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Chapter 15. Options Markets-The applications. outline. Features of options Call vs., put, Long vs. short In the money, out of the money and at the money Profit and payoff at expiration (examples and calculations) for calls Call buyer Call seller Graph For Puts Put buyer Put seller

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Chapter 15

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Chapter 15

Chapter15

Options Markets-The applications


Outline

outline

  • Features of options

    • Call vs., put, Long vs. short

    • In the money, out of the money and at the money

  • Profit and payoff at expiration (examples and calculations)

    • for calls

      • Call buyer

      • Call seller

      • Graph

    • For Puts

      • Put buyer

      • Put seller

      • Graph


Outline1

Outline

  • Option strategy

    • The risk return trade off

    • Basic Strategies

      • Buy Call: the dangerous one

      • Sell Call (covered call): Cap your gain

      • Buy Put (protective put): Do you really need the protection?

      • Sell Put: Get paid for a limit order

    • Advanced Strategies

      • Straddle: bet the price would have huge move

      • Spread: betting on the price pattern

      • Collar: bracket your profit

    • Index options and options on index futures


I features and payoff of options

I. Features and payoff of options


Define option

Define option

  • Option is the right to buy or sell an asset at a specified exercise price on or before a specified expiration date.

  • Call Option:

  • Put Option:

  • Check:


American vs european options

American vs. European Options

American - the option can be exercised at any time before expiration or maturity

European - the option can only be exercised on the expiration or maturity date


Option terminology

Option Terminology

  • Buy - Long

  • Sell - Short

  • Call

  • Put

  • Key Elements

    • Exercise or Strike Price

    • Premium or Option Price

    • Maturity or Expiration


Market and exercise price relationships

Market and Exercise Price Relationships

In the Money - exercise of the option would be profitable (without considering the cost/premium of the option)

Call: market price>exercise price

Put: exercise price>market price

Out of the Money - exercise of the option would not be profitable

Call: market price>exercise price

Put: exercise price>market price

At the Money - exercise price and asset price are equal


Payoffs and profits on options at expiration calls

Payoffs and Profits on Options at Expiration - Calls

Notation

Stock Price = ST Exercise Price = X Premium=P

Payoff: value of option at expiration


Payoffs and profits on options at expiration calls1

Payoffs and Profits on Options at Expiration - Calls

Payoff to Call Writer

- (ST - X) if ST >X

0if ST < X

Profit to Call Writer

Payoff + Premium


Chapter 15

Profit Profiles for Calls

Profit

Call Holder

0

Call Writer

Stock Price at expiration


Payoffs and profits at expiration puts

Payoffs and Profits at Expiration - Puts

Payoffs to Put Holder

0if ST> X

(X - ST) if ST < X

Profit to Put Holder

Payoff - Premium


Payoffs and profits at expiration puts1

Payoffs and Profits at Expiration - Puts

Payoffs to Put Writer

0if ST > X

-(X - ST)if ST < X

Profits to Put Writer

Payoff + Premium


Chapter 15

Profit Profiles for Puts

Profits

Put Writer

0

Put Holder

Stock Price at expiration


Ii option strategy

II. option strategy


Equity and options risk and return

Equity and Options-risk and return

InvestmentStrategyInvestment

Equity onlyBuy stock @ 80100 shares$8,000

Options onlyBuy calls @ 10800 options$8,000

Option exercise price: $80, expire in one year


Equity and options

Equity and Options

Apple Price

$75$80$100

All Stock$7,500$8,000$10,000

All Options$0$0$16,000


Equity and options1

Equity and Options

Apple Price

$75 $80$100

All Stock-6.25% 0% 25%

All Options-100% -100%100%


Option strategies long call

Option Strategies-Long Call

  • Long call: bullish

    • Leap Call

    • Calls that will expire soon

    • Out of the money call: a gamble

    • Deep in the money call: a replacement of stock investing

  • The downside

    • 90% of the time, you lose 100% of your investment (out of the money call)

    • You lose money even you are right about the stock

    • You often pay short term capital gain


Option strategies long put

Option Strategies-Long Put

Protective Put (you stock hold is protected by put option)

Goal: Buy insurance for your stock, protect it from falling price.

Tax reason: ST tax v. LT tax

Execution:

buy Stock and buy Put

Critics:

why pay for unnecessary insurance

You need to continue to roll over


Option strategies

Option Strategies

Covered Call (potential obligation to deliver the stock is covered by the stock held, compared with naked option writing)

Execution:

Long Stock, Short Call

Critics: Why cap the gain when sky is the limit


Option strategies short put

Option Strategies-Short Put

  • The Process: Sell a put secured by cash

  • The payoff:

    • Keep Premium when price above Ex.

    • Exercised when price below Ex.

  • The idea: a limit order with upfront pay

  • The view: bullish, flat


Option strategies short put1

Option Strategies-Short Put

  • Buy stock vs. Sell put: a risk return trade off

  • Short In-the-Money vs. Out-of-the-Money


Advanced option strategies

Advanced Option Strategies

  • Straddles

  • Spreads

  • Collar


Option strategies1

Option Strategies

Straddle (Same Exercise Price)

  • Bet price will move a lot

    • Long Call

    • Long Put

  • Short straddle

    • Short SPX (S&P 500 index) Puts and Calls, 2 year leap, both out of the money


Option strategies2

Option Strategies

  • Spread: A combination of two or more call options (or put options) on the same stock with differing exercise prices or time to maturity

    • Money spread: buy one and sell another with same maturity, but different exercising price (betting on price range)

      • Bullish call spread

        • Buy AAPL call ex $400 @$35, with maturity Jan 2015

        • Sell AAPL call ex $500 @$15, with maturity Jan 2015

        • Cost: 35-15=$20

        • Bet: stock go up above $400, but not high enough to touch $500

        • Idea: Use premium from selling calls (with higher ex price) to lower the cost of buying call (with lower ex price)

      • Bearish Call spread

        • Sell NFLX call ex$330 @$25. with maturity Jan 2013 (bet NFLX won’t go above $330)

        • Buy NFLX call ex$370 @$17 (protect unlimited loss)


Spread continued

Spread (continued)

  • Money spread (continued)

    • Bullish Put

      • Sell AAPL put , ex $300 (bet price won’t go below $300)

      • Buy AAPL put, ex $250 (protect it stock drops below $250)

      • Idea: bet stock price won’t fall below $300, but cap the loss if stock does fall below $250.

    • Bearish Put spread:

      • Buy E-Mini S&P put, ex 1300 @$40

      • Sell E-mini S&P put, ex 1200 @$15

      • Bet index might fall below 1300, but above 1200

  • Time spread (price timing)

    • Short AAPL call ex $900 Jan 2014, buy call ex$900 Jan 2015

    • Bet price will be much higher than $900 by Jan 2015, but not by Jan 2014.


Option strategies3

Option Strategies

  • Collar

    • Goal: Brackets the value of your portfolio between two bounds. (so you can keep the profit without selling the stock, for tax reasons)

    • Execution: buy a protective put (to protect the very possible downside) and sell a covered call (to offset the cost of put)

    • Example:

      • You hold 100 shares of Dell, current price $14

      • Buy a put : Expiration-Jan 2014, Ex-$13, premium$0.46

      • Sell a call: Expiration-Jan 2014, Ex-$15, premium$0.36

      • Cost: 0.46-0.36=$0.1


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