls will expire worthless and the naked call writer will
earn a profit equal to $4.55 a share, the initial premium received.
This is the most that this call writer can expect to earn from this strategy.
But if the price of the shares increases, the naked call writer will realize a loss if
the stock price is higher than the strike price plus the premium received, in this
case $54.55.
In this instance, the naked call writer will be forced to buy the stock at the
higher market price and then turn around and sell them to the call buyer at the
$50 strike price.
When the stock price is greater than $54.55, the cost of buying the stock is
greater than the combined proceeds from selling the stock and the premium
initially received.
Strategy # 2: Naked Call Writing
For example, if the price of the XYZ rose to $60 at expiration, the naked call
writer will suffer a $10 loss on the purchase and sale of the shares (buy at $60,
sell at $50).
This loss is offset somewhat by the initial premium of $4.55, so that the actual
loss is $5.45 a share, or $5,450 in total ($5.45 × 100 shares × 10 contracts).
Strategy # 2: Naked Call Writing; Example
Buying Put Options
Investors buy put options for:
• To profit from an expected decline in the price of the stock. - speculative
strategy relies on the fact that put option prices tend to rise as the price of the
stock falls. Just like buying calls, the selection of an expiration date and strike
price is crucial to the success (or lack thereof ) of the strategy.
• For risk management purposes. - puts can be used to lock in a minimum
selling price for a stock, they are very popular with investors who own stock.
Buying puts can protect investors from a decline in the price of a stock below
the strike price.
Strategy #1: Buying Puts to Speculate
Assume an investor buys 10 XYZ September 50 put options at the current price
of $1.50. The put buyer pays a premium of $1,500 ($1.50 × 100 shares × 10
contracts) to obtain the right to sell 1,000 shares of XYZ Inc. at $50 a share on
or before the expiration date in September.
Because the options are out-of-the-money (the strike price is less than the stock
price), the $1.50 premium consists entirely of time value. The option has no
intrinsic value.
Opinion of put buyer might be the exact opposite of the opinion of put seller. If
the stock price falls, the XYZ September 50 put options will likely rise in value.
This will allow the put buyer to sell his options for a profit. Of course, if the
stock price rises, the put options will most likely lose value and the put buyer
may be forced to sell the options at a loss.
E.g., if XYZ stock is trading at $45 one month before the September expiration
date, the XYZ September 50 puts will be trading for at least their intrinsic value,
or $5.
Since there is still one month before the expiration date, the options will have
some time value as well.
Assuming they have time value of $0.25, the options will be trading at $5.25.
Therefore, the put buyer could choose to sell the puts for $5.25 and realize a
profit of $3.75 a share, which is equal to the difference between the current put
price and the put buyer’s original purchase price.
Based on 10 contracts, the put buyer’s total profit is $3,750
i.e. ($3.75 × 100 shares × 10 contracts).
Strategy #1: Buying Puts to Speculate
But if, XYZ were trading at $60 a share, the XYZ September 50 puts might be
worth only $0.05.
Because the options are so far out-of-the-money, and because there is only one
month left until the options expire, the options will not have a lot of time value.
The low option price tells us the market does not believe there is much of a
chance for XYZ shares to fall below $50 anytime over the next month.
Put buyer has to decide whether to sell the options at this price, or hold on in
hope that the price of XYZ does fall to below $50. If the stock does fall, the
price of puts will rise. If the stock doesn’t fall below $50, the puts will be
worthless when they expire. If the put buyer decides to sell the options at $0.05,
a loss equal to $1.45 a share ($0.05 – $1.50) or $1,450 i.e.
($1.45 × 100 shares × 10 contracts) would result.
Strategy #1: Buying Puts to Speculate
Strategy #2: Buying Puts to Manage Risk
Assume an investor buys 10 XYZ September 50 put options at the current price
of $1.50, but in this case the put buyer actually owns 1,000 shares of XYZ. –
thus the put purchase acts as insurance against a drop in the price of the stock. -
Recall that put buyers have the right to sell the stock at the strike price.
Buying a put in conjunction with owning the stock, a strategy known as a
married put or a put hedge, gives the put buyer the right to sell the stock at the
strike price.
If the price of the stock is below the strike price of the put when the puts expire,
the put buyer will most likely exercise the puts and sell the stock to the put
writer.
The strike price acts as a floor price for the sale of the stock.
E.g., if XYZ shares are trading at $45 just prior to the expiration date in
September, the puts will be trading very close to their intrinsic value of $5,
because the puts are in-the-money and there is very little time left until the
expiration date.
The put buyer may choose to exercise the puts and sell the stock at the $50
strike price. The put buyer has been protected from the drop in the stock price
below $50.
The protection was not free, because the put buyer had to pay $1.50 for the
puts. The put buyer’s effective sale price is actually only $48.50, after
deducting the cost of the puts. But this sale price is still better than the stock’s
$45 market price.
Example: Strategy #2: Buying Puts to Manage Risk
The put buyer, may not want or even be able to sell the stock. If so, the puts
should be sold.
Any profit on the sale of the puts reduces the put buyer’s effective stock
purchase price.
If the put buyer originally bought the stock at a price of, $40, and then sold the
puts at $5, for a net profit of $3.50, the effective stock purchase price becomes
$36.50.
Eventually, when the shares are sold, the put buyer will measure the total profit
on the stock purchase as the difference between the sale price and the effective
purchase price of $36.50.
Example: Strategy #2: Buying Puts to Manage Risk
Writing Put Options
Primarily done for the income they provide - in the form of premium, - the
writer’s to keep no matter what happens to the price of the underlying asset or
what the buyer eventually does.
Like call-writing, put-writing strategies are primarily speculative in nature, but
they can also be used to manage risk.
• Put option writers can be classified as either covered or naked. Covered put
writing, is not nearly as common as covered call writing because, technically,
a covered put write combines
a short put with a short position in the stock. More common is a “nearly”
covered put writing strategy is known as a cash-secured put write.
A cash-secured put write involves writing a put and setting aside an amount of
cash equal to the strike price.
• Naked put writers have no position in the stock and have not specifically
earmarked an amount of cash to buy the stock. They must be prepared to buy
the stock, so they should always have the financial resources to do so.
They hope to profit from a stock price that stays the same or goes up.
If this happens, the price of the puts will likely decline as well, and the chance
of being assigned will also be less.
The naked put writer may then choose to buy back the options at the lower
price to realize a profit. If the stock price does not rise, the put writer may be
assigned, and may suffer a loss.
Based on how low the stock price is and the amount of premium received,
naked put writers may still profit even if they are assigned.
Writing Put Options
Strategy # 1: Cash-Secured Put Writing
Assume investor writes 5 XYZ December 55 put options at the current price of
$4.85. The put writer receives a premium of $2,425 ($4.85 × 100 shares × 5
contracts) to take on the obligation of buying 500 shares of XYZ Inc. at $55 a
share on or before the expiration date in December.
Because the options are in-the-money (the strike price is greater than the stock
price), the $4.85 premium consists of both intrinsic value and time value.
Intrinsic value is equal to $2.50 and time value is equal to $2.35.
If the put writer set aside cash equal to the purchase value of the stock, the
strategy is known as a cash-secured put write. The put writer in this case would
have to set aside $27,500 ($55 strike price × 100 shares × 5 contracts).
Some investors actually use cash-secured put writes as a way to buy the stock at
an effective price that is lower than the current market price.
The effective price is equal to the strike price minus the premium received.
Strategy # 1: Cash-Secured Put Writing
Example: Strategy # 1: Cash-Secured Put Writing
E.g., if at expiration in December the price of XYZ stock is less than $55, the
put writer will be assigned and will have to buy 500 shares of XYZ at the strike
price of $55 a share.
The effective purchase price is actually $50.15, because the put writer received
a premium of $4.85 when the options were written.
This effective purchase price is less than the $52.50 price of the stock when the
cash-secured put write was established.
If at expiration in December the price of XYZ stock is greater than $55, the
cash-secured put writer will not be assigned because the options are out-of-the-
money.
The cash-secured put writer, however, gets to keep the premium of $4.85, and
will have to decide whether to use the cash to buy the stock at the market price.
Example: Strategy # 1: Cash-Secured Put Writing (b)
Strategy #2: Naked Put Writing
Suppose a different investor writes 5 XYZ December 55 put options at the
current price of $4.85.
If the put writer does not set aside a specific amount of cash to cover the
potential purchase of the stock, the put writer is considered a naked put writer.
The naked put writer desires the price of XYZ to be higher than $55 at
expiration.
If this happens, the puts will expire worthless and the put writer will earn a
profit equal to $4.85 a share, the initial premium received.
Strategy #2: Naked Put Writing (b)
If the price of XYZ stock falls, the naked put writer will most likely realize a
loss, as put buyers will exercise their options to sell the stock at the higher
strike price.
(The naked put writer in this case will suffer a loss only if XYZ stock is trading
for less than $50.15 at option expiration.)
The naked put writer will have to buy stock at a price that is higher than the
market price.
If the put writer does not want to hold the shares in anticipation of a higher
price, they could be sold.
Example: Strategy #2: Naked Put Writing
E.g., if the price of XYZ fell to $45 at expiration, the naked put writer will
suffer a $10 loss on the purchase and sale of the shares (buy at the strike price
of $55, sell at the market price of $45).
This loss is offset somewhat by the initial premium of $4.85, so that the actual
loss is $5.15 a share, or $2,575 in total ($5.15 × 100 shares × 5 contracts).
Option Strategies for Corporations
Normally, corporations do not speculate with derivatives.
They are interested in managing risk, and often use options to do it.
These risks are often related to interest rates, exchange rates or commodity
prices.
E.g., corporations take on debt to help finance their operations and attimes the
interest rate on the debt is a floating rate that rises and falls with market interest
rates.
Just like the investor who buys a call to establish a maximum purchase price for
a stock, corporations can buy a call to establish a maximum interest rate on
floating-rate debt.
Call Option Strategies: Corporations
Suppose a Canadian company knows it will buy US$1 million worth of goods
from a U.S. supplier in three months’ time.
If the exchange rate is C$1.12 per U.S. dollar, the U.S. dollar purchase will
cost the company C$1.12 million.
The company can either buy the US$1 million now and pay C$1.12 million, or
wait three months and pay whatever the exchange rate is at that time.
If company chooses to do the latter and wait, by doing this, it faces the risk that
the value of the U.S. dollar will strengthen relative to the Canadian dollar.
Thus, the Canadian dollar cost of the purchase would be higher than C$1.12
million.
To protect itself against this risk, the corporation can buy a call option on the
U.S. dollar.
Suppose the corporation buys a three-month U.S. dollar call option with a strike
price of C$1.15.
This option is an OTC option and would most likely be written by the
corporation’s bank.
If at the end of three months the exchange turns out to be C$1.20, the
corporation will exercise the call and buy the U.S. dollars from its bank for
C$1.15 million.
If, however, the U.S. dollar weakens so that in three months the exchange rate is
C$1.10, the corporation will let the option expire and will buy the U.S. dollars
at the lower exchange rate.
The purchase of the call option has capped the exchange rate at C$1.15 plus the
cost of the option.
Call Option Strategies: Corporations
Put Option Strategies - Corporations
Assume a Canadian oil company will have 1 million barrels of crude oil to sell
in six months’ time and present price of crude oil is US$70 a barrel but unsure
of what the price will be in six months.
To lock in a minimum sale price, the company buys a put option on one million
barrels of crude oil with a strike price of US$68 a barrel.
This will protect the company from an oil price lower than US$68 a barrel.
in six months, if price of crude oil is less than US$68, the company will exercise
its put option and sell the oil to the put option writer at the strike price.
But if the price is greater than US$68, the company will let the option expire
and will sell the oil at the going market price.
Fortuna Favi et Fortus Ltd.,
:118 Old Ewu Road, Aviation Estate, Lagos,
:(+234)7032530965 www.ffavifortus.com info@ffavifortus.com

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Fundamentals of Option Contracts

  • 2. Options - A contract between two parties, a buyer (also known as the long position or holder) and a seller (also known as the short position or the writer). -Contract gives certain rights or obligations to buy or sell a specified amount of an underlying asset, at a specified price (known as the strike price or exercise price), within a specified period of time. - Buyer has the right but is not obligated to exercise her contract, whilst seller is obligated to fulfill his part of the contract, if called upon to do so. For the right to buy or sell the underlying asset, option buyers must pay sellers a fee, known as the ‘option price or option premium’. Upon payment, the option buyer has no further obligation to the writer, unless the buyer decides to exercise the option. Thus, the most that the buyer of an option can lose is the premium paid.
  • 3. Options Writers must always be ready to fulfill their obligation to buy or sell the underlying asset. As evidence of constant ability to fulfill their obligations, writers of exchange-traded options are required to provide and maintain sufficient margin in their option accounts. Writers of OTC options typically do not have this requirement. An option that gives its holder the right to buy and its writer the obligation to sell the underlying asset is known as a call option. An option that gives its holder the right to sell and its writer the obligation to buy the underlying asset is referred to as a put option. Options
  • 4. Rights And Obligations Associated With Option Positions Call Pays premium to the writer for the right to BUY the underlying asset. Receives premium from the buyer and has the obligation to SELL the underlying asset, if called upon to do so. Put Pays premium to the writer for the right to SELL the underlying asset. Receives premium from the buyer and has the obligation to BUY the underlying asset, if called upon to do so. Buyer or Holder Writer or Seller Buyer or Holder Writer or Seller
  • 5. Syntax to Describe an Option - summarizing the option’s most salient features into a phrase: “{Underlying Asset} + {Expiration Month} + {Strike Price} + {Option Type}” i.e. investor wants to buy 10 exchange-traded call options on XYZ stock with an expiration date in December and a strike price of $50, would say that he wanted to “buy 10 XYZ December 50 calls.” Same as buying a stock, the investor would also indicate the price at which he is willing to pay. He could purchase “at market,” in which case he agrees to accept the best price currently available, or he could enter a limit order by specifying the highest price at which he is willing to pay.
  • 6. An option’s trading unit describes the size or amount of the underlying asset represented by one option contract. E.g, all exchange-traded stock options in North America have a trading unit of 100 shares. Thus, a holder of one call option has the right to buy 100 shares of the underlying stock, while the holder of one put option has the right to sell 100 shares. Premium of an option is always quoted on a “per unit” basis, i.e. the premium quote for a stock option is the premium for each share of the underlying stock calculated by multiplying the premium quote by the option’s trading unit. E.g., if a stock option is quoted with a premium of $1, it will cost the buyer $100 for each contract. Options
  • 7. Options : American and European Style Options that can be exercised at any time up to and including the expiration date are referred to as American-style options. Options that can only be exercised on the expiration date are referred to as European-style options. Traditionally, options have been listed with relatively short terms of nine months or less to expiration but there are exchanges that have listed options with much longer expirations (2-3yrs) called Long-Term Equity Anticipation Securities (LEAPS). LEAPS are long term option contracts and offer the same risks and rewards as regular options.
  • 8. Option Transactions Establishment of a new position in an option contract by an investor is referred to as an Opening Transaction. An opening buy transaction results in a long position in the option. An opening sell transaction results in a short position in the option. On or before an option’s expiration date, one of three things will happen to long and short option positions. • For exchange traded options, positions may be liquidated prior to expiration by way of an offsetting transaction, which, in effect, cancels the position. Offsetting a long position involves selling the same type and number of contracts, while offsetting a short position involves buying the same type and number of contracts. OTC Contracts can be offset by negotiation
  • 9. • The party holding the long position can exercise the option. i.e, the party holding the short position is said to be assigned on the option. For the owners of call options, the act of exercising involves buying the underlying asset from the assigned writer at a price equal to the strike price. For the owners of put options, exercising involves selling the underlying asset to the assigned put writer at a price equal to the strike price. • Parties holding a long position can let the option expire. Buyers of options have rights, not obligations. If they do not want to exercise their options before they expire, they don’t have to; it’s a right not an obligation. Owners of options will exercise only if it is in their best financial interest, which can only occur when an option is in-the-money. Option Transactions
  • 10. • A call option is in-the-money when the price of the underlying asset is higher than the strike price. If this be the case, the call option holder can exercise the right to buy the underlying asset at the strike price and then turn around and sell it at the higher market price. • A put option is in-the-money when the price of the underlying asset is lower than the strike price. If this be the case, the put option holder can exercise the right to sell the underlying asset at the higher strike price, which would create a short position, and then cover the short position at the lower market price. Option Transactions
  • 11. The in-the-money portion of a call or put option is referred to as the option’s intrinsic value. E.g., if XYZ stock is trading at $60, a call option on XYZ stock with a strike price of $55 has $5 of intrinsic value. Similarly, a put option on XYZ with a strike price of $65 has $5 of intrinsic value. Thus, Intrinsic Value of an In-the-Money Call Option = Price of Underlying – Strike Price; $5 = $60 – $55 Intrinsic Value of an In-the-Money Put Option = Strike Price–Price of Underlying; $5 = $65 – $60 Option Transactions
  • 12. If an option is not in-the-money, it has zero intrinsic value. E.g., a call option on XYZ with a $65 strike price has no intrinsic value, as does a put option with a strike price of $55. Option Transactions
  • 13. Prior to the expiration date, most options trade for more than their intrinsic value. The amount by which an option is trading above its intrinsic value is known as the option’s time value. E.g., if a call option on XYZ with a strike price of $55 is trading for $6 when XYZ stock is trading at $60, the option has $1 of time value. Time Value of an Option = Option Price – Option’s Intrinsic Value $1 = $6 – $5 Rearranging the equation: Option Price = Intrinsic Value + Time Value Option Transactions: Time Value
  • 14. Intrinsic Value is the amount that the owner of an in-the- money option would earn by immediately exercising the option and offsetting any resulting position in the underlying asset. Time Value represents the value of uncertainty. Option buyers want options to be in-the-money at expiration; option writers want the reverse. The greater the uncertainty about where the option will be at expiration, either in-the-money or out-of-the-money, the greater the option’s time value. Option Transactions: Intrinsic Value & Time Value
  • 15. ‘Out of’ or ‘At the Money’ Options Owners of options will definitely not exercise if they are out-of-the-money or at-the-money. • A call option is out-of-the-money when the price of the underlying asset is lower than the strike price. • A put option is out-of-the-money when the price of the underlying asset is higher than the strike price. • Call and put options are at-the-money when the price of the underlying asset equals the strike price. If a call option is out-of-the-money, it does not make financial sense for the call option holder to buy the underlying asset at the strike price (by exercising the call) when it can be purchased at a lower price in the market.
  • 16. if a put option is out-of-the-money, it does not make financial sense for the put option holder to sell the underlying asset at the strike price (by exercising the put) when it can be sold at a higher price in the market. There is generally no advantage to exercising an at-the-money option (for which the strike price equals the market price of the underlying asset), at-the-money options are normally left to expire worthless. ‘Out of’ or ‘At the Money’ Options
  • 17. Equity Option Quotation XYZ Inc. 17 3/4 Bid Ask Last Opt Vol Opt Int Mar $17.50 3.80 4.05 3.95 50 1595 $17.50P 2.35 2.60 2.40 5 3301 Sept $17.50 1.10 1.35 1.25 41 3403 $17.50P 0.95 1.05 1.00 30 1058 Dec. $20.00P 1.85 2.00 1.90 193 1047 Total 319 10404 Explanation: XYZ Inc. The underlying equity for the option., 17 ¾ - The closing market price of the underlying equity., Mar. The options’ expiration month (March, September, December).,
  • 18. Explanation: Equity Option Quotes XYZ Inc. The underlying equity for the option., 17 ¾ - The closing market price of the underlying equity., Mar. The options’ expiration month (March, September, December)., $17.50 - The exercise price of each series., $17.50P - The option is a put., 3.80 - closing bid price for each XYZ option expressed as a per share price., 4.05 - closing asked price for each XYZ option expressed as a per share price., 3.95 - The last sale price (last premium traded) of an option contract for the day expressed as a per share price. E.g., the 3.95 figure for the XYZ March 17.50 calls is the last sale price for this series on the trading day in question.
  • 19. Op Int – i.e. open interest – the total number of option contracts in the series that are currently outstanding and have not been closed out or exercised. E.g., the figure 1595 refers to the open interest for the XYZ March 17.50 calls. The figure 10,404 refers to the open interest of all series of XYZ options, including the series that did trade as well as the series that did not trade. Explanation: Equity Option Quotes
  • 20. Option Strategies For Individual And Institutional Investors Range and complexity of trading strategies are practically limitless. Eight option strategies used by individual and institutional investors will be discussed involving either a long or short position in an XYZ call or put option. Strategies will either be a speculative or risk management based on exchange- traded options. At times, the option position will be the only part of the strategy, but in other cases the option position will be combined with a position or expected position in XYZ stock. There are other, more complex strategies that are commonly employed.
  • 21. The strategies assume that it is currently June and that XYZ Inc. stock is trading at $52.50 per share. If XYZ Inc. was a real company and it had options listed on its stock, there would typically be a variety of expiration dates and strike prices to choose from. –see four options listed in Table. General assumption: it is currently June and XYZ Inc. stock is trading at $52.50 per share. Option Strategies For Individual And Institutional Investors
  • 22. Four Options on XYZ Inc. Stock Trading At $52.50 Option Type Expiration Strike Price Premium Call September $50 4.55 Call December $55 2.00 Put September $50 1.5 Put December $55 4.85 For simplicity, commissions, margin requirements and dividends are ignored in all of the examples XYZ Inc. has options listed on its stock, with a variety of expiration dates and strike prices to choose from. –see Table.
  • 23. Buying Call Options Reasons: to profit from an expected increase in the price of the underlying stock – a speculative strategy that relies on the fact that call option prices tend to rise as the price of the stock rises. Challenge: selecting the appropriate expiration date and strike price to generate maximum profit given the expected increase in the price of the stock. Two ways to realize profit on call options when the underlying increases in price: • Investors can exercise the option and buy the stock at the lower exercise price • They can sell the option directly into the market at a profit.
  • 24. Calls may be bought to establish a maximum purchase price for the stock, or to limit the potential losses on a short position in the stock. - buying options act much like insurance, protecting the investor when the stock price moves higher. Buying Call Options
  • 25. Strategy #1: Buying Calls to Speculate An investor buys 5 XYZ December 55 call options at the current price of $2. Pays a premium of $1,000 ($2 × 100 shares × 5 contracts) to obtain the right to buy 500 shares of XYZ Inc. at $55 a share on or before the expiration date in December. The options are out-of-the-money (the strike price is greater than the stock price of $52.50), the $2 premium consists entirely of time value. The options have no intrinsic value.
  • 26. For the speculative investor - intent of the call purchase is to profit from an expectation of a higher XYZ stock price. The call buyer will want to sell the 5 XYZ December 55 calls before they expire, preferably at a higher price than what was paid for them. But if the price of XYZ shares rise, the price of the calls will likely rise, and the call buyer will be able to sell them at a profit. Of course, the call buyer faces the risk that if the stock price does not rise or, worse, it falls. Strategy #1: Buying Calls to Speculate
  • 27. E.g., if by September the price of XYZ stock is $60, the XYZ December 55 calls will be trading for at least their intrinsic value, which in this case is $5. Since there are still three months remaining before the options expire, the premium will also include some time value. Assuming the calls have $1.70 of time value, they will be trading at $6.70. Therefore, the investor could choose to sell the options at $6.70 and realize a profit of $4.70 a share, equal to the difference between the current premium minus the premium paid, or $2,350 total ($4.70 × 100 shares × 5 contracts). Strategy #1: Buying Calls to Speculate
  • 28. However, XYZ shares are trading at $45 a share in September, the XYZ December 55 calls might be worth only $0.25. At this time, and indeed, at all other times before expiration, the investor will have to decide whether to sell the options or hold on in the hope that the stock price (and the options’ price) recovers. If the investor sells at this time, a loss equal to $1.75 a share, or $875 total ($1.75 × 100 shares × 5 contracts) will result. Selling before expiration allows the call buyer to earn any time value that remains built into the option premium. Also, the option buyer gives up any chance of reaping any further increases in the option’s intrinsic value. The call buyer’s outlook for the stock price plays a crucial role in the decision. Strategy #1: Buying Calls to Speculate
  • 29. Strategy #2: Buying Calls to Manage Risk Investors buy call options to manage risk. E.g., a fund manager intends to buy 50,000 shares of XYZ stock, but will not receive the funds until December. Buying 500 XYZ December 55 call options will protect the fund manager from any sharp increase in the price of XYZ above the $55 strike price, because they will establish a maximum price at which the shares can be purchased. E.g., if XYZ shares increase to $60 just prior to the expiration date in December, the options will be trading for their intrinsic value only, in this case $5 = ($60 – $55).
  • 30. Since the call buyer now has the money to buy the shares, the calls can be exercised, at which point the call buyer will purchase 50,000 shares of XYZ at the strike price of $55. Thus, the call buyer’s net purchase price is actually $57 a share, considering the $2 paid for the option. But If, XYZ shares are trading at $45 just prior to the expiration date, the call buyer will let the options expire and will buy the shares at the going price of $45 each. The investor’s effective cost is $47, which includes the $2 paid for the calls. Strategy #2: Buying Calls to Manage Risk
  • 31. Writing Call Options Investors write call options primarily for the income they provide. i.e. the premium, which is the writer’s to keep no matter what happens to the price of the underlying asset or what the buyer eventually does. Call-writing strategies are primarily speculative in nature, but it can also be used to manage risk. Two classifications of call option writers: • Covered call writers own the underlying stock, and will use this position to meet their obligations if they are assigned. • Naked call writers do not own the underlying stock and if assigned, the underlying stock must first be purchased in the market before it can be sold to the call option buyer.
  • 32. Call option buyers will only exercise if the price of the stock is above the strike price, assigned naked call writers must buy the stock at one price (the market price) and sell at a lower price (the strike price). Naked call writers hope, that this loss is less than the premium they originally received, so that the overall result for the strategy is a profit. Since all exchange-traded stock options have an American-style exercise feature, call writers (and put option writers) face the risk of being assigned at any time prior to expiration. Prior to expiration, it is more advantageous for call buyers to sell their options rather than exercise them - because by selling they receive the option’s time value as well as its intrinsic value. Writing Call Options
  • 33. Only the intrinsic value is captured when an option is exercised. So the chance of being assigned before expiration is not as great as one might think. Though this happens, particularly when the time value is small, and option writers must be aware of this. Writing Call Options
  • 34. Strategy #1: Covered Call Writing Assume an investor writes 10 XYZ September 50 call options at the current price of $4.55. The investor receives a premium of $4,550 ($4.55 × 100 shares × 10 contracts) to take on the obligation of selling 1,000 shares of XYZ Inc. at $50 a share on or before the expiration date in September. Because the options are in-the-money (the strike price is less than the stock price), the $4.55 premium consists of both intrinsic and time value. Intrinsic value is equal to $2.50 and time value is equal to $2.05. If the investor already owned (or purchased at the same time as the options were written) 1,000 shares of XYZ, the overall position is known as a covered call. i.e. covered call writer.
  • 35. At expiration in September, the price of XYZ stock is greater than $50 (i.e., the options are in-the-money), the covered call writer will be assigned and thus have to sell the stock to the call buyer at $50 a share. From the covered call writer’s perspective, however, the effective sale price is $54.55, because of the initial premium of $4.55. Strategy #1: Covered Call Writing
  • 36. But If, the price of the stock at expiration in September is less than $50, the covered call writer will not be assigned and the options will expire worthless. Call buyers will not elect to buy stock at $50 when it can be purchased for less in the market. The covered call writer will retain the shares and the initial premium. Thus, the premium reduces the covered call writer’s effective stock purchase price by $4.55 a share. i.e., if the covered call writer bought the XYZ stock at, $50, and the options expired worthless, the covered call writer’s effective purchase price is now $45.45 ($50 – $4.55). In this sense, writing the call slightly reduces the risk of owning the stock. Strategy #1: Covered Call Writing
  • 37. Strategy # 2: Naked Call Writing Assume an investor writes 10 XYZ September 50 call options at the current price of $4.55. if call is not already owned - a naked call writer. The best the naked call writer could hope for is, that the price of XYZ stock will be lower than $50 at expiration. In this instance, the calls will expire worthless and the naked call writer will earn a profit equal to $4.55 a share, the initial premium received. This is the most that this call writer can expect to earn from this strategy.
  • 38. But if the price of the shares increases, the naked call writer will realize a loss if the stock price is higher than the strike price plus the premium received, in this case $54.55. In this instance, the naked call writer will be forced to buy the stock at the higher market price and then turn around and sell them to the call buyer at the $50 strike price. When the stock price is greater than $54.55, the cost of buying the stock is greater than the combined proceeds from selling the stock and the premium initially received. Strategy # 2: Naked Call Writing
  • 39. For example, if the price of the XYZ rose to $60 at expiration, the naked call writer will suffer a $10 loss on the purchase and sale of the shares (buy at $60, sell at $50). This loss is offset somewhat by the initial premium of $4.55, so that the actual loss is $5.45 a share, or $5,450 in total ($5.45 × 100 shares × 10 contracts). Strategy # 2: Naked Call Writing; Example
  • 40. Buying Put Options Investors buy put options for: • To profit from an expected decline in the price of the stock. - speculative strategy relies on the fact that put option prices tend to rise as the price of the stock falls. Just like buying calls, the selection of an expiration date and strike price is crucial to the success (or lack thereof ) of the strategy. • For risk management purposes. - puts can be used to lock in a minimum selling price for a stock, they are very popular with investors who own stock. Buying puts can protect investors from a decline in the price of a stock below the strike price.
  • 41. Strategy #1: Buying Puts to Speculate Assume an investor buys 10 XYZ September 50 put options at the current price of $1.50. The put buyer pays a premium of $1,500 ($1.50 × 100 shares × 10 contracts) to obtain the right to sell 1,000 shares of XYZ Inc. at $50 a share on or before the expiration date in September. Because the options are out-of-the-money (the strike price is less than the stock price), the $1.50 premium consists entirely of time value. The option has no intrinsic value. Opinion of put buyer might be the exact opposite of the opinion of put seller. If the stock price falls, the XYZ September 50 put options will likely rise in value. This will allow the put buyer to sell his options for a profit. Of course, if the stock price rises, the put options will most likely lose value and the put buyer may be forced to sell the options at a loss.
  • 42. E.g., if XYZ stock is trading at $45 one month before the September expiration date, the XYZ September 50 puts will be trading for at least their intrinsic value, or $5. Since there is still one month before the expiration date, the options will have some time value as well. Assuming they have time value of $0.25, the options will be trading at $5.25. Therefore, the put buyer could choose to sell the puts for $5.25 and realize a profit of $3.75 a share, which is equal to the difference between the current put price and the put buyer’s original purchase price. Based on 10 contracts, the put buyer’s total profit is $3,750 i.e. ($3.75 × 100 shares × 10 contracts). Strategy #1: Buying Puts to Speculate
  • 43. But if, XYZ were trading at $60 a share, the XYZ September 50 puts might be worth only $0.05. Because the options are so far out-of-the-money, and because there is only one month left until the options expire, the options will not have a lot of time value. The low option price tells us the market does not believe there is much of a chance for XYZ shares to fall below $50 anytime over the next month. Put buyer has to decide whether to sell the options at this price, or hold on in hope that the price of XYZ does fall to below $50. If the stock does fall, the price of puts will rise. If the stock doesn’t fall below $50, the puts will be worthless when they expire. If the put buyer decides to sell the options at $0.05, a loss equal to $1.45 a share ($0.05 – $1.50) or $1,450 i.e. ($1.45 × 100 shares × 10 contracts) would result. Strategy #1: Buying Puts to Speculate
  • 44. Strategy #2: Buying Puts to Manage Risk Assume an investor buys 10 XYZ September 50 put options at the current price of $1.50, but in this case the put buyer actually owns 1,000 shares of XYZ. – thus the put purchase acts as insurance against a drop in the price of the stock. - Recall that put buyers have the right to sell the stock at the strike price. Buying a put in conjunction with owning the stock, a strategy known as a married put or a put hedge, gives the put buyer the right to sell the stock at the strike price. If the price of the stock is below the strike price of the put when the puts expire, the put buyer will most likely exercise the puts and sell the stock to the put writer. The strike price acts as a floor price for the sale of the stock.
  • 45. E.g., if XYZ shares are trading at $45 just prior to the expiration date in September, the puts will be trading very close to their intrinsic value of $5, because the puts are in-the-money and there is very little time left until the expiration date. The put buyer may choose to exercise the puts and sell the stock at the $50 strike price. The put buyer has been protected from the drop in the stock price below $50. The protection was not free, because the put buyer had to pay $1.50 for the puts. The put buyer’s effective sale price is actually only $48.50, after deducting the cost of the puts. But this sale price is still better than the stock’s $45 market price. Example: Strategy #2: Buying Puts to Manage Risk
  • 46. The put buyer, may not want or even be able to sell the stock. If so, the puts should be sold. Any profit on the sale of the puts reduces the put buyer’s effective stock purchase price. If the put buyer originally bought the stock at a price of, $40, and then sold the puts at $5, for a net profit of $3.50, the effective stock purchase price becomes $36.50. Eventually, when the shares are sold, the put buyer will measure the total profit on the stock purchase as the difference between the sale price and the effective purchase price of $36.50. Example: Strategy #2: Buying Puts to Manage Risk
  • 47. Writing Put Options Primarily done for the income they provide - in the form of premium, - the writer’s to keep no matter what happens to the price of the underlying asset or what the buyer eventually does. Like call-writing, put-writing strategies are primarily speculative in nature, but they can also be used to manage risk. • Put option writers can be classified as either covered or naked. Covered put writing, is not nearly as common as covered call writing because, technically, a covered put write combines a short put with a short position in the stock. More common is a “nearly” covered put writing strategy is known as a cash-secured put write. A cash-secured put write involves writing a put and setting aside an amount of cash equal to the strike price.
  • 48. • Naked put writers have no position in the stock and have not specifically earmarked an amount of cash to buy the stock. They must be prepared to buy the stock, so they should always have the financial resources to do so. They hope to profit from a stock price that stays the same or goes up. If this happens, the price of the puts will likely decline as well, and the chance of being assigned will also be less. The naked put writer may then choose to buy back the options at the lower price to realize a profit. If the stock price does not rise, the put writer may be assigned, and may suffer a loss. Based on how low the stock price is and the amount of premium received, naked put writers may still profit even if they are assigned. Writing Put Options
  • 49. Strategy # 1: Cash-Secured Put Writing Assume investor writes 5 XYZ December 55 put options at the current price of $4.85. The put writer receives a premium of $2,425 ($4.85 × 100 shares × 5 contracts) to take on the obligation of buying 500 shares of XYZ Inc. at $55 a share on or before the expiration date in December. Because the options are in-the-money (the strike price is greater than the stock price), the $4.85 premium consists of both intrinsic value and time value. Intrinsic value is equal to $2.50 and time value is equal to $2.35. If the put writer set aside cash equal to the purchase value of the stock, the strategy is known as a cash-secured put write. The put writer in this case would have to set aside $27,500 ($55 strike price × 100 shares × 5 contracts).
  • 50. Some investors actually use cash-secured put writes as a way to buy the stock at an effective price that is lower than the current market price. The effective price is equal to the strike price minus the premium received. Strategy # 1: Cash-Secured Put Writing
  • 51. Example: Strategy # 1: Cash-Secured Put Writing E.g., if at expiration in December the price of XYZ stock is less than $55, the put writer will be assigned and will have to buy 500 shares of XYZ at the strike price of $55 a share. The effective purchase price is actually $50.15, because the put writer received a premium of $4.85 when the options were written. This effective purchase price is less than the $52.50 price of the stock when the cash-secured put write was established.
  • 52. If at expiration in December the price of XYZ stock is greater than $55, the cash-secured put writer will not be assigned because the options are out-of-the- money. The cash-secured put writer, however, gets to keep the premium of $4.85, and will have to decide whether to use the cash to buy the stock at the market price. Example: Strategy # 1: Cash-Secured Put Writing (b)
  • 53. Strategy #2: Naked Put Writing Suppose a different investor writes 5 XYZ December 55 put options at the current price of $4.85. If the put writer does not set aside a specific amount of cash to cover the potential purchase of the stock, the put writer is considered a naked put writer. The naked put writer desires the price of XYZ to be higher than $55 at expiration. If this happens, the puts will expire worthless and the put writer will earn a profit equal to $4.85 a share, the initial premium received.
  • 54. Strategy #2: Naked Put Writing (b) If the price of XYZ stock falls, the naked put writer will most likely realize a loss, as put buyers will exercise their options to sell the stock at the higher strike price. (The naked put writer in this case will suffer a loss only if XYZ stock is trading for less than $50.15 at option expiration.) The naked put writer will have to buy stock at a price that is higher than the market price. If the put writer does not want to hold the shares in anticipation of a higher price, they could be sold.
  • 55. Example: Strategy #2: Naked Put Writing E.g., if the price of XYZ fell to $45 at expiration, the naked put writer will suffer a $10 loss on the purchase and sale of the shares (buy at the strike price of $55, sell at the market price of $45). This loss is offset somewhat by the initial premium of $4.85, so that the actual loss is $5.15 a share, or $2,575 in total ($5.15 × 100 shares × 5 contracts).
  • 56. Option Strategies for Corporations Normally, corporations do not speculate with derivatives. They are interested in managing risk, and often use options to do it. These risks are often related to interest rates, exchange rates or commodity prices. E.g., corporations take on debt to help finance their operations and attimes the interest rate on the debt is a floating rate that rises and falls with market interest rates. Just like the investor who buys a call to establish a maximum purchase price for a stock, corporations can buy a call to establish a maximum interest rate on floating-rate debt.
  • 57. Call Option Strategies: Corporations Suppose a Canadian company knows it will buy US$1 million worth of goods from a U.S. supplier in three months’ time. If the exchange rate is C$1.12 per U.S. dollar, the U.S. dollar purchase will cost the company C$1.12 million. The company can either buy the US$1 million now and pay C$1.12 million, or wait three months and pay whatever the exchange rate is at that time. If company chooses to do the latter and wait, by doing this, it faces the risk that the value of the U.S. dollar will strengthen relative to the Canadian dollar. Thus, the Canadian dollar cost of the purchase would be higher than C$1.12 million. To protect itself against this risk, the corporation can buy a call option on the U.S. dollar.
  • 58. Suppose the corporation buys a three-month U.S. dollar call option with a strike price of C$1.15. This option is an OTC option and would most likely be written by the corporation’s bank. If at the end of three months the exchange turns out to be C$1.20, the corporation will exercise the call and buy the U.S. dollars from its bank for C$1.15 million. If, however, the U.S. dollar weakens so that in three months the exchange rate is C$1.10, the corporation will let the option expire and will buy the U.S. dollars at the lower exchange rate. The purchase of the call option has capped the exchange rate at C$1.15 plus the cost of the option. Call Option Strategies: Corporations
  • 59. Put Option Strategies - Corporations Assume a Canadian oil company will have 1 million barrels of crude oil to sell in six months’ time and present price of crude oil is US$70 a barrel but unsure of what the price will be in six months. To lock in a minimum sale price, the company buys a put option on one million barrels of crude oil with a strike price of US$68 a barrel. This will protect the company from an oil price lower than US$68 a barrel. in six months, if price of crude oil is less than US$68, the company will exercise its put option and sell the oil to the put option writer at the strike price. But if the price is greater than US$68, the company will let the option expire and will sell the oil at the going market price.
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  • 61. Fortuna Favi et Fortus Ltd., :118 Old Ewu Road, Aviation Estate, Lagos, :(+234)7032530965 www.ffavifortus.com info@ffavifortus.com