Option Characteristics and Strategies

A Primer on Call and Put Options OLLI ClassFall, 2011Call options A listed call option on an individual stock is a contract that allows the call buyer to buy from the call option seller (or writer)100 shares of a specified stock at a specified price (striking price)any time before the date of expirationby paying a premium to the option seller Put optionsA listed put option is a contract which allows the put buyer to:sell to the put option seller (writer)100 shares of a specified stock at a specified price (striking price)any time before the date of expirationby paying a premium to the option sellerEssential termsThe buyer of a put or call has a long position in the option and the right of exercise.The call seller has a short position and has the obligation to sell the stock if assigned. The put seller is short the put and must buy the stock if assigned.American or European StyleAll listed options can be traded prior to expiration, but:American options can be exercised anytime prior to expiration. All listed equity options and the OEX (S&P100) are American options.European options can be exercised only at expiration. Most index options are European style options.All else equal, an American option will have a higher premium than the identical European optionTypes of Options AvailableIndividual equity/stock optionsIndex OptionsBroad Based (S&P 500, DJIA, S&P 100)Sector indexesLEAPS (long term options up to 2 years)FLEX options (customized contracts)Interest Rate optionsForeign Currency optionsBasic Option StrategiesCreating a call payoff diagramExercise price = 70 70 days to expiration Interest rate = .06 Stock price = $70 Premium = $ 5.25

Stock and call payoff at expirationstock call payoff stock payoff 65 0-5.25 = -5.25 -70+ 65 = - 5.00 70 0-5.25 = -5.25 -70+ 70 = 0.00 75 5-5.25 = - .25 -70+ 75 = + 5.00 80 10-5.25 =+4.75-70+ 80 = +10.00 Risk Management Strategies:Long stock compared to buying calllong stockbuy call705.25LossProfitstock price atexpiration75.25Market outlook: bullishRisk Management Strategies:Short the call: (i.e. sell the call)ProfitLosssell callstock price at expiration5.25 70Market outlook: bearishRisk Management Strategies:Covered Call: long stock - sell callProfitLosslong stocksell callstock price at expiration5.25 70long stock - short call64.75Market outlook: long term bullish but short term neutralRisk Management Strategies:Buy Put compared to shorting stockshort stock4.625LossProfitstock price atexpirationbuy put7065.375Market outlook: bearishRisk Management Strategies:Short put: (sell the put)4.625LossProfitstock price atexpirationsell put7065.375Market outlook: bullishRisk Management Strategies:Protective put: long stock + buy put

ProfitLosslong stockbuy putstock price atexpirationlong stock+ buy put4.62570Market outlook: nervously bullishThe Costless Collar: long stock + put - callBuy stock @ $70buy 65 put @ -2.625 sell 75 call @ +3.25. net cost of $69.375 ProfitLossstock price at expiration 70655.6254.37575Market outlook: neutral but nervously bearish+put-call+stock2.653.25Trading Volatility: The StraddleLong straddle: buy the call and put with same characteristics. Exercise price is $70: profit/loss profit/lossStock call@$5.25 put@$4.625 portfolio 55 -5.25 10.375 5.125 60 -5.25 5.375 .125 65 -5.25 .375 -4.875 70 -5.25 - 4.625 -9.875 75 - .25 - 4.625 -4.875 80 +4.75 - 4.625 .125 85 +9.75 - 4.625 5.125 Risk Management Strategies:Long straddle: buy call + buy put

ProfitLossbuy putstock price atexpiration9.87570buy callMarket outlook: volatility will increaseRisk Management Strategies:Sell the straddle: short call + short put

ProfitLosssell putstock price atexpiration9.87570sell callMarket outlook: volatility will decreaseCreating a Synthetic ForwardSell the 70 put for $4.625 and buy the 70 call for $5.25 for a debit of $ .625.profitloss-put70+call-put + callStock priceAt expiration4.6255.25Strategies for Todays MarketIt Depends on Your Market ViewJust the fact, maam:The S&P 500 (SPY) is at 128.00 having varied between 135 and 125 since January 2011.

Volatility is relatively low, about 17 on the VIX

You own 1,000 shares of SPY stock.

SPY Option Premiums:June 17, 2011 SPY 500 @ 128Strike Aug Sep DecPriceCalls Puts Calls Puts Calls Puts120 9.45 1.90 10.50 2.95 11.75 4.95 125 5.68 3.12 6.75 4.40 8.20 6.60130 2.65 5.08 3.65 6.70 5.40 8.90135 .82 8.45 1.60 9.25 3.25 11.25 Aug: 63 days Sep: 105 days Dec: 182 days Case 1: You are neutral to bearish between now and OctoberYou could sell all your stock, but what if youre wrong. Lets consider some option strategies:

Conservative Strategies to Manage Downside RiskCovered call strategy: Sell Aug calls with strike of 130 (neutral to slightly bearish)

Protective put strategy: Buy Sep puts with strike of 125 (bearish, but dont want to be out of the market).

Collar strategy: Sell Aug 130 calls and buy Aug 120 puts (very bearish).Payoff Table Covered Call: long stock @ 128 +sell Aug 130 call @ 2.65Stock call@$2.65 Stock@128 portfolio 115(2.65 - 0.00)=+2.65-13.00 -10.35 120(2.65 - 0.00)=+2.65- 8.00 - 5.35 125(2.65 - 0.00)= +2.65 - 3.00 - .35 128 (2.65 - 0.00)= +2.65 0.00 + 2.65 130 (2.65 - 0.00) = +2.65+ 2.00 + 4.65 135 (2.65 - 5.00)= -2.35 + 7.00 + 4.65 140 (2.65 -10.00)= -7.35+12.00 + 4.65

Covered Call: long stock - sell callOwn Stock at 128; Sell 130 Aug Call $2.65ProfitLossstock price at expiration4.65 130long stock - short call125.35Market outlook: long term bullish but short term neutralMax Return = (4.65/128) = 3.6% for 63 days; max loss unlimited less $2.65 Payoff Table Protective Put: Long Stock @ 128 + Buy Sep 125 put @ 4.40Stock Put@4.40 Stock@128 portfolio 115(-4.40+10.00)=+5.60-13.00 -7.40 120(-4.40+ 5.00)=+ .60- 8.00 -7.40 125(-4.40 - 0.00)=-4.40 - 3.00 -7.40 128 (-4.40 - 0.00)=-4.40 0.00 -4.40 130(-4.40 - 0.00)=-4.40+ 2.00 -2.40 135 (-4.40 - 0.00)=-4.40 + 7.00 +2.60 140 (-4.40 - 0.00)=-4.40+12.00 +7.60Protective put: long stock + buy putProfitLossstock price atexpirationlong stock+ buy put7.40125Market outlook: nervously bullishMax loss price 120.60Max loss = 7.40/128 = 5.8% over 105 days; Max gain = unlimited134.40Payoff Table Collar: Long Stock @ 128Sell Sep 130 call @ 3.65; Buy Sep 120 put @ 2.95Stock call@3.65 put@2.95Stock@128 portfolio 115+ 3.65+ 2.05- 13.00- 7.30 120+ 3.65- 2.95- 8.00- 7.30 125+ 3.65- 2.95- 3.00- 2.30 128+ 3.65- 2.950.00+ 1.30 130+ 3.65- 2.95+ 2.00+ 2.70 135- 1.35- 2.95+ 7.00+ 2.70 140- 6.35- 2.95+12.00+ 2.70The Costless Collar: long stock + put - callProfitLossstock price at expiration 120$7.30130Market outlook: neutral but nervously bearish$2.30Max loss = 5.7%; Max gain = 1.8%; over 105 daysCase 2: You have cash and are neutral to bearish between now and December but willing to buy if market goes down another 5+%. Instead of a limit order below the market, sell a cash secured put

Payoff table Cash Secured Put:Sell Dec 120 put @4.95; Invest cash (T-bills) of $120-$4.95 = $115.05 Stock Cash of 115.051120 put@+4.95 portfolio2 115115.05- 0.05115.00 120115.05+ 4.95120.00 125115.05+ 4.95120.00 128115.05+ 4.95120.00 130115.05+ 4.95120.00 135115.05+ 4.95120.00 140115.05+ 4.95120.00

1Would include 182 days of interest, which today is close to 0%2This is a return of 4.95/115.05 = 4.3% for 182 days (8.6% annualized) if the market stays above 120.Case 3: The Bullish Case by year endYou think the market will be flat until early fall then will rally above 140 by December.Split Strike Synthetic:Buy the Dec 135 call for $3.25Sell the Dec 120 put for $4.95

Payoff table Split Strike Synthetic:Sell Dec 120 put @4.95; Buy Dec 135 call @3.25Stock 135 call@-3.25 120 put@+4.95 portfolio 115- 3.25- 0.05- 3.30 120- 3.25+ 4.95+ 1.70 125- 3.25+ 4.95+ 1.70 128- 3.25+ 4.95+ 1.70 130- 3.25+ 4.95+ 1.70 135- 3.25+ 4.95+ 1.70 140+ 1.75+ 4.95+ 6.70

Synthetic Forward: Long Call + Short Putprofitloss-put120Stock priceAt expiration1.70135You are out of the market between 120 and 135 with a return of $1.70 over 182 daysCase 4: You are neutral to bearish between now and December, but You are willing to buy stock if the market goes below 120 and sell what you have above 135

Sell a Strangle sell a put and call with same expirations but different strikes.Sell the Dec 135 Call for $3.25 and sell the Dec 120 put for $4.95, you own the stock at 128:Stock 135 call120 putstockportfolio 115+ 3.25- 0.05- 13.00- 9.00 120+ 3.25+ 4.95- 8.00.20 125+ 3.25+ 4.95- 3.00+ 5.20 128+ 3.25+ 4.950.00+ 8.20 130+ 3.25+ 4.95+ 2.00+ 10.20 135+ 3.25+ 4.95+ 7.00+ 15.20 140- 1.75+ 4.95+12.00+ 15.20

Sell a strangle and own the stock:Sell 120 put; sell 135 call; own the stockProfitLossstock price atexpiration15.20135Sell you stock at $141.20 if market goes above 135;Buy more stock at $11.80 if market goes below 120.120115.20