Options
Price and trading
Agenda
• Useful terminology
• Option types
• Underlying assets
• Options trading
• Bull call/put, bear and butterfly spread
• Straddle, strip, strangle
Useful terminology
• holders – the buyers of the options, which are also the owners of those options
• writers – sellers of the options
• premium - money paid by the buyer to the writer at the beginning of the options
contract
• strike price- price at which a derivative can be exercised
• expiration date - in derivatives is the last day that an options or future contract is valid
• exercising - means to put into effect the right specified in a contract
What are the options?
Options
gives a buyer the right, but not
the obligation, to buy or sell a
specified quantity of an
underlying asset at a pre-agreed
exercise price
Option types
call option is where the buyer has the right to buy the asset at the
exercise price, if they choose to.
put option is where the buyer has the right to sell the underlying
asset at the exercise price.
Example
• Suppose shares in ABC company are trading at $3.24 and an investor buys a $3.50
call for three months. The investor, Jack, has the right to buy ABC shares from the
writer(seller) of the option (another investor –Bill) at $3.50 if he chooses, at any
stage over the next three months.
ABC
shares
if they rise to 6$
are below 3,5$
three months later,
Jack will abandon
the option
buy the share
persuade Bill to give
at $3.50 and
keep it, or sell
it at $6.00
him $6.00 – $3.50 =
$2.50 to settle the
transaction
Example
If Jack paid a premium of 42 cents to Bill, what is Jack’s maximum loss and what
level does A company have to reach for Jack to make a profit?
The most Jack can lose is 42 cents
naked
covered
ABC shares:
1) rise above $3.92, so then Jack makes a
profit
2) If the shares rose to $3.51 then Jack
would exercise his right to
Exercise styles – when, how and under what circumstances?
European - style
May only be
exercised at
the option’s
expiration date
American - style
Can be exercised at
any time up to the
option’s expiration
Bermudan – style
May only be
exercised on
specified dates
Whether and when to exercise an option?
American - style
options should not be
exercised before
expiration
options should only
be exercised if it
is in the money
Early exercise is a possibility
whenever the benefits of
being long, outweigh the
cost of surrendering the
option early
Short selling vs. purchasing a put option
Short sale transactions
Borrowing shares from a broker
Selling them on the market in
the hope that the share price
will decrease
Purchase of
a put option
Limits the
amount of
loss
Net payoffs
The profit (or loss) from the sale of an item after the costs of selling it
and any accounting losses have been subtracted.
Call option
Put option
net payoff = market price of underlying - (strike price+ premium)
net payoff = strike price - (market price of underlying + premium)
In,at,out of money options
AT THE MONEY
 an option's strike
price is identical to the
price of the underlying
security
 Both call and put
options will be
simultaneously "at the
money”
IN THE MONEY
OUT THE MONEY
 stock option is worth
money and you can turn
around and sell or
exercise it
 For a call option, when
the option's strike price
is below the
market price of
the underlying asset
 For a put option, when
the strike price is above
the market price of the
underlying asset.
 out of the money is a
call option with a strike
price that is higher than
the market price of the
underlying asset, or
 put option with a strike
price that is lower than
the market price of
the underlying asset
Underlying assets
The underlying of a derivative is an asset, basket of assets, index, or
even another derivative, such that the cash flows of the (former)
derivative depend on the value of this underlying.
interest rate
security price
commodity price
foreign exchange rate
index of prices or rates
other variable
Options trading
There are two main forms of trading options
Exchange-trading
Over-the-counter trading
Options trading
Exchange - traded options that are also called (''listed options'') as they
have standarized contracts and are settled through a clearing house with
fulfillment guaranteed by the Options Clearing Corporation (OCC)
Options are described in following scheme:
1. Root symbol of the underlying stock or ETF, padded with spaces to 6
characters
2. Expiration date, 6 digits in the format yymmdd
3. Option type, either P or C, for put or call
4. Strike price, as the price x 1000, front padded with 0s to 8 digits
Example of stock options
GOOG 141122P00019500
Stock ticker
symbol
Exp. Date
YY/MM/DD
Put
Or
Call
Strike price
x1000
This is put option for Google shares with expiration date
2014/11/20 with strike price $19.50
Over-the-counter options
These are traded between two private parties, and are not listed on
an exchange. The terms of an OTC option are unrestricted and may
be individually tailored to meet any business need. In general, the
option writer is a well-capitalized institution (in order to prevent the
credit risk).
Counterparty risk
Risk that a counterparty in a derivatives transaction will default
prior to expiration of the trade and will not make the current and
future payments required by the contract.
OTC counterparties must establish credit lines with each other, and
conform to each other's clearing and settlement procedures.
Put-Call Parity
States that the premium of a call option implies a certain fair price for
the corresponding put option having the same strike price and
expiration date, and vice versa.
Since American style options allow early exercise, put-call parity will
not hold for them.
If these two portfolios have same expiration value, then they must have the
same present value. If the put-call parity is not achieved, arbitrage trader can
go long on the undervalued portfolio and short on the overvalued portfolio to
make a riskfree profit on expiration day!
Some trading strategies explanation
Covered call
Protective put
Bullish strategies
Bearish strategies
Butterfly
Covered call
A covered call is an options strategy whereby an investor holds a long position in an
asset and writes (sells) call options on that same asset in an attempt to generate
increased income from the asset. This is often employed when an investor has a
short-term neutral view on the asset and for this reason hold the asset long and
simultaneously have a short position via the option to generate income from the
option premium.
Protective put
The put option acts like an
insurance policy - it costs
money, which reduces the
investor's potential gains from
owning the security, but it also
reduces his risk of losing
money if the security declines
in value
EXAMPLE
If an investor purchased a stock for $10 that is now worth
$20 but he has not sold it, he has unrealized gains of $10.
If he doesn't want to sell the stock yet (perhaps because
he thinks it will appreciate further) but he wants to make
sure he doesn't lose the $10 in unrealized gains, he can
purchase a put option for that same stock that will
protect him for as long as the option contract is in force.
If the stock continues to increase in price, say, going up
to $30, the investor can benefit from the increase.
If the stock declines from $20 to $15 or even to $1, the
investor is able to limit his losses because of the
protective put.
Example of bull call spread
Let's assume that a stock is trading at $18 and an investor has
purchased one call option with a strike price of $20 and sold one call
option with a strike price of $25.
If the price of the stock jumps up to $35, the investor must
provide 100 shares to the buyer of the short call at $25. This
is where the purchased call option allows the trader to buy
the shares at $20 and sell them for $25, rather than buying
the shares at the market price of $35 and selling them for a
loss.
Bull put spread
We have to purchase one put option while
simultaneously selling another put option
with a higher strike price
Goal of this strategy is realized when the
price of the underlying stays above the higher
strike price,
Short option to expire worthless, resulting in
the trader keeping the premium.
This type of strategy (buying one option and
selling another with a higher strike price) is
known as a credit spread because the
amount received by selling the put option
with a higher strike is more than enough to
cover the cost of purchasing the put with the
lower strike.
Bear call spread
A bear call spread is a limited
profit, limited risk options trading
strategy that can be used when
the options trader is moderately
bearish on the underlying security.
It is entered by buying call options
of a certain strike price and selling
the same number of call options
of lower strike price (in the
money) on the same underlying
security with the same expiration
month.
Bear call spread example
Let's assume that a stock is trading at $30. An option investor has
purchased one call option with a strike price of $35 for a premium of
$0.50 and sold one call option with a strike price of $30 for a premium
of $2.50.
If the price of the underlying asset closes below $30 upon expiration,
then the investor collects:
$200 (($2.50 - $0.50) * 100 shares/contract)
Butterfly spread
In finance, a butterfly is a limited risk,
non-directional options strategy that is
designed to have a large probability of
earning a limited profit when the
future volatility of the underlying asset
is expected to be lower than the
current volatility.
Long butterfly
The spread is created by
buying a call with a relatively
low strike (x1), buying a call
with a relatively high strike
(x3), and shorting two calls
with a strike in between (x2)
Examples of combined strategies
Straddle
Strip
Strap
Strangle
Straddle
A straddle is an options strategy with
which the investor holds a position in
both a call and put with the same strike
price and expiration date.
This allows the investor to make a
profit regardless of whether the price
of the security goes up or down,
assuming the stock price changes
dramatically.
Strip
The strip is a modified,
more bearish version of the
common straddle
It involves buying a number
of at-the-money calls and
twice the number of puts of
the same underlying stock,
striking price and expiration
date.
Strangle
The strategy involves
buying an out-of-themoney call and an out-ofthe-money put option. A
strangle is generally less
expensive than a straddle
as the contracts are
purchased out of the
money.
Strap
Same as strip but here we
find more probably to rise in
price
Thank you for attention 