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Options: a cynical boy's guide

A quick introduction to options

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The cynical boy's guide to Options
Contents
I. Introduction................................................................................................................................2
II. What are options, and where do they come from?........................................................................2
A....................................................................................................................................................2
B. What is a stock option?............................................................................................................2
1. Call options .........................................................................................................................3
C. Put Options.............................................................................................................................4
III. A bit of history.........................................................................................................................5
1. Tulip options........................................................................................................................7
B. More on puts and calls.............................................................................................................8
1. Who buys options, and why?................................................................................................8
C. Options strategies .................................................................................................................10
I. Introduction
Thisdocumentprovidesagentle introductionto stockoptions.The guide will be gentleenoughsothata
readerwithoutanypreviousexposure tooptionsoroptionstradingshouldbe able tofollow.Onthe
otherhand,the guide will be thoroughenoughsothatsomeone whomakesitall the waythroughit
shouldhave notrouble answeringthe options-relatedquestionsonone of the standardsecuritiesexams
(Series3,Series6,or Series7).
II. What are options, and where do they come from?
A.
In thissectionwe will explainwhatthe mostcommontypesof optionsare andgive a bit of history.
B. What is a stock option?
Stock options,broadlydefined(forthose whohave misspenttheiryouthsgambling) are nothingmore
than side betsinthe greatestCasinoonEarth – the securitiesmarket(sometimespeople claimthatthe
Stock Marketis the biggestCasinoonEarth, buttheyare wrong – boththe ForEx (foreignexchange)
Robber: Your money or your life!
Jack Benny: I’m thinking, I’m thinking…
marketand the Bond (debt) marketare farbigger.) Thisdefinition,however,issobroadas to be
useless,andsowe will describethe simplest kindsof bets(alsoknownasoptionscontracts).
1. Call options
Suppose thatyouruncle Louie isa janitorat Apple’sshinynew Spaceshipheadquarters,andwhile
emptyingoutthe trashcans, he foundthe plansfor the
new artificiallyintelligentproduct,whichcandoeverything
moderatelywell.Itturnsoutthat the productis hittingthe
marketintwo months.Obviously,once itdoes,the skyis
the limitforApple’sstock price (Apple’sstockticker
symbol isAAPL) W are now facedwiththe questionof how
to maximize ourgains.We don’ttrustany of our so-called
“friends”,andwe have a total of $10000 inour savings
account. While AAPLmightasmuchas double onthe news
of the fantasticnew product,$20000 is notquite enough
to retire toBelize on.Whatto do?
This,luckilyforus,iswhere call options come in.A call optionisa contract whichgivesusthe rightto
buy100 sharesof the stock(knowntothe sophisticatesas theunderlying) ata certainprice (knownas
the strike price) anytime before acertaindate (knownas theexpiration).
At the time of thiswriting(February17,2018), AAPLsellsforaround$172 per share.Call optionswith
the strike price of $185 and expiration on March 23, 2018 sell for$4.80 (the options premium).If we
believethatAAPLwill double byMarch 23rd
, we can eitherbuy$10000 worth of stock,and make
$10000, or we can buy the $185 call options,whichallow us tobuy20000 sharesof AAPLEstock at
$185. Since the stockwill be worth$345 at the time (we hope),the value of these optionswill be ($345-
$185)*2000 = $160 * 2000 = $320000. Still notquite enoughtospendalifetime inBelize,sadtosay,but
not tooshabbyfor a day’swork.
Of course,nothingisquite free.If the documentUncle Louie foundwasactuallyajoke,thenAAPLisstill
goingto be worth around$172 a share on March 23rd
, and the opportunitytobuythemat that time for
$185 isnot goingto be worth much.More precisely,itwillbe worth$0.00, so we will have lostour
savings.Hadwe boughtthe underlyinginstead,we wouldnothave lostanymoneyatall,sothisway of
usingcall optionsisakinto buyingalotteryticket.
C. Put Options
Your otheruncle Fredworksat Tesla(tickerTSLA) and hasdiscoveredthatElonMusk hadconfusedtwo
of hisbusinesses,andthatTeslahadaccidentallyinstalledrocketenginesinsome of theircars,leading
to some of theircustomerstravelingtothe Mooninsteadof the local 7-11. A majorclass-actionlawsuit
isbrewing,TSLA issure to tank, and youare lookingtoaugmentyourill-gottengainsinAAPL.Whatto
do? Youcould,of course,sell Teslasharesshort,butthishastwo problems.One isthe same sortof
problemasbefore – yourgainsare limitedbythe amountof moneyyouinvest,andif yousell $10000 of
TSLA short,and the price of TSLA goesdownby 50%, you standto make a measly$5000. The other
problemisthatif there are enoughpeople crazy enoughto wanttogo to the Moon rather thanthe 7-
11, Teslasharesmightgo upa lot,andyou mightbe out a lotof money(an unlimited amountof
money).Here too,optionsprovideareadysolution:
A put optionona stockis a contract whichgivesusthe rightto sell 100 sharesof the underlyingstockat
a givenprice (the strike) anytime beforeagivendate (the expirationdate).Atthe time of thiswriting
(February18, 2018) TSLA was sellingfor$335 a share,while $310 putson TSLA witha March 16th
2018
expirationweregoingfor$4.15 each(remember,the $4.15 is the optionspremium),soforour $1000
we couldbuy putson some 2200 shares,andwhen(andif) TSLA losthalf itsvalue,andwas sellingfor
Remark: there are actuallytwodifferentkindsof calls –the American,whichgivesusthe
rightto buy the underlyinganytime before the expiration,andthe European,whichgivesus
the right to buythe underlying onthe expirationdate. Since we wouldnotwant to be
unpatriotic,the optionswe discusshenceforthwillbe American.
$167.50, we wouldhave the rightto sell it for $310. This rightwouldbe worth$(310-167.5) = $143.5,
and so we wouldnetclose to$300000 on the deal (withthe alreadyseenprovisothatif the price of
Tesladid notdrop, as we had hoped,andstayedabove $310, we wouldbe cleanedout.
There isa lotmore to say aboutcall andput optionsandtheiruses,butrightnow,let’ssummarize:
1. Pop-up quiz. An American option can be exercised:
a) Any time beforeexpiration.
b) On expiration day only.
2. Pop-up quiz, continued: A European option can be exercised:
a) Any time beforeexpiration.
b) On expiration day only.
III. A bit of history
Giventhatmany people (includingmanyof those readingthisGuide)know little aboutoptions,one
mightthinkthat theyare some sort of a recentinventionbypencil-neckedquantsinthe Goldman-Sachs
basement. Inactuality,nothingcouldbe furtherfromthe truth.The firstrecordeduse of options(not
A Call Option is a contract giving the holder the right to buy 100 shares of a stock (the
underlying) at a fixed price (the strike price) on or before a fixed date (the expiration). What
you pay for the option is the options premium.
A Put option is a contract giving the holder the right to sell 100 shares of the underlying at a
fixed strike on or before the expiration.
History repeats itself – first time as a tragedy, second
time as a farce.
--Karl Marx
stockoptions) isbyThalesof Miletus (c.624 B.C – c 545 B. C.) , a mathematicianandphilosopherof
great renown(he wasthe firstpersontostate a mathematical theorem, andalsotodiscovermagnetism,
and to measure the heightof objectbythe lengthof theirshadows,aswell astoperformsome
impressivefeatsof militaryengineering,suchasdivertingrivers).Inanycase, nosoonerdidThalesshow
hisprowessinscience andphilosophy
than he discoveredthe eternaltaunt:If
youare so smart,how come youare not
rich? Thisiswhat happenednext:
Aristotle (inpartXIof Book 1 of his
‘Politics’)relatesthe tale.
Accordingto Aristotle’saccount,Thales
put a depositduringthe winteronall the
olive-pressesinChiosandMiletus,which
wouldallow himexclusive use of the
pressesafterthe harvest.Because the
harvestwasin the future,andnobody
couldbe sure whetherthe harvestwould
be plentiful ornot,he wasable to secure
the contracts for a verylow price.Infact,
we are informedthatthere wasnotone
bidagainsthim.From the olive press
owners’pointof view,theywere
protectingthemselvesagainstapoor
harvestbyearningat leastsome money
up frontregardlessof how thingsturned
out.
Thales’betcame off,bigtime.The
harvestwasexcellentandthere was
heavydemandforthe presses.Thales
heldthe monopolyandwasable torent
themout at a huge profit.Eitherhe wasan expertforecaster,orhe had calculatedthata bad harvest
wouldnotlose himmuchin termsof lostdeposits,whereasthe upside of agoodharvestwasenormous.
“Thus,he showedthe worldthatphilosopherscaneasilybe richif theylike,butthattheirambitionisof
anothersort”,wrote Aristotle.
For our purposeswhatissignificantisthatThaleswrote the firstrecordedcall contract:

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Options: a cynical boy's guide

  • 1. The cynical boy's guide to Options
  • 2. Contents I. Introduction................................................................................................................................2 II. What are options, and where do they come from?........................................................................2 A....................................................................................................................................................2 B. What is a stock option?............................................................................................................2 1. Call options .........................................................................................................................3 C. Put Options.............................................................................................................................4 III. A bit of history.........................................................................................................................5 1. Tulip options........................................................................................................................7 B. More on puts and calls.............................................................................................................8 1. Who buys options, and why?................................................................................................8 C. Options strategies .................................................................................................................10 I. Introduction Thisdocumentprovidesagentle introductionto stockoptions.The guide will be gentleenoughsothata readerwithoutanypreviousexposure tooptionsoroptionstradingshouldbe able tofollow.Onthe otherhand,the guide will be thoroughenoughsothatsomeone whomakesitall the waythroughit shouldhave notrouble answeringthe options-relatedquestionsonone of the standardsecuritiesexams (Series3,Series6,or Series7). II. What are options, and where do they come from? A. In thissectionwe will explainwhatthe mostcommontypesof optionsare andgive a bit of history. B. What is a stock option? Stock options,broadlydefined(forthose whohave misspenttheiryouthsgambling) are nothingmore than side betsinthe greatestCasinoonEarth – the securitiesmarket(sometimespeople claimthatthe Stock Marketis the biggestCasinoonEarth, buttheyare wrong – boththe ForEx (foreignexchange) Robber: Your money or your life! Jack Benny: I’m thinking, I’m thinking…
  • 3. marketand the Bond (debt) marketare farbigger.) Thisdefinition,however,issobroadas to be useless,andsowe will describethe simplest kindsof bets(alsoknownasoptionscontracts). 1. Call options Suppose thatyouruncle Louie isa janitorat Apple’sshinynew Spaceshipheadquarters,andwhile emptyingoutthe trashcans, he foundthe plansfor the new artificiallyintelligentproduct,whichcandoeverything moderatelywell.Itturnsoutthat the productis hittingthe marketintwo months.Obviously,once itdoes,the skyis the limitforApple’sstock price (Apple’sstockticker symbol isAAPL) W are now facedwiththe questionof how to maximize ourgains.We don’ttrustany of our so-called “friends”,andwe have a total of $10000 inour savings account. While AAPLmightasmuchas double onthe news of the fantasticnew product,$20000 is notquite enough to retire toBelize on.Whatto do? This,luckilyforus,iswhere call options come in.A call optionisa contract whichgivesusthe rightto buy100 sharesof the stock(knowntothe sophisticatesas theunderlying) ata certainprice (knownas the strike price) anytime before acertaindate (knownas theexpiration).
  • 4. At the time of thiswriting(February17,2018), AAPLsellsforaround$172 per share.Call optionswith the strike price of $185 and expiration on March 23, 2018 sell for$4.80 (the options premium).If we believethatAAPLwill double byMarch 23rd , we can eitherbuy$10000 worth of stock,and make $10000, or we can buy the $185 call options,whichallow us tobuy20000 sharesof AAPLEstock at $185. Since the stockwill be worth$345 at the time (we hope),the value of these optionswill be ($345- $185)*2000 = $160 * 2000 = $320000. Still notquite enoughtospendalifetime inBelize,sadtosay,but not tooshabbyfor a day’swork. Of course,nothingisquite free.If the documentUncle Louie foundwasactuallyajoke,thenAAPLisstill goingto be worth around$172 a share on March 23rd , and the opportunitytobuythemat that time for $185 isnot goingto be worth much.More precisely,itwillbe worth$0.00, so we will have lostour savings.Hadwe boughtthe underlyinginstead,we wouldnothave lostanymoneyatall,sothisway of usingcall optionsisakinto buyingalotteryticket. C. Put Options Your otheruncle Fredworksat Tesla(tickerTSLA) and hasdiscoveredthatElonMusk hadconfusedtwo of hisbusinesses,andthatTeslahadaccidentallyinstalledrocketenginesinsome of theircars,leading to some of theircustomerstravelingtothe Mooninsteadof the local 7-11. A majorclass-actionlawsuit isbrewing,TSLA issure to tank, and youare lookingtoaugmentyourill-gottengainsinAAPL.Whatto do? Youcould,of course,sell Teslasharesshort,butthishastwo problems.One isthe same sortof problemasbefore – yourgainsare limitedbythe amountof moneyyouinvest,andif yousell $10000 of TSLA short,and the price of TSLA goesdownby 50%, you standto make a measly$5000. The other problemisthatif there are enoughpeople crazy enoughto wanttogo to the Moon rather thanthe 7- 11, Teslasharesmightgo upa lot,andyou mightbe out a lotof money(an unlimited amountof money).Here too,optionsprovideareadysolution: A put optionona stockis a contract whichgivesusthe rightto sell 100 sharesof the underlyingstockat a givenprice (the strike) anytime beforeagivendate (the expirationdate).Atthe time of thiswriting (February18, 2018) TSLA was sellingfor$335 a share,while $310 putson TSLA witha March 16th 2018 expirationweregoingfor$4.15 each(remember,the $4.15 is the optionspremium),soforour $1000 we couldbuy putson some 2200 shares,andwhen(andif) TSLA losthalf itsvalue,andwas sellingfor Remark: there are actuallytwodifferentkindsof calls –the American,whichgivesusthe rightto buy the underlyinganytime before the expiration,andthe European,whichgivesus the right to buythe underlying onthe expirationdate. Since we wouldnotwant to be unpatriotic,the optionswe discusshenceforthwillbe American.
  • 5. $167.50, we wouldhave the rightto sell it for $310. This rightwouldbe worth$(310-167.5) = $143.5, and so we wouldnetclose to$300000 on the deal (withthe alreadyseenprovisothatif the price of Tesladid notdrop, as we had hoped,andstayedabove $310, we wouldbe cleanedout. There isa lotmore to say aboutcall andput optionsandtheiruses,butrightnow,let’ssummarize: 1. Pop-up quiz. An American option can be exercised: a) Any time beforeexpiration. b) On expiration day only. 2. Pop-up quiz, continued: A European option can be exercised: a) Any time beforeexpiration. b) On expiration day only. III. A bit of history Giventhatmany people (includingmanyof those readingthisGuide)know little aboutoptions,one mightthinkthat theyare some sort of a recentinventionbypencil-neckedquantsinthe Goldman-Sachs basement. Inactuality,nothingcouldbe furtherfromthe truth.The firstrecordeduse of options(not A Call Option is a contract giving the holder the right to buy 100 shares of a stock (the underlying) at a fixed price (the strike price) on or before a fixed date (the expiration). What you pay for the option is the options premium. A Put option is a contract giving the holder the right to sell 100 shares of the underlying at a fixed strike on or before the expiration. History repeats itself – first time as a tragedy, second time as a farce. --Karl Marx
  • 6. stockoptions) isbyThalesof Miletus (c.624 B.C – c 545 B. C.) , a mathematicianandphilosopherof great renown(he wasthe firstpersontostate a mathematical theorem, andalsotodiscovermagnetism, and to measure the heightof objectbythe lengthof theirshadows,aswell astoperformsome impressivefeatsof militaryengineering,suchasdivertingrivers).Inanycase, nosoonerdidThalesshow hisprowessinscience andphilosophy than he discoveredthe eternaltaunt:If youare so smart,how come youare not rich? Thisiswhat happenednext: Aristotle (inpartXIof Book 1 of his ‘Politics’)relatesthe tale. Accordingto Aristotle’saccount,Thales put a depositduringthe winteronall the olive-pressesinChiosandMiletus,which wouldallow himexclusive use of the pressesafterthe harvest.Because the harvestwasin the future,andnobody couldbe sure whetherthe harvestwould be plentiful ornot,he wasable to secure the contracts for a verylow price.Infact, we are informedthatthere wasnotone bidagainsthim.From the olive press owners’pointof view,theywere protectingthemselvesagainstapoor harvestbyearningat leastsome money up frontregardlessof how thingsturned out. Thales’betcame off,bigtime.The harvestwasexcellentandthere was heavydemandforthe presses.Thales heldthe monopolyandwasable torent themout at a huge profit.Eitherhe wasan expertforecaster,orhe had calculatedthata bad harvest wouldnotlose himmuchin termsof lostdeposits,whereasthe upside of agoodharvestwasenormous. “Thus,he showedthe worldthatphilosopherscaneasilybe richif theylike,butthattheirambitionisof anothersort”,wrote Aristotle. For our purposeswhatissignificantisthatThaleswrote the firstrecordedcall contract:
  • 7. 1. Tulip options. In the middle of the seventeenthcentury,The Netherlandsfell preytothe infamousTulipBulbBubble (whichwasthe spiritual forefatherof the manybubbleswe have experiencedinrecentyears(the dot com bubble of the late 1990s (whichpoppedin2001) andthe housingbubble of the beginningof the 21st century(whichpoppedin2008). Justas the housingbubble,the TulipBulbbubble wasmade worse by the use of derivatives(optionsandfutures).The storyisthe following: In the early1600s, tulipswere extremelypopularas a status symbol amongthe Dutcharistocracy. And as theirpopularitybegantospill acrossHolland’sborderstoa worldwide market,priceswentup dramatically. To hedge riskincase of a badharvest,tulipwholesalers beganto buycall options,andtulipgrowersbeganto protectprofitswithputoptions.Atfirst,the tradingof optionsinHollandseemedlikeperfectlyreasonable economicactivity.Butasthe price of tulipbulbs continuedtorise,the value of existingoptioncontracts increaseddramatically.Soasecondarymarketfor those optioncontractsemergedamongthe general public.In fact, itwas notunheardof forfamiliestouse their entire fortunestospeculate onthe tulipbulbmarket. Unfortunately,when Dutcheconomyslippedintorecessionin1638, the bubble burstandthe price of tulipsplummeted.Manyof the speculatorswhohadsoldputoptionswere eitherunable orunwillingto fulfilltheirobligations.Tomake mattersworse,the optionsmarketin17th-centuryHollandwasentirely unregulated.Sodespite the Dutchgovernment’seffortstoforce speculatorstomake goodontheir optioncontracts,this“counterpartyrisk”was veryreal,anda lot of people lostalot of money(the Dutch economytookdecadestorecover). However,thiseventlaidthe seeds(sotospeak) of the current regulatedoptionsmarket,whichisnotsubjecttocounterpartyrisk. The depositThalesputdownonthe olive presseswasthe price of his“call option”. Warning:institutionsoftengotoinvestmentbanksforbespoke overthecounteroptions. These are not necessarilyprotectedfromrisk of the counterpartywelchingorsimplybeing unable topay.
  • 8. B. More on puts and calls Let usgo back to our AAPLcalls.At the time thatthe underlyingwassellingfor$172.5, we boughta call for $185. Notice that itis worthnothingtous to exercise the call rightimmediately:if the stockisselling for $172.5, the rightto pay $185 forit is worthless.This(asalways) givesusanexcuse tointroduce more jargon:the intrinsic valueof a call is whatit wouldbe worthif youwere forcedto exercise it immediately.Forexample,if insteadof a$185 call we hadbought a $160 call,thenthe intrinsicvalue of that call wouldbe $172.5-$160 = $12.5. Similarly,the righttosell for$180 a stockthat is worth$172.5 is worth$7.5, so a $180 put on AAPLwouldhave anintrinsicvalue of $7.5. An optionwhichhasnonzero intrinsicvalue is(forrelativelyobviousreasons) called inthe money. An optionwhichhasa zero intrinsicvalue iscalled outofthe money,and,to confuse matters,anoptionwhose strike price isvery close to the currentprice of the underlying securityiscalled at the money. (so,if we buy a $172.5 AAPLcall while AAPLis tradingfor $172.5, we are buyinganat the moneycall, whichisjust barelyoutof the money). An obvious question,then, is:if the intrinsic value of an optionis$0, whyare we payingforit? The answeris that there isa decentchance that, just because of random fluctuation,the price of AAPL mightmove above,say,$200 inthe next month, inwhich case the intrinsicvalue of our call option will jumpto$15 (of course,if our uncle Louie isto be trusted,the Skyis the limit). Whatpeople sayis that the optionhas time value – the difference betweenthe premiumandthe intrinsicvalue isthe time value.Inour example,the whole premiumistime value.Obviously,if we buyanoptionveryclose toits expiration,the timevalue isveryclose tozero. 1. Who buys options, and why? Above,we gave acouple of scenarioswhere youmightwantto buyan optionas a sort of a lotteryticket – if youhave some reasonto anticipate alarge up or downmove inthe underlying,youmight(justlike Thales) buya call or a put,and if youare wrong,youdon’tlose verymuch,while if youare right,youwill make a lot.While thismotivationiscommonamongsmall investors,thisis notwhatdriveslarge or institutional investors.Interestingly,itisthe exactopposite –optionsare mostlyusedas insuranceto safeguardthe investors’portfoliofromlarge moves.Indeed,supposeyourhedge fundhaddecidedthat
  • 9. AAPL’smanagementwasdoinganexcellentjob,andinvested$1 billioninApple stockbacktenyears ago. The stock has beendoingverywell,andyouare now lesssure that itwill continue doingwell,and are alsonotingthat TimCookis notgettinganyyounger,andso a change of managementmightbe in the cards. You believethatApple still hasroomto advance,andalsoyoudon’t wantto sell toomuch because thatwouldtriggera capital gainstax.Instead,youask yourinvestorswhatamountof riskthey are willingtotake,andif theyrespondwith“5%”, you buyenough5% out of the money(inourcase, $163.5) AAPLputs.These will be quite cheap,andwillprotectyouagainstcatastrophiccollapse inAAPL share price. This iswhythe price you payfor an optioniscalled thepremium – itis the insurance premiumyoupayfor protectingyourportfolio. C. Exercises: 1. On February 10 2018, an investor sees a quote for call options to buy stock XYZ by March 23 for $50. The options sell for $5, and the current price of XYZ is $55. a) Are the optionsin-the-money, out-of-the-money orat-the-money? b) Whatis the intrinsicvalue of thecall options? c) Whatis the timevalue of the options? d) Whatis the optionspremium? 2. An investor has heard from his friend in the Sheriff’s department that the CEO of XYZ has been arrested on insider trading charges. The information is not yet publicly available, so the investor is keen to use an options strategy to make money. Should she: a) Buy a call? b) Buy a put? D. Non-stock options Since,aswe have discussed,anoptionisbasicallyaside betonthe market,we can take a side beton justabout anything(andpeople do).The mostrelevantoptionsforthisguide are the following: 1. Index options. An index isanumberassociatedtothe market.It couldbe roughlyequivalenttoaportfolioof stocks (forexample,the S&P500, the Dow JonesIndustrial Average) ornot(the VIXvolatilityindex).Itisbest to thinkof it as a number,andwe can beton the future behaviorof thisnumberjustaswe can beton the future behaviorof stocks.Forexample,if the Dow JonesIndustrial Averageisat25700 (as itis of this writing),we canbuyDow 26000 call optionswitha range of expirationdates,ora 25500 put, or a put or call of almostanyimaginable strike andexpiration.Tounderscore thatthese are purelybets,exercising an optionsimplypaysoutthe intrinsicvalue in cash. Itshouldbe notedthatthere are index ETFs(like SPY or DIA),optionsonwhichare justlike ordinaryoptions,andare not the same as index options. 2. Currency options These are justlike equityoptions,exceptinsteadof equities,youare bettingonthe price movement(or lack thereof of currency).Forexample,youcanbuya call on the Euro or a put on the Britishpound. Exercisinganoptionactuallydepositsalongor shortpositioninthe currencyinyour account.
  • 10. 3. Interest rate options These are betson the movementsininterestrates(asgivenbyvariousUSTreasury instruments,likethe T-Bill andthe TreasuryNote).Justas index options,theypayoff incash,and notin anysort of financial instruments.Suchoptionsare usuallytradedbylarge institutionswhoneedtohedge interestrate risk (forexample,Toll Brothers’salesare adverselyaffectedbyarise ininterestrates,since thateffectively pushesupthe price of houses,soitmightbehoove themtohedge bybuyingcalls(orwritingputs) on interestrates. 4. Pop Quiz! What happenswhenyouexerciseanindex option? E. Options strategies In thissectionwe describe some of the zooof optionsstrategies,startingwiththe simplestand proceedingtothe more esoteric(humanimaginationbeingwhatitis,there isnolimittohow esoteric one can get.) The maintool we will use isthe profit-lossgraph.This isa graph, where the X-asisisthe price of the underlyingsecurity,whilethe Yaxisisthe profit(if positive) orloss(if negative) incurredif the underlyingprice movestoagivenpointonthe X-asis. The general structure isshownbelow: Here is the simplestpossible optionsstrategy(itissosimple thatnooptionsare involvedatall!) a) Long Stock In thisstrategy,we buyand holda positioninthe underlyingitself. The arrow onthe endof the blue line indicatesthatthere isnolimitonhow muchmoneywe can make (note thatthere isno arrow on the lowerleftsince we cannotlose more thanwe had paidfor(the Y-axisiscalibratedincents,the X- axisindollars,justtomake thingsmore confusing:
  • 11. Obviously,we wouldenteralongstock positionif we were of the opinionthatthe stockwouldgo up. The opposite of a longstock positionis: b) ShortStock We wouldenterashort stockpositionif we believedthe stockprice wouldgodown.Notice thatsucha positionhas unlimited losspotential (forexample,if we boughtAAPLbackin2000 for$30, we would have lostabout$40 for everydollarinvested.Note thatnotall retail investorsare allowedtoshort stocks. The nextsimplestpositionisa c) Long Call In the graph itis assumedthatthe strike price is$60. Since we alwayslose the time value of the option, our returnis negative unlessthe price of the underlyingexceedsthe strike price byatleastthe time value.The maximumgainfromthisstrategyisunlimited,whilethe maximallossdoesnotexceedthe
  • 12. optionpremium.Onthe otherhand,the stockhas to appreciate considerably before the expiration date,so itis unwise touse thisstrategyunlessyoubelieve the stockwill moverelativelyrapidly. d) Naked Call(also known asan uncovered call or ShortCall): Thisstrategyis the opposite of alongcall.It doeshave the unpleasantpossibilityof losing unlimited amountsof money,while the total earningsare cappedbythe optionpremium.Youwouldwritea nakedcall if you were highlyconfidentthatthe underlyingwouldnotmove much.Note thatthis strategyisviewedassoriskythat retail investorsare usuallynotallowedtowrite (sell) nakedcalls. e) Long Put Long putis verymuch like alongcall (exceptwe are bettingona drop ratherthan a rise inthe price of the underlying)–if the underlyingdropsbymore thanthe time value,we make money,if not,we lose money.The one subtle difference isthatwhile we have unlimitedupsidewithalong call,we donot, witha put – the stockcannot dropbelow zero,sowiththe example inthe graphwe can make at most $60 (abit less,due tothe lossof the time value). f) Naked Put(uncovered put, shortput) A nakedputis notunlike anakedcall,withthe difference thatwe make moneyif the underlyingdoes not dropa lot,andwe do lose moneyif itdoes.Unlike anakedcall,we can not lose more thanthe strike
  • 13. price,butevenso,the downside isconsiderable,andourgainisat most the premium.Justlike anaked call,mostretail investorsare notpermittedtouse thisstrategy. g) Covered Call In thisstrategyyouown stock and write (sell) callsonthe stockyouown.If the stockgoesup a lot,you don’tgetmuch benefit –the short call cancelsyourprofit,butyou still getthe premium.If the stock goesdown,youlose money(thoughthe painisslightlylessenedbypocketing the optionspremium).On the otherhand,since the losscomesfrom the stockyou hold,youcan alwaysbail outif the stockgoes down(warningtoretail investors:coveredcalls areallowed,however,if youtryto sell yourstock when it goesdown,notice thatdoingsowill make yourcall naked,soyour brokerwill notletyoudothat).So, thisstrategyismost suitable if youdon’texpectmuchmovementinthe underlying. h) Covered Put The ideais to sell the stockshortand sell adeep-in-the-moneyputthatistradingfor close to itsintrinsic value.Thiswill generate cashequal tothe option'sstrike price,whichcanbe investedinaninterest bearingasset.Assignmentonthe putoption,whenandif itoccurs, will cause completeliquidationof the position.The profitwouldthenbe the interestearnedonwhatisessentiallyazerooutlay.The dangeris thatthe stockralliesabove the strike price of the put,inwhichcase the risk isopen-ended. The same warningsapplyaswiththe coveredcall – the positionisnotas easyto bail out of as you might hope. i) Protected (orMarried) Put
  • 14. You ownstock and youbuyputs as insurance againstthe possibilitythatthe stockwill drop.Sucha positionisoftenenteredtolockingainson a trade where some furthergainsmaybe expected,aswell as short termvolatility. j) SyntheticLong Stock In thisstrategyyoubuya call and sell aput on a stock,where the twooptionshave the same strike price and expirationdate. Youwill notice thatthe profitlossgraphlooksexactlythe same asthat for a longstock position!So,whywouldyouentersuchapositioninsteadof buyingstock?There actuallyare a numberof reason.First,yourcapital outlayis muchlowerthanit wouldbe if youwere buyingthe stock.For example,youcouldsimulate alongpositioninAAPL(whichissellingat$172 at thiswriting) for around$30 netoutlay.Second,the factthat a syntheticlongshouldhave the same profitandloss profile asa longpositioninastock isa special case of an optionslaw,knownas put call parity, whichis discussedinmore detail below. However,lawsof financial markets(unlikethose of physics)are sometimesviolated,creatingamispricing,andinthatcase an opportunitytomake money(knownto sophisticatesas anarbitrage opportunity) presentsitself,soan arbitrageur mightenterasyntheticlong position,combinedwithashortpositioninthe stock,guaranteeinghim- orher- self arisk-free profit. k) Syntheticshortstock Thisis the reverse of the syntheticlongstockstrategy,withall the same motivationsandcaveats – the investorsellsacall andbuysa putwiththe same expirationandstrike price –thishas the same profit and lossgraphas justsellingthe stockshort.There isone more reasontouse thisstrategythan the syntheticlongposition –undercertainmarketconditions,itiseitherimpossibleorverydifficulttoshort sell astock, andthisis a way aroundit.
  • 15. l) Collar(Protective Collar, or split-strike) In thisstrategy,the investorbuysanoutof the moneyput,and sellsoutof the moneycall (usuallythese are symmetricallyarrangedsothatthe premiumscancel eachother).The effectof thisstrategyistoclip the investor’sgains and losses,sothatagain,anypreviousgainsare lockedin.If the investorbelieves that the stock will notgoup too muchbefore expiration,he believesthatthisis,essentially,free insurance.Aninterestinghistorical factoidisthatthe infamousBernieMadoff claimedthatthisstrategy (underthe name split-strike) washisnot-so-secretsauce. m) Long Straddle Here,we buya call ANDa putwiththe same strike price and expiration.We lose moneyif the underlyingdoesnotmove much,butwe make money (andpossiblyalotof it) if the underlyingdoes move,sothisstrategyis a beton a big move.Forexample,suppose Congresswill holdavote intwo weeksonlegalizingmarijuanainthe US.If itvotesto legalize,marijuana-relatedstockswillsoar.If it votesto keepitillegal forthe nextthirtyyears,marijuanastockswill dive.Eitherwaywe will make money.However,Congressmightdecide thatthe issue istoovolatile,andcancel the vote,inwhichcase we will lose money.
  • 16. n) Shortstraddle In thisstrategywe sell aput and a call withthe same strike and expiration.Ourmaximal gainisthe sum of the premiums(premia?) forthe twooptions,andourmaximal lossisunlimited,sowe should undertake thisstrategyonlyif we are reasonablyconfident thatthe underlyingwon’tmove much. o) Long Strangle In thisstrategy,the investorbuysanoutof the moneyputand and outof the moneycall (at the same expiration).The ideaisthatthisisthe a cheaper(butlessprofitable)versionof the longstraddle –both strategiesbetthatthe stock price will be volatile inthe nearfuture (butwithoutaclearindicationof whichwaythe price will swing). p) ShortStrangle In a short strangle,the investorwritesanoutof the moneyputandan out of the money call,hoping that the underlyingwill notmove much.Thishashigh(unlimited) risk,andlimitedprofit(the total premium),soshouldonlybe undertakenwithcaution.Mostretail investorswouldnotbe able to execute thisstrategy.
  • 17. q) Bull Call Spread (debitcall spread) In thisstrategy,we buya call option,andsell (write) anothercall at a higherstrike price. The short optionreducesthe optionspremium,butinreturnitputsa cap on how much moneywe canmake,so we shouldenterthisstrategyif we thinkthe underlyingwill move up,butnottoomuch.The reasonfor the secondname (“debitcall spread”) isthatthe longcall premiumishigherthanthe shortcall premium,sowe are payingmoneytoenterthe trade. r) BearCall Spread (credit call spread) In thisstrategywe againbuya call option,butnow we sell anoptionat a lowerstrike price.The resultis that we pocketsome money(hence “creditcall spread”),butnow we are bettingthe stocknotgoingup too much. s) Bull PutSpread (creditputspread) Thisstrategyis executedthe same wayasa bull call spread,andsimilarlyhaslimitedup-and-downside (the initial investmentisnegative,soyouhave cash upfront).
  • 18. t) BearPutSpread (debitputspread) Thisstrategyis similartoa bearcall spread,withthe difference thatthe initial cashflow isnegative. F. Exercises Here we testthe reader’sunderstandingof the material. 1. It is November 7th, tomorrow is the US Presidential election, and the investor suspects that, despite almost universal belief to the contrary, the underdog candidate (a billionaire from Queens) will win. The investor is not sure which way the market will react, but he is expecting a large move. The investor intends to use the ETF SPY (which is a proxy for the S&P 500 Index) options to try to benefit from his insight. Should she a) Buy calls b) Buy puts c) Buy a straddle d) Sell a straddle e) Buy a call spread 2. An investor had bought 1000 shares of Apple, Inc stock back in 2000, since which time the stock (accounting for splits) gone up by a factor of 40, and is now worth over a million dollars. The investor is unwilling to pay the large capital gains tax on his proceeds, and believes that the stock still has some room to grow. Which options strategy would be appropriate for him? a) A covered call b) A protectiveput c) A straddle
  • 19. 3. An investor holds 10000 shares of Apple, and while he has no plans to sell, and believes that AAPL will appreciate, albeit slowly. She would like to generate a bit of cash flow (while holding on to the stock). Should she: a) Buy a married put b) Sell a covered outof themoney call c) Sell a strangle 4. An investor writes a call option to buy XYZ shares for $50. XYZ currently trades for $35. The investors loss is: a) At most$15 b) At least $15 c) Unlimited