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What is an Option?

An option provides the holder with the right, but not the obligation, to buy or sell a specified quantity of an underlying asset at a fixed price (called a strike price or an exercise price) at or before the expiration date of the option.

Options Terminologies

Option to buy is a call option

± Buyer has the long position in the contract

** Option to sell is a put option
**

± Seller (writer) has the short position in the contract

Buyer and seller are counterparties in the transaction Option premium ± amount paid for the option Exercise price or strike price ± The price at which an

underlying stock can be purchased or sold if the option is exercised Expiration date - the date the option expires

**Options Contract The contract specifies:
**

± ± ± ± ± Whether it is a put or call option Underlying security Strike price or exercise price Expiration date Option Premium

An option is a binding contract with strictly defined terms and properties.

The Options Market

Options can be:

± exercised ± traded in open market ± allowed to expire worthless

**Market-exercise price relationship:
**

In the money ± allows the option owner at that instant to enrich himself with sure profits At the money ± has the exercise price equal to the spot/market price Out of the money ± will result in losses to the holder if the option is exercised

³Moneyness´ of options In the money At the money Out of the money

Call Option Holder SP > EP SP = EP SP < EP

Put Option Holder SP < EP SP = EP SP > EP

Why Trade Options?

Options trade both on exchanges (where contracts are standardized) and over-the-counter (where the contract specification can be customized). Traders use options to speculate, which is a relatively risky practice, while hedgers use options to reduce the risk of holding an asset.

Types of Options:

According to rights:

± Call options (right to buy): the holder/owner has the right to purchase the underlying good/asset at a specified price and this right lasts until a specified date ± Put options (right to sell): the holder has the right to sell the underlying good/asset at a specified price at a specified date

Types of Options:

For example: you discover a house that you want to purchase. Unfortunately, you don't have the cash to buy it. You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of $200,000. The owner agrees, but for this option, you pay a price of $3,000.

Types of Options:

Consider two theoretical situations: ± 1. It's discovered that the house is actually the birthplace of Elvis! As a result, the market value of the house skyrockets to $1 million. Because the owner sold you the option, he is obligated to sell you the house for $200,000. In the end, you stand to make a profit of $797,000 ($1 million - $200,000 $3,000). ± 2. While touring the house, you discover that the walls are chock-full of asbestos with a family of rats in the basement. You now consider it worthless. On the upside, because you bought an option, you are under no obligation to go through with the sale. Of course, you still lose the $3,000 price of the option.

Types of Options:

According to expiration:

± European: can be exercised only at expiration ± American: exercised any time on or before expiration

**Value of options on stocks at expiration
**

(SP ± Stock Price; EP ± Exercise Price): Pay ± off to Call Holder Pay ± off to Put Holder Pay ± off to Call Writer Pay ± off to Put Writer SP - EP 0 0 EP - SP 0 0 If SP > EP EP EP If SP < EP EP EP

- (SP - EP) If SP > EP

- (EP - SP) If SP < EP

Determinants of Option Value: Effect of Increases

** Current Stock Price - For a given exercise price, the higher
**

the stock price, the greater the intrinsic value of the option (the higher the probability that the call will be in the money).

** Exercise Price - The higher the exercise price (or strike
**

price), the lower the probability that the call will be in the money (the lower the price at which you can buy, the more value).

** Volatility - Both the call and put will increase in price as the
**

underlying asset becomes more volatile.

Determinants of Option Value: Effect of Increases

Interest Rates - The higher the interest rate, the lower the present value of the exercise price. As a result, the value of the call will increase Time to Expiration - The longer the time to expiration, the more likely the option will be valuable. Generally, both calls and puts will benefit from increased time to expiration. Cash Dividends - On ex-dividend dates, the stock price will fall by the amount of the dividend. So the higher the dividends, the lower the value of a call relative to the stock.

Determinants of Option Value: Effect of Increases

Summary of Effects

Call Option Current Stock Price Exercise Price Volatility Interest Rates Dividends Time to Expiration Increase Decrease Increase Increase Decrease Increase Put Option Decrease Increase Increase Decrease Increase Increase

Fundamentals of Option Valuation/Prices:

** Pricing models include the
**

± Binomial options model for American options and ± Black-Scholes model for European options.

**Fundamentals of Option Valuation/Prices: Black-Scholes model options pricing model
**

Value is a function of five variables:

± ± ± ± ± Current stock price (S) Exercise price (E) Market interest rate (r) Time to expiration (t) Standard deviation of annual returns ()

where:

± C = market value of call option ± N(d1) = cumulative density function of d1 ± N(d2) = cumulative density function of d2

C = S N( d 1 ) - E e (-R E

ln [ d 1=

)(T)

N( d 2 ) equation (3

S 1 ] + T [RF + W 2 ] E 2 a nd d 2 = d 1 - W T W T

**Fundamentals of Option Valuation/Prices: Binomial options pricing model
**

Useful for valuing derivatives such as American options Simpler compared to Black-Scholes, and is therefore relatively easy to build and implement with a computer spreadsheet

One Period Binomial Model:

rd p! ud

Cj !

p
C ju 1 p
C jd

r

**Multi-Period Binomial Model:
**

®N ¾ N! N j 1 C o ! ¯§ p j p
max 0, u j d N j S X ¿ z r n ! j °! 0 N j
j! À

?

A

SOME OPTION STRATEGIES

**Factors to Consider in Option Strategy Development
**

Size of Position Option Price Break even point Net investment required Investment Return Return if exercised Expected Return

**Some Option Strategies
**

Buying a call Buying a Put Writing a Naked Call Writing a Covered Call Writing Against a Convertible Security Writing a Ratio Covered Call Writing a Naked Put Writing a Covered Put

Bull Spreads Bear Spreads Butterfly Spreads Calendar Spreads Ratio Spreads Ratio Calendar Spreads Straddles and Strangles Synthetic Calls and Puts Synthetic Longs and Shorts

Selecting an Appropriate Strategy

1. Identify ideas on the major factors that affect option prices (the greeks) 2. Systematically rank various option strategies

Strategy Selection

Strategy Time Decay Time Decay Time Decay Helps Mixed Hurts x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x Implied Volatility Increasing x x Implied volatility decreasing

Buy C ll Bull Spr S ll ut BULLISH Buy I stument/ Buy ut Buy C ll/ Sell ut C vered C ll Write Buy ut Bear Spread Sell Call BEARISH Sell instrument / Buy Call Buy ut / Sell Call C vered ut Write Sell Straddle Sell Strangle STABLE Rati Write PRICES Sell Butterfly Rati Spread VOLATILE Buy Straddle PRICES Buy Butterfly

Buying a Call

A bullish strategy that requires a price rise in the underlying instrument

RISK / REWARD : Unlimited returns, limited risk The maximum return from the option is unlimited while the maximum risk is the premium paid for the option. BREAK EVEN POINT : Strike Price + Call Premium If the stock price is below the strike price, the call holder simply does not exercise the option. NET INVESTMENT REQUIRED : Payment of premium PREFFERED EXPIRATION DATE: Expected peak of the underlying instrument¶s price.

Buying a Call

r fit fr m Strateg

2000

Exampl : B a all pti 100 har f XYZ pti ri : $5 f r rit

1500 1000 500 0 -500

Exer i e ri e: $30

10

20

30 St

40

50

k ri e at Expirati

**Profits to Call Option Seller
**

From the seller¶s perspective, the call option guarantees him a certain of return, but at the same time exposes him to opportunity losses.

000 1500 1000 500 0 -500 St 10 0 30 0 50 ri e at Expirati

Buying a Put

A bearish strategy that requires a price drop in the underlying instrument

RISK / REWARD : Limited returns, limited risk The maximum profit potential is limited by the fact that the price of the underlying instrument cannot go below zero. The maximum risk is the premium paid for the option. BREAK EVEN POINT : Strike Price - Put Premium If the stock price is higher than the strike price, the put holder simply does not exercise the option. NET INVESTMENT REQUIRED : Payment of premium PREFFERED EXPIRATION DATE: underlying instrument¶s price. Expected lowest point of the

Buying a Put

r fit fr m Strategy

000

Example: B a put pti f r 100 hares f securit XYZ pti rice: $5

1500 1000 500 0 -500

Exercise rice: $30

10

0

30

0

50

St ck rice at Expirati

**Profits to Put Option Seller
**

From the seller¶s perspective, the put option represents a maximum return equivalent to the premium and a potential loss when the price of the underlying instrument drops.

000 1500 1000 500 0 -500 St ck rice at Expirati

10

0

30

0

50

**Naked Call Writing
**

A bearish strategy where a call is sold without owning the underlying instrument

RISK / REWARD : Limited returns, open risk The maximum profit potential is equivalent to the premium but .losses increase as the price of the underlying instrument increases. BREAK EVEN POINT : Strike Price + Call Premium If the stock price rises on or before expiration, buyers of the naked call will exercise, therefore requiring the writer to buy the stocks at the higher price. NET INVESTMENT REQUIRED : Margin required by the broker PREFFERED EXPIRATION DATE: to fall below the strike price When stock price is expected

**Profits to the Naked Call Writer
**

The best situation for a naked call writer is for the price of the underlying instrument to fall below the strike price at expiration, thus rendering the call worthless.

2000 1500 1000 500 0 -500 St ck rice at Expirati

10

20

30

40

50

**Covered Call Writing
**

Buy an underlying instrument and sell a call on that instrument.

RISK / REWARD : Limited returns, open risk Maximum profit potential is equal to the strike price of the option minus the underlying instrument¶s price, plus the call price (SPUI+CP). BREAK EVEN POINT : Underlying Instrument Price ± call premium If the stock price rises on or before expiration, buyers of the covered call will exercise, and the writer is obliged to sell the instruments at a lower price that what it would have commanded in the market. NET INVESTMENT REQUIRED : Purchase of share price ± call premium PREFFERED EXPIRATION DATE: When prices on the underlying instrument is below the strike price.

Covered Call Writing

r fit fr m Strategy

Example: urrent share price: 100 Strike rice: 110 all price:

8 4 0 -4 -8 -12 -16 -20

90

95

100

105

110

115

St ck rice at Expirati n

Straddles

Consists of a call and a put with the same exercise price and the same expiration Generally considered as a neutral strategy

Long Straddle

The buyer of the straddle buys both the option and the put.

Pr fit fr m Strategy

Example:

16

E ercise Price: $100 Call remium: $5 Put remium: $4

12 8 4 0 -4 -8 -12 -16 -20 90 95 100 105 110 115

Long Put Long Call

St ck Price at Expirati n

Long Straddle

16 12 8 4 0 -4 -8 -12 -16 -20

90 95 100 105 110 115 90 95 100 105 110 115

**RISK / REWARD : Unlimited returns, limited risk BREAK EVEN POINT :
**

Upside Breakeven: strike price + net debit Downside Breakeven: strike price ± net debit

NET INVESTMENT REQUIRED : Payment of premiums PREFFERED EXPIRATION DATE: when price of the underlying instrument reaches the highest possible level not lower than the strike price (extreme prices)

Short Straddle

The seller of the straddle sells both the option and the put.

RISK / REWARD : Limited returns, open risk

16

**BREAK EVEN POINT :
**

Upside Breakeven: strike price + net credit Downside Breakeven: strike price ± net credit

12 8 4 0 -4 -8 -12 -16 -20

90 95 100 105 110 115

NET INVESTMENT REQUIRED : Payment of premiums PREFFERED EXPIRATION DATE: when the price of the underlying instrument is at or near the strike price

Strangles

A straddle with different strike prices. The call has an exercise price above the stock price and the put has an exercise price below the stock price.

Long Strangle

The buyer of the strangle buys both the option and the put.

Pr fit fr m Strategy

Example: Call E ercise Price: $85 Put E ercise Price: $80 Call remium: $3 Put remium: $4

10 5 0 -5 60 65 70 75 80 85 90 95

**Long Put Long Call
**

St ck Price at Expirati n

Long Strangle

10 5 0 -5 60 65 70 75 80 85 90 95

RISK / REWARD : Unlimited returns, limited risk BREAK EVEN POINT :

Upside Breakeven: Highest strike price + net debit Downside Breakeven: Lowest Strike price ± net debit

10 5 0 -5 60 65 70 75 80 85 90 95

NET INVESTMENT REQUIRED : Payment of premiums PREFFERED EXPIRATION DATE: when price of the underlying instrument reaches the highest possible level not lower than the higher strike price (extreme prices)

Short Strangle

The seller of the strangle sells both the option and the put.

RISK / REWARD : Limited returns, open risk BREAK EVEN POINT :

Upside : Highest strike price + net credit Downside : Lowest strike price ± net credit

10 5 0 -5 60 65 70 75 80 85 90 95

NET INVESTMENT REQUIRED : Payment of premiums PREFFERED EXPIRATION DATE: when the price of the underlying instrument is between the two breakeven points

Butterfly Spreads

Usually considered neutral strategies that can be constructed with either puts or calls. However, butterflies can be constructed to have a bullish or bearish bias. Constructed using four (4) options to limit losses

Long Butterfly

The long butterfly is a neutral strategy in that it does not look for prices to move very far.

COMPOSITION: COMPOSITION: Buy one low-strike option Sell two medium-strike options Buy one high-strike options

4 2 0 -2

**EXAMPLE: Current Share Price: $100
**

Exercise Price $ 105.00 $ 100.00 $ 95.00 Opti n Premium $ 3.00 $ 4.00 $ 7.00

-4 -6 -8 80 85 90 95 100 105 110 115

Long 1 call Short calls Long 1 call

Long Butterfly

RISK / REWARD : Limited returns, limited risk BREAK EVEN POINT :

Upside : Highest strike price - net debit Downside : Lowest strike price +net debit

NET INVESTMENT REQUIRED : Payment of premiums PREFFERED EXPIRATION DATE: when the price of the underlying instrument is between the two breakeven points

Short Butterfly

The long butterfly is a neutral strategy in that it not looks for prices to move significantly in one direction.

RISK / REWARD : Limited returns, limited risk BREAK EVEN POINT :

Upside : Highest strike price - net credit Downside : Lowest strike price +net credit

NET INVESTMENT REQUIRED : Payment of premiums PREFFERED EXPIRATION DATE: when the price of the underlying instrument is lower than the lowest strike price or higher than the highest strike price

Condor Spreads

A specialized position that involves four (4) options on the same underlying good The Condor has 4 different exercise prices while the butterfly only has three unique exercise prices.

Long Condor Short Condor

Bull Spreads

Long a low-strike call and short a high strike call, or Long a low strike put and short a high strike put

RISK / REWARD : Limited returns, limited risk

8

BREAK EVEN POINT : Bull Put Spreads:

High strike price ± net credit received

4 0 -4

**Bull Call Spreads:
**

Low Strike Price + net debit If the market moves only moderately higher, the investors will end up with greater profit had they simply bought calls.

-8 -12 -16 80 85 90 95 100 105 110 115

**Example: Example: Share Price: $100
**

Exercise price 95 105 Option Premium 7 3

Low strike High trike

Bear Spreads

Long a high-strike call and short a low strike call, or Long a high strike put and short a low strike put

**RISK / REWARD : Limited returns, limited risk BREAK EVEN POINT : Bear Put Spreads:
**

High strike price ± net debit paid

8 4 0 -4 -8 -12 -16 80 85 90 95 100 105 110 115

**Bear Call Spreads:
**

Low Strike Price + net credit received

**Profit / Loss Characteristics
**

Strategy Buy Call Buy ut S ort Call S ort ut Covered Call Write Covered ut Write Bull Spread Bear Spread Long Butterfly S ort Butterfly Calendar Spreads Long Straddle S ort Straddle Profit pen pen Limited Limited Limited Limited Limited Limited Limited Limited Open Open Limited Loss Limited Limited Open Open Open Open Limited Limited Limited Limited Open Limited Open

RISK APPLICATION

Language Barrier: Moneyness

In-the-money Deep-in-the-money At-the-money

Call S> E

S=E

Put S<E

S=E

S>E

**Out-of-the-money Deep-out-of-the-money
**

Let S = Stock Price and E = Exercise Price

S<E

Option Portfolio Risk Management Strategies

Hedging - trading technique that¶s used to manage risk.

The Greeks

Are measurements of risk that explain several variables that influence option prices. They are delta, gamma and vega

Delta

(c Delta ! (S

or ! N(d1)

where c = option price S = underlying price ± The sensitivity of an option¶s price to the price of the underlying security

Delta

Delta values ranges from: Deep-outof-the-money 0.0 -1.0 Deep-inthe-money 1.0 0.0

Option Call Put

Hence, 0.5 is often given as an ³average delta´

**Here is how it works:
**

Call Option Deep-out-ofthe-money 0.0 0.5 Deep-inthe-money 1.0

at-the-money

**Delta Hedging Call
**

Call Delta (DC) = dC/dS where dC = Change in call option price dS = Change in underlying price

From Black-Scholes model, DC = N(d1) ==>(approximately) Ex.: If S=74.49, X=75, r=1.67%, s=38.4%, t=0.1589 yrs. Then, C = 4.40 and N(d1) = 0.5197

± If S increases by $1, C increases by $0.5197 ± Hedge Ratio = H = 1/DC = 1/0.5197 = 1.924 ± Sell 1.924 calls per share of stock held to hedge!

**Delta Hedging - Puts
**

Put Delta = DP= dP/dS From Black-Scholes model DP= DC ± 1 =N(d1) - 1

Ex.: If S=74.49, X=75, r=1.67%, s =38.4%,t=0.1589 yrs. Then, C = 4.40, P = 4.71, N(d1) = 0.5197, and N(d1) -1 = -0.4803 If S increases by $1, P decreases by $0.4803 Hedge Ratio = H = 1/D = 1/0.4803 = 2.082 Buy 2.082 puts per share of stock held to hedge!

In summary

To carry out delta hedging: Delta>0 = write(sell) call options Delta<0 = buy put options

**Problem with delta hedging
**

As stock price keeps changing, the delta will change. Thus, we need to rebalance the portfolio in order to maintain the delta neutral condition. The continual readjustment of the delta hedge ensures that the portfolio always has a zero delta. However, every time we readjust the delta hedge the portfolio in the process loses value.

Gamma

(delta Gamma ! (S

N (d1) or ! SW T

- Measures the sensitivity of delta to changes in the underlying security price ± If a delta-hedged position were risk free, gamma = 0 ± If Gamma is small (big), delta changes slowly (quickly).

**Vega & Volatility Risk
**

(option.price Vega ! (volatility

The sensitivity of the option price to the volatility Option price is very sensitive to the volatility of the underlying Volatility is the only unobservable variable required to value an option. Vega is positive for both calls and puts

**How sensitive is the option price to volatility
**

For example,

If S= $52.75 X= $50 r= 0.0488 T= 0.75

at a volatility of 0.35 at a volatility of 0.40

C=8.619 C=9.446

**Problem with Vega
**

1. Measuring the sensitivity of the option price to the volatility is difficult 2. Managing Vega risk requires jointly monitoring and managing the risks associated with delta and gamma.

Hedging in Practice

In an ideal world, a trader would like to rebalance his portfolio to get zero delta, zero gamma, zero vega In practice, It¶s difficult and expensive to find another suitable option to conduct the gamma and vega hedging. Traders usually rebalance the portfolio daily to get zero delta (mainly trading the underlying asset).

End of Presentation

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