Options on Stocks

1. Options on Stocks Buying Options offers Profit Potential with Limited Risk A good way to economically place your bet or a good way to lose your shirt? aaii.albuquerque@gmail.com Ted Heath & George Proctor, AAII-NM, Pres. 6/25/13

2. Disclaimer We are not investment professionals. We are investors and these presentations are a forum for the exchange of ideas. The information in these slides is drawn from freely available internet sources and may not be completely attributed. This is due to the nature of the internet and not with any intent to claim any credit not our due. Thank You for Your Interest

3. Upcoming - 2nd TuesdaysAt Copper Canyon Cafe • 2nd Tuesday July 9 Dave Menicucci on Bullish Vertical Spreads in Detail • 2nd Tuesday Aug 13 – • Ted Heath on Bearish Vertical Spreads (& calendar spreads) Contact aaii.albuquerque@gmail.com for details

4. Options Are Simple, Right?

5. What Basics We’ll Cover • What are options on stocks & ETFs? • What does ‘long’ and ‘short’ mean? • What is a Call? A Put? • Definitions of elements of options. • A simple, useful Profit/Loss graph • Then we’ll get into the weeds!

6. What is an Option? • A Contract between a Buyer and Seller that gives the buyer the right, but not the obligation to buy or sell a specific stock at a specific price (Strike Price) on or before a specific date (Expiration Date) in exchange for a market premium (Option Price).

7. What is an Option? (cont) • An Option Contract is normally for 100 shares of a stock, although there are now Mini’s that are for 10 shares. • The Option Price is always listed in per share terms. • Ie. your cost for a contract will be 100 times the listed price for a normal option or 10 times the listed price for a mini.

8. Long = Buy/Own Short = Sell/Owe

9. Types of Options • Call Option = The right to buy a stock • The buyer has the right but not the obligation to buy a stock • The seller has the obligation to sell the stock at the “Strike Price” • Put Option = The right to sell a stock • The buyer has the right but not the obligation to sell a stock • The seller has the obligation to buy the stock at the “Strike Price”

10. Option Buyer • Becomes Option Holder/Owner • Long the Option • Buying Options • The Owner of an option has the right but not the obligation to exercise the contract. It is a choice. An Owner is not legally bound to execute the contract. • Buying Option – Risk is limited to cost of the option

11. Option Seller • Is the Option Writer • Short the Option • Selling Options • The Seller of an option is in a legally binding contract and has an obligation to fulfill the buyer’s execution if the contract is In The Money. • Selling Options Carries Unlimited Risk

12. How are options priced Options prices (costs) are calculated using four elements: • Strike Price • Expiration date • Stock Price • Volatility

13. Definitions • Strike price: This is stock price where the action happens. There are many strike prices for each stock for each month. • Expiration: The day that a particular option is over. Generally the third Friday of each month*. (note: there are weekly options on a few stocks and ETFs) • Volatility: Based on how much the stock price moves over time.

14. Option Strike vs Stock Price • At the Money (ATM): Option Strike = Stock Price • In the Money (ITM): 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. • Out of the Money (OTM): For a call option, when the option's strike price is above the market price of the underlying asset. For a put option, when the strike price is below the market price.

15. Puts & Calls in everyday life Your auto and home insurance are put options The coupons in the Sunday paper are call options

16. The Profit/Loss Chart Your Profit Down < The Stock’s Price > Up Your Loss

17. Buy a Stock (Long Stock)

19. Buy a Call Option(Long Call) • If you are bullish (you believe the stock price will increase), you could buy a Call option. • If you buy a Call option and the stock goes down, your risk is the money paid for the option. • If the stock goes up your reward is unlimited.

20. Buy a Call Option (Long Call)

21. Note the Delta - 0.27 There is a 27% chance this option will expire At the Money

22. Think of Delta as the probability of success • A Delta of 0.27 suggests you have about 1 chance in 4 (~25%) of the stock price even reaching the Strike Price, not to say Breaking Even • Why? The 30 days until this option expires, possibly worthless.

23. Compare Long Stock vs Long Call • The costs (premiums) don’t seem so large. • The problem is time.

24. Buy a Put Option(Long Put) • If you are bearish (you believe the stock price will decrease), you could buy a Put option. • If you buy a Put option and the stock goes up, your risk is the money paid for the option. • If the stock goes down, your reward is unlimited.

25. Short (Sell) Stock(Selling a Stock you do not own) ---- + PROF IT Price - The lower the stock price goes, the more you gain. The higher the stock price goes the more you lose.

26. Buy a Put Option (Long Put)

27. Buy a Put Option (Long Put)

28. Notice the Delta. Only 20% chance of ‘winning’

29. Again, Note Delta & Time to Expiration • Here the Delta of -0.21 suggests you have about 1 chance in 5 (~20%) of making any money with this option. • Why? Again, the 30 days until this option expires, possibly worthless.

30. Compare Long Put vs Long Call

31. Covered Call (Buy-Write) • The Covered Call, also known as a Covered Buy Write or Covered Call Write, is the first options trading strategy that most beginners learn about and is also the options trading strategy most widely taught. • It is an options trading strategy which seeks to make income by selling call options against stocks you already own.

32. Covered Call (Buy-Write)

33. Covered Call Results • If you sell a covered call and the stock price goes down, what happens? • Simple. You still own the stock but at a lower price! • You do get to keep the premium so you lose a little less. • But you can’t sell the stock until you buy back the option. (i.e. no ‘stop loss’ orders)

34. Selling a Put

35. Cash Covered Put • Selling a put option when you do not own that put option in the first place. • When the stock rises, the put options that you sold expire out of the money, giving the whole price of the put options as profit. • It is an options trading strategy that seeks to make income by selling a put on a stock that is going up.

36. Short Put (Cash Covered Put)

37. Covered Call vs Cash Covered Put Why is a Covered Call (Buy/Write) considered Safe While a Short Put (Cash Covered Put) is scary/risky? Hint. Covered Call is VERY safe… For the broker.

38. Options are a zero sum game Well, a zero sum game, minus commissions.

39. Possible combinations

40. So what is the point? • In my opinion, Long Call, Long Puts, and Covered Calls are safe for the brokerage company. • But they can be quite dangerous to your portfolio’s long term health. • They can be the death of a thousand cuts.

41. So Why Even Consider Options? As the upcoming speakers will show, There is good money to be made with Option Spread Strategies But you need some basics first Stay Tuned

42. What’s Next? • 2nd Tuesday July 9 (Copper Canyon Cafe) Dave Menicucci on Bullish Vertical Spreads in Detail 2nd Tuesday Aug 13 – Ted heath on Bearish Vertical Spreads (&/or calendar spreads)