Introduction to options

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Introduction to options Schwab Trading Services 2018 Charles Schwab

2 Important information Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. With long options, investors may lose 100% of funds invested. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received. Please read the Options Disclosure Document titled "Characteristics and Risks of Standardized Options" before considering any option transaction. Call Schwab at for a current copy. Supporting documentation for any claims or statistical information is available upon request. Investing involves risks, including loss of principal. Hedging and protective strategies generally involve additional costs and do not assure a profit or guarantee against loss. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor should review an investment strategy in the context of his or her personal situation before making any investment decision. If you are not completely satisfied for any reason, at your request Charles Schwab & Co., Inc. ( Schwab ) or Charles Schwab Bank ( Schwab Bank ), as applicable, will refund any eligible fee related to your concern within the required timeframes. Schwab reserves the right to change or terminate the guarantee at any time. Go to schwab.com/satisfaction to learn what s included and how it works Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 2

3 We believe in the power of investing to transform peoples lives. We look at the world through clients eyes. We re here to serve you Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 3

01 02 Options defined Options pricing Today we ll discuss 03 Using options

6 Stock vs. Options Stock position Ownership Costs more Dividends No premium Option contract No ownership Costs less No dividends Premium 2018 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 6

7 What is an option? An option is a two-sided contractual agreement between a buyer and a seller. Buyer (long) Owner Opportunity to buy or sell shares at a fixed price Pays a premium for the opportunity Seller (short) Writer Obligation to fulfill the commitment Receives a premium for the obligation The premium is the option price Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 7

8 The options contract Let s look at a sample options contract Sample quote: XYZ 01/15/2018 $65.00 Call/Put Definition/ description Additional information Underlying security symbol Stock, ETF or index Standard contract size = 100 shares Expiration date Date contract ceases to exist Dates are standardized by industry Strike price Potential transaction price There are typically several choices in strike price Strike prices set by exchanges Option type Call: Owner can buy the underlying security at the strike price Put: Owner can sell the underlying security at the strike price 2018 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 8

10 Options have two main pricing components Intrinsic value + Time value = Option price Intrinsic value is an option s inherent value without reference to its market value Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 10

Intrinsic value: Calls Stock price Status of call option Intrinsic value= Current price Strike price Above the strike price In-the-money Current price Strike price Same as the strike price

11 Intrinsic value: Calls Stock price Status of call option Intrinsic value= Current price Strike price Above the strike price In-the-money Current price Strike price Same as the strike price At-the-money $0 Below the strike price Out-of-the-money $0 Calls have intrinsic value if underlying > strike price 2018 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 11

12 Example: Stock at $80 The strike price is $90 Is a $90 call option in-the-money, at-the-money, or out-of-the-money? Does it have intrinsic value? Stock price Strike price Stock price Answer: Stock price < Strike price Call is out-of-the-money ($0 intrinsic value) 2018 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 12

13 Example: Stock at $90 The strike price is $90 Is a $90 call option in-the-money, at-the-money, or out-of-the-money? Does it have intrinsic value? Stock price Strike price Stock price Answer: Stock price = Strike price Call is at-the-money ($0 intrinsic value) 2018 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 13

14 Example: Stock at $100 The strike price is $90 Is a $90 call option in-the-money, at-the-money, or out-of-the-money? Does it have intrinsic value? Strike price Stock price Stock price Answer: Stock price > Strike price Call is in-the-money ($10 intrinsic value) 2018 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 14

15 Intrinsic value: Call summary When the stock price is greater than the strike price, call options are in-the-money and have intrinsic value. In-the-money Strike price Stock price 80 Out-ofthe-money 2018 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 15

Intrinsic value: Puts Stock price Status of put option Intrinsic value = Current price Strike price Above the strike price Out-of-the-money $0 Same as the strike price At-the-money $0 Below

16 Intrinsic value: Puts Stock price Status of put option Intrinsic value = Current price Strike price Above the strike price Out-of-the-money $0 Same as the strike price At-the-money $0 Below the strike price In-the-money Strike price Current price Puts have intrinsic value if underlying < strike price 2018 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 16

17 Example: Stock at $80 The strike price is $90 Is a $90 put option in-the-money, at-the-money, or out-of-the-money? Does it have intrinsic value? Stock price Strike price Stock price Answer: Stock price < Strike price Put is in-the-money ($10 intrinsic value) 2018 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 17

18 Example: Stock at $100 The strike price is $90 Is a $90 put option in-the-money, at-the-money, or out-of-the-money? Does it have intrinsic value? Stock price Strike price Stock price Answer: Stock price > Strike price Put is out-of-the-money ($0 intrinsic value) 2018 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 18

19 Intrinsic value: Summary If underlying price is: Above strike Below strike Calls are in-the-money Puts are in-the-money Strike price 2018 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 19

20 Now let s look at time value Intrinsic value + Time value = Option price Time value is the difference between an option s intrinsic value and its market price Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 20

Time value and time decay About Time Decay: Benefits: Loses value as expiration approaches Not linear it accelerates as expiration approaches Advantage for the seller; risk for the buyer Opportunity

21 Time value and time decay About Time Decay: Benefits: Loses value as expiration approaches Not linear it accelerates as expiration approaches Advantage for the seller; risk for the buyer Opportunity for option to gain value prior to expiration Options with more time to expiration have higher premiums due to time value Price of out-of-themoney options is time value Time value ($) Days to expiration 2018 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 21

Obligation to buy shares Intrinsic value + Time value = Option price

23 Options: Summary Option type Buyer (long) Seller (short) Calls Puts Right to buy shares Right to sell shares Obligation to sell shares Obligation to buy shares Intrinsic value + Time value = Option price 2018 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 23

24 Why do traders use options? To hedge risk Example: Protective puts Lock in a sale price by buying puts on shares you own To generate income Example: Covered calls Collect premiums by selling calls against shares you own To speculate Example: Long calls Try to lower entry cost by buying calls on a security you think will appreciate 2018 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 24

25 Entering the trade Buyer buys to open Buy Calls to Open (BCO) Buy Puts to Open (BPO) Seller sells to open Sell Calls to Open (SCO) Sell Puts to Open (SPO) 2018 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 25

26 Closing an option position Buyer s choices Sells to close Prior to expiration Sell same option in the market Attempts to capture a profit or limit a loss Exercises the option Prior to expiration Activate terms of contract Lets it expire At expiration ATM or OTM Do nothing, option expires worthless Seller s choices Buys to close Prior to assignment and/or expiration Purchase same option in the market Attempts to capture a profit or limit a loss Gets assigned Prior to expiration Obligated to fulfill terms of contract Lets it expire At expiration ATM or OTM Do nothing, option expires worthless 2018 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 26

27 Let s review what we ve learned An option is a twosided contractual agreement between a buyer and a seller An option s price reflects intrinsic value and time value Options can be used to hedge risk, generate income, or speculate There are a variety of ways that options traders can close their positions 2018 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 27

28 Relevant tools and information All-in-One trade ticket Live workshops, webcasts & online seminars Market Insight Schwab.com Learning Center 2018 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. 28

29 Get priority access to trading support Sharpen your skills in the Schwab Learning Center. schwab.com/learningcenter View more of our Live webcast offerings. schwab.com/liveonline Experienced Options Specialists are ready to help. Call

How can I use index options to hedge my portfolio?

10 Common Options Questions Series: # 6 How can I use index options to hedge my portfolio? (1018-84KJ) We believe in the power of investing to transform peoples lives. We look at the world through clients