Options Trading

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Options Trading

• Rishi Nalubola
• Shri Capital LLC
• Commodity Trading Advisor
• www.shricapital.com

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Options

• What is an option?
• An option is a contract giving the buyer the
  right, but not the obligation, to buy or sell an
  underlying asset (a stock, bond, index, etc.) at
  a specific price on or before a certain date
• An option is a security, just like a stock or a
  bond, and constitutes a binding contract with
  strictly defined terms and properties

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Options vs. Stocks

• Similarities
• Listed Options are securities, just like stocks.
• Options trade like stocks, with buyers making
  bids and sellers making offers.
• Options are actively traded in a listed market,
  just like stocks. They can be  bought and sold
  just like any other security.
• Differences
• Options are derivatives, unlike stocks (i.e,
  options derive their value from  something else,
  the underlying security).
• Options have expiration dates, while stocks do
  not.
• There is not a fixed number of options, as there
  are with stock shares available.
• Stockowners have a share of the company, with
  voting and dividend rights. Options convey no
  such rights.

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Call Options

• A Call Option is an option to buy a stock at a
  specific price on or before a certain date. In
  this way, Call options are like security
  deposits.
• If, for example, you wanted to rent a certain
  property, and left a security deposit for it, the
  money would be used to insure that you could, in
  fact, rent that property at the price agreed upon
  when you returned.
• When you buy a Call option, the price you pay for
  it, called the option premium, secures your right
  to buy that certain stock at a specified price,
  called the strike price.

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Put Options

• Put Options are options to sell a stock at a
  specific price on or before a certain date.
• Put options are like insurance policies If you
  buy a new car, and then buy auto insurance on the
  car, you pay a premium and are, hence, protected
  if the asset is damaged in an accident. If this
  happens, you can use your policy to regain the
  insured value of the car. In this way, the put
  option gains in value as the value of the
  underlying instrument decreases.
• If all goes well and the insurance is not needed,
  the insurance company keeps your premium in
  return for taking on the risk.

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Call example

• Date April 5th
• XYZ _at_ 29
• You think it will go past 30 by May 3rd Friday
• You decide to buy May 30 call _at_ 2.00
• You pay 200

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Call example (contd.)

• On 3rd Friday of May, assume stock _at_35
• You paid, 2.00, now you can sell it for 5.00
• Your profit 300
• XYZ at 32 is your breakeven price
• Max loss 200

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Put example

• XYZ _at_ 32
• You think it will go below 30
• You decide to buy Aug 30 put _at_ 1.00
• You pay 100

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Put example (contd.)

• 3rd Friday of Aug XYZ _at_ 25
• You paid, 1.00, now you can sell it for 5.00
• Your profit 400
• XYZ at 29 is your breakeven selling price
• Max loss 100

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Potential Benefits of options

• Increase Income
• Reduce Risk
• Reduce Cost
• Protect stockholdings
• Protect profits
• Target buy prices
• Target sell prices
• Customize market exposure

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LEAPS

• Long Term Equity Anticipation Securities
• Options up to 3 years and may be beyond
• Not available on all stocks but on widely held
  stocks
• Traded just like any other options

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Option price

• Intrinsic Value Time Value
• At-the-money no or very little intrinsic value
• In-the-money mostly intrinsic value
• Out-of-the-money mostly time value

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Option price components

• Car Insurance
• Value of car
• Deductible
• Time span of policy
• Interest rates
• Risk

• Option Price
• Stock Price
• Strike Price
• Time until expiration
• Cost of money
• Volatility

High risk High premium 17 year old driver vs. a
35 year old with no tickets Dot com company vs. a
paper company
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Theoretical Values

• Volatility 16 means the stock could move 42 -
  58
• Historical
• Implied
• Volatility is compared like a P/E ratio

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Time Value Intrinsic Value
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Covered Call / Naked Put

• Covered call for short term Neutral expectation
• Income generation on a steady stock
• Own XYZ, current price 25
• Sell 27.50 call at 1.00
• At expiration, XYZ below 27.50, profit 1.00
  (you out-performed the stock)
• XYZ above 27.50, will be assigned (limited
  profit, you underperformed the stock)
• Naked put Identical Profit/Loss to CC
• Willing to own the stock

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Selling Put

• Put sellers must be willing to buy the underlying
  at the strike price (Buffets favorite Leap
  Puts)
• Conservative trader XYZ _at_ 53
• Would love to own XYZ below 50
• Sells 50 put at 2.00, if stock below 50 ..
• Aggressive trader
• Sells put to pocket the premium

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Protective Put

• Protect a stockholding or paper profit
• IRA account vs. regular account
• Protect your diversified portfolio buy index
  puts
• Buy puts on similar stocks to avoid selling the
  long term position
• ETFs Short (1x, 2x)

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Vertical Call Spread

• Bull Call Spread
• XYZ _at_ 102.50
• Buy Oct 100 call _at_ 9
• Sell Oct 110 call _at_ 5
• Net cost 400 (Max loss)
• Max profit 600
• Break-even XYZ _at_104

• Same expiration, different strikes
• Limited risk, limited profit
• Moderately bullish, up to the sell strike

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Vertical Put Spread

• Bear Put Spread
• XYZ _at_ 63.75
• Buy Oct 65 Put _at_ 5.50
• Sell Oct 60 Put _at_ 3.25
• Net cost 225 (Max loss)
• Max profit 275
• Break-even XYZ _at_ 62.75

• Same expiration, different strikes
• Limited risk, limited profit
• Moderately bearish, down to the sell strike

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Ratio Call / Put Spread

• Buying and Selling uneven number of contracts on
  a vertical spread
• Example
• Ratio Call Spread
• Buy 1 XYZ Oct 100 call _at_ 9
• Sell 2 XYZ Oct 110 calls _at_ 5
• Ratio Put Spread
• Buy 1 XYZ Oct 65 Put _at_ 5.50
• Sell 2 XYZ Oct 60 Put _at_ 3.25
• To reduce the risk, one can buy 2 and sell3 or
  buy 3 and sell 4-6

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Buying Stock Ratio Call Spread

• XYZ _at_ 50
• Buy XYZ _at_ 50
• Buy 1 Oct 50 Call _at_ 3
• Sell 2 Oct 55 Calls _at_ 1.50
• At expiration,
• XYZ at or below 50, long stock
• XYZ above 55, stock is assigned, calls offset
  for profit

Long vertical spread almost for free Limited
profit
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Stock Repair

• Application for Long stock Ratio call spread
• Bought XYZ _at_ 50, now it is _at_ 45
• Buy 1 Oct 45 Call _at_ 3
• Sell 2 Oct 50 Calls _at_ 1.50
• At expiration,
• XYZ at or above 50, even on the stock, made 200
  on the call, with almost no new investment
• Doubling up involves additional capital, more
  downside risk
• One could sell a 50 call

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Greeks Defined

• - Theoretical Price fair value of an option
  (Options Calculator)
• Delta Rate of change in an options theoretical
  value for one-unit (1) change in the underlying
• Gamma Rate of change in an options delta for
  one-unit change in the price of underlying
• Theta Time decay of an option

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Greeks Defined (Contd.)

• Vega Rate of change in an options theoretical
  value for one-unit (1) change in volatility
• Rho The expected change in an options
  theoretical value for a 1 percent change in
  interest rates.
• Delta and Theta, most important Greeks!

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Delta

• Delta Rate of change in an options theoretical
  value for one-unit (1) change in the underlying
• Delta values range from 0 to 1
• Delta for at-the-money option is 0.50
• If the stock price goes up by 1, the option
  price goes up 0.50

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Theta

• XYZ _at_ 50
• 45 Call line A
• In-the-money, more intrinsic, less time value
• 50 Call line B
• At-the-money, 100 time value
• Decays faster as it nears expiration

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Put / Call parity

• Put and Call prices are maintained in line with
  each other for fair values
• Arbitrage opportunity exists if Put or Call
  values are out of line

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Straddle (long)

• XYZ at 45.61
• Buy Oct 45 Call at 2.10
• Buy Oct 45 Put at 1.60
• Max risk 370
• Breakeven upper 48.70
• Breakeven lower 41.30

Low volatility Expecting a move one way or the
other (earnings, news, etc) Limited risk,
unlimited potential
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Strangle (long)

• XYZ at 47.83
• Buy Oct 50 Call at 0.95
• Buy Oct 45 Put at 1.00
• Max risk 195
• Breakeven upper 51.95
• Breakeven lower 43.05

Low volatility cheaper options Expecting a move
one way or the other (earnings, news,
etc) Limited risk, unlimited potential
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Iron Condor

• XYZ at 45.00
• Sell Oct 50 Call at 1.00 100
• Buy Oct 55 Call at 0.50 (50)
• Sell Oct 40 Put at 1.00 100
• Buy Oct 35 Put at 0.50 (50)
• Net Credit 100
• Max risk 400
• Breakeven upper 51
• Breakeven lower 39

100
45
50
40
400
Not expecting a move one way or the other
Limited risk, very limited potential ETFs and
Indexes are good candidates
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Collar

• OTM Covered Call long Put
• Limited profit, limited risk on the downside
• Breakeven point purchase price of underlying
  net premium paid (received)
• One can do a costless collar
• Very good for market conditions where the upside
  expectations are limited and downside are
  unlimited

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Bull Calendar Spread

• Sell 1 Near Term OTM Call
• Buy 1 Long Term OTM Call
• Unlimited upside, limited downside
• Ex XYZ trading at 40. Expecting it to gradually
  go up to 50 or beyond in the next four months
• Sell Oct 45 Call at 1.00 100
• Buy Jan 45 Call at 2.00 200
• Net Risk 100 Expecting Oct call to expire 0
• Then take off to the moon!

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Long Call Butterfly

• Buy 1 ITM Call
• Sell 2 ATM Calls
• Buy 1 OTM Call
• Expecting stock to go no where
• Limited profit, limited risk
• Lot of commissions
• Ex XYZ trading at 40.
• Buy 1 Oct 30 Call at 11.00 (1100)
• Sell 2 Oct 40 Calls at 4.00 800
• Buy 1 Oct 50 Call at 1.00 (100)
• Net Risk 400 Stock stays at 40, Max profit
  600
• Max loss if stock below 30 or above 50

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Short Call Butterfly

• Sell 1 ITM Call
• Buy 2 ATM Calls
• Sell 1 OTM Call
• Volatility is high
• Limited profit, limited risk
• Expecting stock to go beyond short strikes
• Ex XYZ trading at 40.
• Sell 1 Oct 30 Call at 11.00 1100
• Buy 2 Oct 40 Calls at 4.00 (800)
• Sell 1 Oct 50 Call at 1.00 100
• Net Risk 600 Max loss if stock stays 40
• Stock stays at below 30 or above 50, Max profit
  400

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Ending Comments

• Know your underlying very well (good stock!)
• Try to keep it simple - strategy
• Try to reduce transaction costs and Bid/Ask
  spreads
• Remember it is possible that you were wrong on
  the direction HOPE is a bad word in this biz
• For long options go long term
• For short options go near month

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Ending Comments

• Try to understand the macro moves (why?)
• Uncertainty temporary or long term