Options 101: The building blocks

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1 PORTFOLIO DISCUSSION J.P. MORGAN U.S. EQUITY GROUP October 2013 Connecting you with our global network of investment professionals IN BRIEF This paper provides an overview of options and describes strategies that can be used as part of an investor s overall investing strategy. Investors can use these financial instruments to generate income, increase returns and manage risks. We explain call and put options instruments that form the building blocks of option strategies. Essentially, buying call and put options on stocks enables the purchaser to participate in a stock s gain or loss, and may provide investors with some protection from market declines. Selling puts and calls on stocks that investors already own can generate income and may provide protection if used in other types of option strategies. Asset managers are increasingly including option strategies as an alternative, risk-controlled approach to enhancing portfolio value. Buying and selling stock options are often seen as fast-moving, fast-money trades. Certainly, options and other derivative securities can be volatile, levered and speculative. But options also offer a pragmatic benefit that may be overshadowed by their reputation. Many investors use options as an integral part of their overall investing, trading or riskmanagement strategies. Options can be used to increase returns, generate income or provide a hedge for stocks and portfolios. The beauty of options is that investors can participate in a stock s price movement at a fraction of the cost of ownership. The cost of an option and the potential profit will be affected by how much the stock price moves, how long the moves take and the stock s volatility. Since options can be complicated and risky, it is important for investors to understand the basic building blocks and the strategies most appropriate for their portfolios and investment goals. Hamilton Reiner Managing Director, Head of U.S. Equity Derivatives J.P. Morgan U.S. Equity Group hamilton.reiner@jpmorgan.com What is an option? Options are contracts that provide a buyer with the right, but not the obligation, to buy or sell a specified quantity of an underlying stock at a fixed price (called the strike price or exercise price) at or before the option s expiration date. That period of time could be as short as a day or as long as a few years, depending on the option. The situation is different for investors who wish to sell, or write, an option. In this case, the seller of the option contract is obligated to fulfill his side of the contract if the holder wishes to exercise. In other words, option buyers have rights and option sellers have obligations. FOR INSTITUTIONAL/WHOLESALE OR PROFESSIONAL CLIENT USE ONLY NOT FOR RETAIL DISTRIBUTION

2 PORTFOLIO DISCUSSION: Title Copy Here Options come in two varieties: calls and puts. When a call option hits its strike price, the holder has the right to buy the underlying stock at a specified price. Conversely, with a put option, the underlying shares can be sold, or put, to someone else. In essence, buying calls is bullish and buying puts is bearish. Selling calls and puts, on the other hand, represents a bearish and bullish view of a stock, respectively. Most active stocks, exchange-traded funds and indexes have options that are available to trade. At any time, investors can buy or sell options contracts that have a wide range of strike prices and expiration dates. Unlike with stocks when one typically aims to buy low and sell high trading with options can allow investors to benefit from many different types of market situations. With options, for example, it is possible to profit whether stocks are going up, down or sideways. In other words, options are a versatile financial instrument. Why use options? While options have the reputation of being risky and complicated, nearly everyone has used options in one form or another. Anyone who has bought a home or an automobile insurance policy has essentially bought a put option to protect the value of his or her property if that asset declines in value due to some misfortune. Potential home buyers who apply for a rate lock on a mortgage are also using the equivalent of a call option. Under a rate lock, a lender promises to hold a certain interest rate, usually for a specified period of time. If rates move higher during the time the application is processed, the borrower exercises his or her option to lock in the promised rate; if rates move lower, the option expires worthless. In investing, there are several reasons why investors would use options. One is for alpha. Since options allow investors to better express and extract value from their beliefs, skilled investors are better able to monetize more specific security or market views. A BRIEF HISTORY OF OPTIONS 1630s: Amid the rise in both the popularity and the prices of tulip bulbs in Holland, options are widely used to speculate on soaring tulip prices. 1800s: An unregulated market for trading options over the counter develops in the U.S. as broker-dealers try to match option sellers with option buyers. Because the terms of contracts are determined between the buyer and seller, the market is illiquid and inefficient and offers little protection for investors. 1973: The Chicago Board Options Exchange (CBOE) is founded and becomes the first marketplace for trading listed options, with rules to standardize contract size, strike price, expiration date and centralized clearing. A few years later, the CBOE introduces computerized price reporting, while the CBOE Clearing Corp. becomes The Options Clearing Corporation (OCC), the industry clearinghouse for all U.S. options trades. 1973: Fischer Black and Myron Scholes publish The Pricing of Options and Corporate Liabilities in the University of Chicago s Journal of Political Economy, introducing the Black- Scholes model, a mathematical model that becomes the standard for evaluating the price of options. 1977: The Securities and Exchange Commission (SEC) allows trading in put options. 1980s: The New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) begin listing equity options and become OCC participant exchanges. 1982: Industry-wide options contract volume exceeds 500,000 per day. Source: cboe.com, optionsclearing.com, optionseducation.org; data as of September : The Options Industry Council (OIC), whose mission is to raise individual investor awareness and understanding of stock options, is formed by the OCC, CBOE, NYSE, American Stock Exchange (AMEX), Pacific Stock Exchange (PSE) and Philadelphia Stock Exchange (PHLX). Mid-1990s: The exchanges sharply increase the number of options product listings in flexibly structured exchangetraded options, long-term options, month-end options and interest-rate options. 1999: Total options volume closes at more than 507 million contracts, marking the first year options trading exceeds the half-billion benchmark. Late 1990s/early 2000s: Multiple listings escalate on the options exchanges. The International Securities Exchange joins OCC as a participant exchange the first all-electronic options exchange. Late 1990s/early 2000s: The electronic trading of options continues to proliferate. 2001: The options industry completes the conversion to decimalization. As part of this conversion, options were priced in decimals instead of fractions on the expectation that doing so would lower investor costs by narrowing the spread. 2011: On November 9, total options volume surpasses four billion contracts for the first time in history. 2013: ISE Gemini becomes an OCC participant exchange, bringing the total number of options markets to 12. 2

3 But the use of options in a speculative manner is also one reason why options have the reputation of being risky. This is because investors have to not only correctly predict the direction of the underlying stock s movement, but also the magnitude and timing of this movement. Despite the risks, investors trade options because of the opportunities for greater profits. With options, investors can leverage a small amount of money to control a larger dollarvalue amount of the underlying stock. The other primary uses of options are for hedging and as a risk-mitigation tool. Many investors use options to generate income or to protect an individual stock position or portfolio of stocks from adverse market movements. Doing so can limit investors losses and lock in profits at a certain price level if the market moves against them. Buying puts Buying a put option (Exhibit 2) gives the buyer the right, but not the obligation, to sell the underlying stock at a fixed price (strike price) on or before a specific date (expiration date). This is a bearish strategy because the value of the put tends to increase as the price of the underlying stock declines. Maximum potential profit: Obtained if the stock price declines all the way to zero. Maximum potential loss: Limited to the total premium paid for the option. : of the option minus the premium paid for the option. EXHIBIT 2: BUYING PUTS The put holder s profit is equal to the intrinsic value minus the put premium Options building blocks Buying calls Buying a call option (Exhibit 1) gives the buyer the right, but not the obligation, to buy the underlying stock at a fixed price (strike price) on or before a specific date (expiration date). This is a bullish strategy because the value of the call tends to increase as the price of the underlying stock rises. Maximum potential profit: Unlimited, as long as the price of the underlying stock continues to rise. Maximum potential loss: Limited to the total premium paid for the option. Break-even : of the option plus the premium paid for the option. EXHIBIT 1: BUYING CALLS The call holder s profit is equal to the intrinsic value minus the call premium Call premium Who should run it: An investor who is bearish on a particular stock and wants to profit from a decline in its price. Selling calls Put premium Selling a call option (Exhibit 3, next page) gives the seller the obligation to sell the underlying stock at the strike price. In return, the seller is paid a premium at the time he or she sells the option. Maximum potential profit: Limited to the premium received from the call s initial sale. Maximum potential loss: Unlimited as the underlying stock price increases. Break-even : of the option plus the premium collected. Who should run it: An investor who is bullish on a particular stock and wants to profit from a rise in its price. J.P. Morgan Asset Management 3

4 PORTFOLIO DISCUSSION: Title Copy Here EXHIBIT 3: SELLING CALLS Who should run it: An investor who is neutral to bearish about the underlying stock and wishes to generate income. (Selling calls on stocks for pure speculation on stocks that the seller does not own is risky and suited for advanced option traders.) Selling puts Selling a put option (Exhibit 4) gives the seller the obligation to buy the underlying stock at the option s strike price if the option is assigned. In return, the seller is paid a premium when the put is written. Maximum potential profit: Limited to the premium received from the put s initial sale. Maximum potential loss: Substantial, but limited to the strike price minus the premium received if the stock price goes to zero. Break-even : of the option minus the premium collected. EXHIBIT 4: SELLING PUTS The call writer s profit is the premium received for the call Call premium The put writer s profit is the premium received for the put Who should run it: An investor who is neutral to bullish about the underlying stock and wishes to generate income. (Selling puts on stocks for pure speculation on stocks that the seller does not own or has no intention of buying is risky and suited for advanced option traders.) Covered calls Covered call writing (Exhibit 5) is either the simultaneous purchase of an asset and the sale of a call option, or the sale of a call option covered by underlying stock currently held by an investor. The seller (or writer) receives cash for selling the call, but will be obligated to sell the stock at the call s strike price if assigned, thereby capping further upside price participation. For this reason, the strategy is slightly bullish or neutral, since the seller is willing to sell the stock if it reaches a specific price. Maximum potential profit: Limited to the premium received from the call s sale plus the difference between the strike price and the stock s purchase price. Maximum potential loss: After the premium received for selling the option, most downside risk comes from owning the underlying stock, which may potentially lose its value. Break-even : Current stock price minus the premium received for selling the call. EXHIBIT 5: COVERED CALLS : stock price premium Put premium Who should run it: An investor who is neutral to bullish and is willing to sell the underlying stock if it reaches a specific price. 4

5 Protective puts Purchasing a put option on a stock a buyer already owns gives the buyer the right to sell that stock at the option s strike price. Protective puts (Exhibit 6) essentially supply the buyer with downside protection on a position. Maximum potential profit: Unlimited, as long as the price of the underlying stock continues to rise, minus the premium paid for the option contract. Maximum potential loss: The downside risk is limited to the current stock price minus the strike price, plus the premium paid for the put. Break-even : Current stock price plus the premium paid for the put. Break-even : If the position is established for a net credit, the break-even is the current stock price minus the net credit received; if established for a net debit, the break-even is the current stock price plus the net debit paid. EXHIBIT 7: COLLAR Protected portfolio Put strike price Call strike price Unprotected portfolio EXHIBIT 6: PROTECTIVE PUTS (PUT HEDGE) Who should run it: An investor who is bullish but nervous. This investor is generally looking to limit the downside risk of a stock position at little or no cost or is willing to forego upside potential in return for downside protection. Who should run it: An investor who is bullish but nervous and wants to protect the value of his or her stock. Collar A collar (Exhibit 7) consists of simultaneously purchasing a protective put option and selling a covered call. Collars are generally used by investors whose primary concern is to limit downside risk. They are willing to give up some upside potential in order to limit downside risk at a low cost because the covered call helps to pay for the protective put. Maximum potential profit: Limited to the call s strike price minus the current stock price, minus the net debit paid or plus the net credit received. Maximum potential loss: Limited to the current stock price minus the put s strike, plus the net debit paid or minus the net credit received. What goes into option pricing? There is a cost, of course, to options. An option s value and its profit potential will be affected by how much the stock price moves, how long that move takes and the stock s volatility. In options terminology, the price of an option is called the premium, which is made up of intrinsic value and time value. Exhibit 8 (next page) breaks down each of the components that makes up an option s premium. Time value, for example, includes several risk factors, such as volatility, days to expiration, dividends and interest rates. The intrinsic value is the difference between the strike price and the current price for a put, and the difference between the stock price and the strike price for a call. In general, an option s value usually increases as the option becomes further in-the-money and decreases as the option becomes more deeply out-of-themoney (see page 7 for more specific definitions). J.P. Morgan Asset Management 5

6 PORTFOLIO DISCUSSION: Title Copy Here EXHIBIT 8: OPTIONS PREMIUM COMPONENTS Price of the underlying stock Intrinsic value Buying options of option contract Options premium Time remaining until expiration Risk-free interest rates Time value Volatility of the underlying stock Dividend rate of the underlying stock Options contracts have been around for many years, but trading activity sharply increased when options were issued with standardized terms and traded through a guaranteed clearinghouse at the CBOE. Today, many options are created in a standardized form and traded through clearinghouses on regulated options exchanges, while other over-the-counter (OTC) options are written as bilateral, customized contracts between a single buyer and seller, one or both of whom may be a dealer or market maker. Some of the key differences between exchange-traded options and OTC options include: Regulatory oversight. When an option is listed on an exchange, the regulatory oversight increases dramatically. Counterparty risk. When options are bought or sold OTC in a private transaction, there are counterparty risks or risks that the party on the other side of the contract might not be able to deliver on the terms of the contract. Because exchange-traded options trade through a clearinghouse, the clearing-house essentially steps in to fulfill the contract if the other participant cannot. Standardization. The terms, strike prices and expiration dates of exchange-traded options are also standardized, while an OTC option can have any expiration or strike price that the buyer and seller agree on. One drawback of exchange-traded options is that a suitable derivative for an investment strategy may not exist in a standardized form. More customized solutions are usually structured for the OTC market. Intermediation. In the OTC market, investors can do business directly with the buyer or seller, eliminating the intermediary. Transactions in an exchange must go through a broker-dealer; investors must pay commissions to the broker, who will then execute the transaction on their behalf. Conclusion In the wake of the financial crisis of 2008 and 2009, individual investors, institutions and asset managers are grappling with the realization that lower returns may be a fact of life. One of the major drivers behind investors increased use of options is the need to improve returns, as investors and money managers pursue alternatives to enhance portfolio value in a riskcontrolled way. As a result, it is no surprise that many investors when faced with heightened risk sensitivity are including options as part of their investing strategies. Asset managers option volume has grown from 5% of total listed volume in 2006 to 20% in Many option strategies, such as collar overlays, offer a means of achieving both improved returns and lower volatility. While these hedging strategies are by no means perfect or easy to implement, the advantages of the potential improvement in risk-adjusted performance are clearly worth the effort to understand them. We hope that this paper provides a basic and helpful explanation of how options work. If you have any questions, please reach out to your client advisor. 1 OCC/Tabb Group; data as of

7 THE GREEKS* AND OTHER OPTIONS TERMINOLOGY At-the-money: An at-the-money option is a call or put option that has a strike price that is equal to the market price of the underlying stock. At-the-money options possess zero intrinsic value and contain only time value. Assignment: When an option owner exercises the option, an option seller (or writer ) is assigned and must make good on his or her obligation. That means he or she is required to buy or sell the underlying stock at the strike price. *Delta: This is the amount by which an option s price is expected to change for each one-point change in the underlying stock price. In other words, delta is a measure of an option s price risk, expressed as the sensitivity of an option s value to a change in the price of the underlying stock. Exercise: This occurs when the owner of an option invokes the right embedded in the option contract, meaning that the option owner buys or sells the underlying stock at the strike price and requires the option seller to take the other side of the trade. Expiration day: The expiration day is the last day an option exists. For listed stock options, this is the Saturday following the third Friday of the expiration month. All listed options have options available for the current month and the next month, as well as specific future months. Each stock has a corresponding cycle of months that it offers options in. There are three fixed expiration cycles, and each cycle has a four-month interval: 1) January, April, July and October; 2) February, May, August and November; 3) March, June, September and December. *Gamma: This measures the expected change in an option s delta for every one-point change in the price of the underlying stock. In-the-money: For call options, this means the strike price is below the current trading price of the underlying stock. So, if a call has a strike price of $50 and the stock is trading at $55, that option is in-the-money. For put options, this means the strike price is above the current trading price of the underlying stock. So, if a put has a strike price of $50 and the stock is trading at $45, that option is in-the-money. In-the-money options are generally more expensive, as their premiums consist of significant intrinsic value on top of their time value. LEAPS: Long-term Equity Anticipation Securities (LEAPS) are longer term options with more than nine months until expiration. Out-of-the-money: For call options, this means the strike price is above the market price of the underlying stock. For put options, this means the strike price is below the market price of the underlying stock. Out-of-the money options have zero intrinsic value. Their entire premium consists of time value. *Rho: This measures the expected change in the price of an option due to a one-percent change in the risk-free interest rate for the period of the option contract. : The agreed upon price per share at which the asset may be bought or sold under the terms of the option contract (sometimes referred to as the exercise price ). *Theta: This is the sensitivity of an option s value to a change in the amount of time remaining until expiration. The theta value is not linear; options lose time value at a faster rate as expiration approaches. Time decay: Generally, the longer the time remaining until an option s expiration, the higher its premium will be. This is because the longer an option s lifetime, the greater the possibility that the underlying share price might move so as to make the option in-the-money. The time decay increases rapidly in the last several weeks of an option s life. When an option expires in-the-money, it is generally worth only its intrinsic value. Time value: The part of an option price that is based on its time to expiration. Subtracting the amount of intrinsic value from an option price results in time value. *Vega: This measures the expected change in the price of an option due to a one-percentage-point increase or decrease in the volatility that is used to calculate theoretical values. *The calculations behind the Greeks measure the expected influence on the price of the option for a given change in one of the specific risk factors: Delta (price risk); Gamma (delta risk); Theta (time risk); Vega (volatility risk); and Rho (interest-rate risk). J.P. Morgan Asset Management 7

8 PORTFOLIO DISCUSSION: Title Copy Here NOT FOR RETAIL DISTRIBUTION: This communication has been prepared exclusively for Institutional/Wholesale Investors as well as Professional Clients as defined by local laws and regulation. The opinions, estimates, forecasts, and statements of financial markets expressed are those held by J.P. Morgan Asset Management at the time of going to print and are subject to change. Reliance upon information in this material is at the sole discretion of the recipient. Any research in this document has been obtained and may have been acted upon by J.P. Morgan Asset Management for its own purpose. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as advice or a recommendation relating to the buying or selling of investments. Furthermore, this material does not contain sufficient information to support an investment decision and the recipient should ensure that all relevant information is obtained before making any investment. Forecasts contained herein are for illustrative purposes, may be based upon proprietary research and are developed through analysis of historical public data. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication may be issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited which is authorised and regulated by the Financial Conduct Authority.; in other EU jurisdictions by JPMorgan Asset Management (Europe) S.à r.l.; in Switzerland by J.P. Morgan (Suisse) SA; in Hong Kong by JF Asset Management Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real Assets (Asia) Limited; in India by JPMorgan Asset Management India Private Limited; in Singapore by JPMorgan Asset Management (Singapore) Limited; in Australia by JPMorgan Asset Management (Australia) Limited; in Brazil by Banco J.P. Morgan S.A.; in Canada by JPMorgan Asset Management (Canada) Inc., and in the United States by J.P. Morgan Investment Management Inc., JPMorgan Distribution Services Inc., and J.P. Morgan Institutional Investments, Inc. member FINRA/ SIPC. 270 Park Avenue, New York, NY JPMorgan Chase & Co. II_Options 101 The Building Blocks FOR INSTITUTIONAL/WHOLESALE OR PROFESSIONAL CLIENT USE ONLY NOT FOR RETAIL DISTRIBUTION