Dont try to buy at the bottom and sell at the top' This cant be doneexcept by liars

1

• Dont try to buy at the bottom and sell at the
  top. This cant be done-except by liars
• Bernard M. Baruch
• Never invest in anything that eats or needs
  repairing.
• Billy Rose

2
Mechanics of Option Trading
3
The Option Clearing Corporation

• The OCC performs much the same function for
  option market as the clearinghouse does for the
  futures market.
• It guarantees that option writers will fulfill
  their obligations under the terms of the options
  contracts and keeps a record of all long and
  short positions.
• The OCC has a number of members and all option
  trades must be cleared through a member.
• Members are required to have a certain minimum
  amount of capital and to contribute to a special
  fund that can be used if any member defaults on
  an option obligations.

4
Buying and Selling options

• Buying Option
• When purchasing an option, the buyer must pay for
  it in full by the morning of the next business
  day.
• Selling Option
• The writer of the option maintains a margin
  account with a broker.
• The broker maintains a margin account with the
  OCC member that clears the trade.
• The OCC member in turn maintains a margin account

5
Exercising an Option
Option Buyer
Broker
Member
Member (short Position)
OCC
Option Seller
6
Exercising an Option

• When an investor notifies a broker to exercise an
  option
• The broker notifies the OCC member that clears
  its trade.
• The floor member then places an exercise order
  with the OCC.
• The OCC randomly selects a member with an
  outstanding short position in the same option.
• The member, using a procedure established in
  advance, selects a particular investor who has
  written the option.
• If the option is a call option, this option
  writer is required to sell futures contracts or
  stock at the strike price.
• If the option is a put option, this option writer
  is required to buy underlying contract at the
  strike price.

7
Exercising an Option

• At the expiration of the option, all in-the-money
  options should be exercised unless transactions
  costs are so high as to wipe out the payoff from
  the option.
• Some brokerage firm will automatically exercise
  options for their clients at expiration when it
  is in their clients interest to do so.

8
Trading Strategies Involving Options
9
Trading Strategies Involving Options

• Take a position in the option the underlying
  stock.
• Spread Position in 2 or more options of the same
  type
• Combination Position in a mixture of calls
  puts

10
Strategies Involving a Single Option and a Stocks

• Long Position in a stock combined with short
  position in a call (covered call).
• Short position in a stock combined with a long
  position in a call
• Long position in a put combined with long
  position in a stock (protective put)
• Short position in a put combined with short
  position in a stock (covered put)

11
Positions in an Option the Underlying

• Figure 9.1 (p. 218)

Profit
Profit
X
ST
ST
X
(a)
(b)
Profit
Profit
X
X
ST
ST
(c)
(d)
12
Problem

• An option writer sells a put option on May
  soybeans at a strike price of 4.80/bu at a
  premium of 0.20 and sold May soybeans at
  4.90/bu. What will be his profit/loss under the
  following scenarios?
• Soybean price (P) 4.90
• 4.80ltSoybean price (P)lt4.90
• Soybean price (P) 4.80

13
Problem

• An investor buys a call option on May soybeans at
  a strike price of 4.90/bu at a premium of
  0.20 and sells May soybeans at 4.60/bu. What will
  be his payoffs under the following scenarios?
• Soybean price (P) 4.90
• 4.60ltSoybean price (P)lt4.90
• Soybean price (P) 4.60

14
Problem

• April 02 Live cattle futures contract is trading
  for 74.2 cents/pound. Suppose you sell a call
  option contract on April live cattle futures with
  a strike price of 74 cents per pound for 1.55
  cents/pound. Each contract is for the delivery of
  40,000 pounds.
• What happens if the contract is exercised when
  the futures price is 74.6 cents?
• What happens if the contract is exercised when
  the futures price is 77 cents/pound and you have
  covered the call option by buying an April live
  cattle futures at 74.2 cents/pound?

15
Problem

• April gold futures is currently trading at
  298.3/oz. An option writer sells a call option
  on December gold at a strike price of 285/oz.
  for a premium of 12.2/oz and immediately covers
  the call option.
• Did the writer make a smart decision? If not, why?

16
Problem

• Henry buys a put option on gold at a strike price
  of 350 per ounce for a premium of 12 per ounce.
  If Henrys option is in-the-money, what is the
  approximate price of the underlying futures
  contract?

17
Different Strategies involving two or more
options of same type (Spread)

• Bull Spread It can be created by buying a call
  option on a stock with a certain strike price and
  selling a call option on the same stock with a
  higher strike price.
• This strategy limits the investors upside and
  downside potential. It has chosen to give up
  upside potential by selling a call option with
  higher strike price.
• Three different types of bull spread Both calls
  are initially out of the money, one call is
  initially in the money, the other call is
  initially out of the money, and Both calls are
  initially in the money.

18
Bull Spread Using Calls

• Figure 9.2 (p.219)

Profit
X1
X2
ST
19
Bull Spread Using Put Options

• Bull spread can also be created by buying a put
  option with a low strike price and selling a put
  with a high strike price.
• Unlike bull spread created from call, bull spread
  created from puts involve a positive cash flow to
  the investor up front.
• Investor has chosen to give up upside potential
  by getting the price of the put option with
  higher strike price.

20
Bull Spread Using Puts
21
Problem

• An investor buys for 3 a call with a strike
  price of 30 and sells for 1 a call with a
  strike price of 35. Calculate the payoff from
  this bull strategy under the following scenarios
• Stock price (S) 30
• 30 lt Stock price (S) lt 35
• Stock price 35

22
Bear Spread

• In bear spread, strike price of the option
  purchased is greater than the strike price of
  option sold.
• Bear spread can be created using either call or
  put option.
• Like bull spread, bear spread also limits both
  the upside profit potential and downside risk.

23
Bear Spread Using Calls
24
Bear Spread Using Puts
25
Problem

• Suppose that put options on a stock with strike
  prices 30 and 35 cost 4 and 7, respectively.
  How can the options be used to create a bear
  spread? Construct a table that shows the profit
  and payoff from the bear spread