2 I Options A Definition The right to buy or sell a specific issue at a specified price the exercise price on or before a specified date regardless of what the market price of the security is on the date the option is exercised ID: 1028140
Download Presentation The PPT/PDF document "I. Options 10/26/2012 Professor James ..." is the property of its rightful owner. Permission is granted to download and print the materials on this web site for personal, non-commercial use only, and to display it on your personal computer provided you do not modify the materials and that you retain all copyright notices contained in the materials. By downloading content from our website, you accept the terms of this agreement.
1. I. Options
2. 10/26/2012Professor James Kuhle2I. OptionsA. Definition: The right to buy or sell a specific issue at a specified price (the exercise price) on or before a specified date regardless of what the market price of the security is on the date the option is exercised.B. Call: The right to buy a security (Upside).C. Put: The right to sell a security (Downside).
3. 10/26/2012Professor James Kuhle3I. Options (continued)D. Option WriterThe person who writes the call or put and receives a premiumE. Option BuyerThe person who buys the call or put and pays the premium
4. I. Options (continued)Stock and Option Markets are unrelated except for the market price of a stock in the stock market and the exercise price of the stock option.10/26/20124CompanyStock MarketInvestorOption MarketOption Investor F. Relation of Options to StockProfessor James Kuhle
5. 10/26/2012Professor James Kuhle5 II. Investor Profit ProfilesAssume you bought 1 share of T.I. at $50. This is your profit profile given various assumptions about T.I.’s future market price.
6. 10/26/2012Professor James Kuhle6Gain $20Loss $-500 $50 PriceProfitGainMarketPrice $70Profit Profile for the Long Stock Position
7. 10/26/2012Professor James Kuhle7II. Investor Profit Profiles A. Call Option Profit Profile of Buyer and SellerSituation: Investor thinks a security will increase in price -- can buy security or a call option. If price declines, Investor has a capital loss in long position or loses his option premium when expired.
8. 1. Profit Profile of Call Buyer (the Upside)Note: Upside potential is unlimited, Downside risk is limited10/26/20128GainLoss0Premium Paid (Price to purchase Option)Strike $50 PriceProfitGainMarketPriceProfessor James Kuhle$3$53
9. Upside (Call)2. Profit Profile of a Call Seller (the other side of the mirror)Note: Upside potential is limited to the premium received. Downside risk is unlimited.10/26/20129GainLoss0Premium ReceivedStrike Price $50ProfitLossMarketPriceProfessor James Kuhle$3$53
10. The DownsideB. Put Option Profit Profile of Buyer and SellerSituation: Investor thinks a security will decrease in price -- can short sell or buy a PUT option. If the security increases in price, the short position produces a capital loss and the option position produces a premium loss.10/26/201210Professor James Kuhle
11. 1. Profit Profile of Put BuyerNote: Upside potential is limited to the price of the security. Downside risk is limited to the premium.10/26/201211GainLoss0Premium $1.50MarketPriceProfessor James KuhleStrike Price $50
12. 2. Profit Graph of Put SellerNote: Upside potential is limited to the premium. Downside risk is limited to the price of the security.10/26/201212GainLoss0Premium $1.50Strike Price $50MarketPriceLossProfessor James Kuhle
13. 10/26/2012Professor James Kuhle13 KO Spot Price Calls Last Sale Net Bid Ask Vol Open Int $65.70 12/02/10 Puts Last Sale Net Bid Ask Vol Open Int KO1018L62.5-E 3.25+0.44 3.15 3.30 3320 10225 10 Dec 62.50 KO1018X62.5-E 0.020.0 0.00.02 0 9643 KO1018L65-E 0.72+0.36 0.68 0.751099 11448 10 Dec 65.00 KO1018X65-E 0.03-0.100.00.02 537 7151 KO1018L67.5-E 0.020.0 0.0 0.01 0 1602 10 Dec 67.50 KO1018X67.5-E 2.35-0.75 1.731.91 10 1495 KO1122A62.5-E 3.35+0.23 3.45 3.55 26 27267 11 Jan 62.50 KO1122M62.5-E 0.29-0.07 0.260.28 486 14536 KO1122A65-E 1.49+0.12 1.49 1.52 786 40281 11 Jan 65.00 KO1122M65-E 0.82-0.18 0.770.80 323 6677 KO1122A67.5-E 0.40+0.10 0.38 0.40 589 8372 11 Jan 67.50 KO1122M67.5-E 2.27-0.37 2.152.19 101 1256 KO1122A70-E 0.07-0.02 0.06 0.09 10 5373 11 Jan 70.00 KO1122M70-E 5.200.0 4.304.40 0 2437C. Listed Options Quotes
14. D. Option Premiums1. Option premium is the price an option buyer must pay for the right and the price an option writer receives for selling the right.10/26/201214Professor James Kuhle
15. D. Option Premiums (continued)2. Effected by:a. The Security PricePremiums are directly related to the relative magnitude of the security price since the risk of price change is a function of the price.Example: Stock A: P = $100 Stock B: P = $10Loss potential as a result of changes in security price is greater for Stock A, and hence, the option writer will require a greater premium.10/26/201215Professor James Kuhle
16. D. Option Premiums (continued)b. Length of Option Life:3, 6, 9 monthsLonger term options on the same security are riskier since the probability of adverse price changes increases with time. Higher premiums compensate the seller for this greater risk.10/26/201216Professor James Kuhle
17. D. Option Premiums (continued)c. Variability of ReturnsThe greater the past variability of return on the security the more likely that the option will be exercised. Greater return variability translates into greater option risk, for which, the writer wants to be compensated for.10/26/201217Professor James Kuhle
18. D. Option Premiums (continued)d. Exercise Price1. In-the-Money: Call exercise price is below the current market price.2. At-the-Money: Call exercise price is equal to the current market price.3. Out-the-Money: Call exercise price is above the current market price.Relation between Call Premium and Exercise Price:10/26/201218Professor James Kuhle
19. 10/26/2012Professor James Kuhle19LEAPSLong-term Equity AnticiPation Securities, referred to as “LEAPS,” are either calls or puts with expiration dates up to 2-1/2 years in the future. Like standard equity options, each LEAPS contract represents 100 shares of the underlying security. LEAPS offer both option and stock investors an excellent profit vehicle by allowing a big-picture trend on a stock to play out, with much less capital required compared to buying the underlying stock outright. Yet LEAPS are less risky than their short-term options counterparts. For those who prefer a one-to-two-year time horizon for their investments, LEAPS offer an excellent alternative using options.
20. E. Option Trading Strategies1. Buying Call Optionsa. Buying to achieve leverageThe price of a call of 100 shares is significantly lower than buying the shares outright.Example: Stock XYZ sells at $50/share and a $50 call costs $5/share. The Investor can buy the call for $500 instead of the 100 shares for $5,000. If XYZ goes to $60, the value of the option is $1000.Return on option: $500/$500 = 100%Return on stock purchase: $1000/$5000 = 20%10/26/201220Professor James Kuhle
21. E. Option Trading Strategies (continued)b. Buying call options to limit riskInvestor dislikes the risk of buying XYZ and watching it go down in value. Therefore, Investor purchases XYZ 50 call at $5 and puts remaining $ in risk-free securities. Hence, given the same $5,000, the Investor buys call and puts $4,500 into Rf securities.Example: If XYZ goes to $60, the Investor can buy or exercise the option to net $500 plus interest from Rf investment. If XYZ stays at $50 or falls below, the investor has lost his option premium which is partly offset by interest income.10/26/201221Professor James Kuhle
22. E. Option Trading Strategies (continued)c. Buying call option to hedge short stock positionInvestor believes XYZ will decline. Investor sells XYZ short to obtain total profit potential but he is exposed to unlimited loss from stock price increase. The Investor buys a call to eliminate loss.10/26/201222Professor James Kuhle
23. E. Option Trading Strategies (continued)2. Put Option Strategiesa. Buying Put options for leverage and limited riskInvestor anticipates significant decrease in the stock price but does not have the margin money for a short sale, and does not want to be exposed to unlimited risk of stock price increases. Investor buys a put.NOTE: Stock price must decline enough to break even.10/26/201223Professor James Kuhle
24. E. Option Trading Strategies (continued)b. Buying Put options to hedge against a stock price declineInvestor holds IBM and has already taken a paper profit. Investor believes IBM will go higher and would like to participate in upside without risking a loss on paper profit. So he buys a put. If price goes up, the potential is only diminished by the cost of the put, whereas the paper profits are protected by the put and decreased only by the put price.10/26/201224Professor James Kuhle
25. Buying Put Options10/26/201225Market PriceNet ProfitGainLoss0OptionProfitLongPositionProfessor James Kuhle
26. E. Option Trading Strategies (continued)3. Option Writing StrategiesDefinition: An investor holds 100 shares of IBM. Writes 2 calls and receives the option call premiums. One option is covered and the other is naked.10/26/201226Professor James Kuhle
27. E. Option Trading Strategies 4. Writing Call Options Strategiesa. Writing covered callsInvestor owns 100 shares of IBM ($50) and writes a call at $55 to earn a greater return than the stock alone. Investor earns D = $1.00 plus $5.00 on the call. Return is $6.00 plus any capital gains.Disadvantage: if price goes above $55, the upside is limited to $6.00.Note: Covered call also provides limited protection to writer against price decline. Price can decline to $45 ($50-Premium) before writer experiences paper loss.10/26/201227Professor James Kuhle
28. E. Option Trading Strategiesb. Writing naked callsInvestor writes a call on IBM and receives a premium income without owning the security.10/26/201228Professor James Kuhle
29. Writing Naked CallsGain is limited to the value of the premium. Loss is unlimited because the investor must go to the market to buy at a higher price to deliver $50/share stock at the exercise price.10/26/201229GainLoss0Limited GainUnlimited LossMarket Price$50Professor James Kuhle
30. E. Option Trading Strategies (continued)5. Writing Put Option Strategiesa. Writing Puts for Premium IncomeInvestor expects the price of the stock he holds to increase. Therefore, he can write a covered put to increase income. The only risk is that the stock falls below current market price.10/26/201230Professor James Kuhle
31. Profit Profile10/26/201231Market PriceProfitGainLoss0Option ProfitLong PositionNet Profit/LossProfessor James KuhleProfit Profile
32. E. Option Trading Strategies (continued)6. Buying or Writing an Option StraddleAn Option Straddle is the purchase or the writing of both a put and a call on the same security.a. Buying a Straddle: Price of underlying security is expected to move SHARPLY up or down before option expiration date. Buy a put and a call. Say you pay for a put and a call premium of $3.00 each. If the stock moves from $50 to above $56 or below $44, a profit is made.10/26/201232Professor James Kuhle
33. Profit Profileb. Writing a Straddle: Price of the underlying security is expected to stay at its current market value until the option expires. Write a put and write a call at $3.00 each and receive a total premium of $6.00.As long as the stock price remains between $44 and $56, the option straddle writer makes a profit.10/26/201233Professor James Kuhle
34. F. Other Option Strategies1. Bull SpreadBuying a call and selling a call with a higher strike priceExamples:1. Buy call with $90 SPPremium = $52. Sell a call with $95 SPPremium = $210/26/201234Professor James Kuhle
35. Profit ProfileQuestion: If stock price goes to $97, what is the net profit to the investor?Assignment: Determine profits from a range of $85 to $110 & profit profile.10/26/201235859095100105110P = $90Professor James Kuhle
36. F. Other Option Strategies (continued)2. Bear SpreadBuy a put option and sell a put with a lower strike priceExamples:1. Buy a put with $110 SPPremium = $52. Sell put with $105 SPPremium = $210/26/201236Professor James Kuhle
37. Profit ProfileAssignment: Determine net profits from a range of prices of $85-$115.Also generate a graph or “profile”.10/26/201237859095100105110P = $110115Professor James Kuhle
38. F. Other Option Strategies (continued)3. BUTTERFLY SPREADThe butterfly spread is a neutral position that is a combination of both a bull and bear spread.Example: P = $60 July 50 call: $12July 60 call: 6July 70 call: 3Butterfly spread: Buy 1 July 50 call: ($1200)Sell 2 July 60 calls: 1200Buy 1 July 70 call: (300) (300)10/26/201238Professor James Kuhle
39. Profit Profile (Bicycle)Assignment: Determine net profits from a range of $40-$80. Profit profile.10/26/2012395053606770Professor James Kuhle
40. F. Other Option Strategies (continued)4. Calendar or Time SpreadInvolves the sale of one option and the simultaneous purchase of a more distant option, both with the same strike price.10/26/201240Professor James Kuhle
41. Calendar or Time SpreadExampleJAN. APR50’s JUL50’s OCT50’sXYZ: $5 $8 $10 $50Neutral Spread: investor should have the initial intent of closing the spread by the time the near-term option expires.10/26/201241Professor James Kuhle
42. Calendar or Time Spread (continued)Assume the following: Call Options APRIL 50 JULY 50 OCT 50JAN(3 mo.) (6 mo.) (9 mo.) 50 5 8 10 APR 50 0 5 810/26/201242Professor James Kuhle
43. Calendar or Time Spread (continued)In January the investor sells the APR 50 call and buys the July 50. His debit position is-3 points.In April the price is unchanged and the 3 month call (July) should be worth 5. The spread between the April 50 and the July 50 has now widened to 5. Since the spread cost 3, a 2 pt. profit exists. Investor should now close his long position by selling his July 50 call and reaping a 2 pt. profit.10/26/201243Professor James Kuhle
44. Bullish Calendar SpreadInvestor sells the near-term call and buys a longer-term call when the underlying stock is some distance below the SP of the calls.Feature of low dollar investment and large potential profit. Example: XYZ: $45 in Jan. Sell April 50 for $1 Buy July 50 for $1 1/210/26/201244Professor James Kuhle
45. Bullish Calendar Spread (continued)Investor wants 2 things to happen:1. Near-term call expires worthless2. Stock price must rise by the time July call expiresAssume price goes to 52 b/w April & July. Investor nets 1 1/2 pts. How?10/26/201245Professor James Kuhle
46. 10/26/201246Key TermsDefinition of a Put and a Call Option. Option Writer and an Option Buyer.Investor Profit Profile and how to use.Covered call and naked call.Derivative security: what it means.In-the-money and out-of-the-moneyOption writing and option premium.Bull and a Bear spread.Calendar spread.Butterfly or Bicycle spread.
47. 10/26/201247ProblemsYou purchase 25 call contracts on Blue Ox stock. The strike price is $22, and the premium is $1. If the stock is selling for $24 per share at expiration, what are your call options worth? What is your net profit? What if the stock were selling for $23? $22?Stock in Bunyan Brewery is currently priced at $20 per share. A call option with a $20 strike and 60 days to maturity is quoted at $2. Compare the percentage gains and losses from a $2,000 investment in the stock versus the option is 60 days for stock prices of $26, $20, and $18. A put option on XYZ stock has a strike price of $40 and is priced at $2 per share, while a call with a strike price of $40 is priced at $3.50. What is the maximum per share loss to the writer of the uncovered put and the maximum per-share gain to the writer of the uncovered call?
48. 10/26/201248ProblemsBill holds 600 shares of P&G. He bought the stock several years ago at $48.50, and the shares are now trading at 75. Bill is concerned that the market will fall over the next 60 days. He doesn’t want to sell the stock, but he would like to be able to protect the profit he’s made. He decides to hedge his position by buying 6 puts on P&G. The 2 month puts carry a strike price of 75 and are currently trading at $2.50. a. What is Bill’s total capital gain if the price of P&G drops to $60/share by the expiration date on the puts and he liquidates his holdings in P&G? If he wants to continue holding 600 shares what would he do? b. How would he do if the stock kept going up in price and hit $90/share? c. Would Bill have been better off using puts with an $70 strike price, trading at $1.00? Madam Butterfly would like to own Coca Cola stock. She plans to purchase 100 shares at the current price of $65. She is unsure of which way the price will move so she plans to create a Butterfly spread with three different call options: Strike prices are $75, $65, $55. The premiums for these three options are $2, $4, and $8, respectively. Calculate the net profit for the following market prices: $74, $70, $66, $55, and $52.Angelo just purchased 500 shares of AT&T at $30/share and has decided to write covered calls against these stocks. Accordingly, he sells 5 AT&T calls at their current market price of $5.25. The calls have 3 months to expiration and carry a strike price of $35/share. The stock pays a quarterly dividend of $.60 which will be paid during the 3 month call period. a. Determine the total dollar profits that will be made during the holding period if the price of the stock moves to $32 just before expiration, assuming he keeps the 500 shares? b. How high can the price of the stock go before Angelo’s return falls to zero (include dividend)? c. What is Angelo’s HPR as a percentage of his initial investment at $32, assuming he keeps his 500 shares?
49. 10/26/2012Professor James Kuhle49