Finance 527: Lecture 30, Options V2

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1 Finance 527: Lecture 30, Options V2 [John Nofsinger]: This is the second video for options and so remember from last time a long position is-in the case of the call option-is the right to buy the underlying security at the specific strike price of the option. And so you re going to make money when the current strike price is higher than the exercise price. That s when it s in the money. So the long position makes money when the underlying stock price goes up. But they have to pay for that option. The person in the short position is the person who sold the option so they get the cash flow for the sale. And if prices go up, then they will end up having to buy from the long position person at the higher price so they ll lose money. As far as risk is concerned, the most the person in the long position can lose is just the price of the option itself. That is if it was quoted at five dollars for a hundred shares so they buy it for five hundred dollars-that s the most this person can lose. That is if the price of the stock goes down and that option over time expires worthless, they lose that 500 dollars. The person in the short position gets to keep that 500 dollars. But they have almost unlimited upside, right. The higher the price goes of stock, the more the person in the long position will be making. A covered call is when you write a call option on stock that you actually own. So that s why it s called a covered call. You own the stock so that when if someone calls it away from you, you have it available. Options V2 John Nofsinger Call Options Strategies Long position: the right (but not obligation) to buy the underlying asset at a strike price for a limited period of time o The right to buy stock at a fixed price becomes more valuable as price of stock increases (in the money when current stock price > exercise price) o Risk for buyer is limited to the call premium and potential is unlimited Short position: payoff mirror image of long position (zero sum game) Covered call: sale of a call option on a stock that is owned [John Nofsinger]: So let s look at the profit/loss diagram of call options. So if you buy a call option-let s say you buy a call option with a strike of 50, k 50 dollars a share-and let s say it costs you, looks like it s gonna cost us 2 dollars a share so 200 total is the cost of buying this option. So we don t make any money if the stock price ends up being lower than 50 dollars a share. See we spent 200 to get it, but if the stock price at the end is lower than 50 dollars a share, we don t make any profit. We don t get any value out of the option, and we lose the premium that we paid. So we start making money when the stock price starts going above the strike price of 50. So let s say the stock price goes to 51, right. Then we can exercise the option, buy it at 50, sell the hundred shares in the market at 51, make one dollar a share profit. So we could make 100 1

2 dollars by exercising the option. But of course, we paid 200 for the option so that s why we re still losing a hundred dollars if the stock price only goes up to 51. If it goes up to 52, now we broke even. And then any price more than 52 dollars, you can see we make unlimited amount of money owning that option. The person who wrote the call option or is in the short position, they have the exact opposite pay-off diagram because it s a zero sum game. If I lose the 200 dollars, it s because they gained it. And then the option expired worthless so they keep the 200. If I get lots of money because the stock price went up, they re gonna lose lots of money. So that is the call option diagram. Well let me do one more thing here, hopefully I can draw it in a little bit. What if I own stock? What is the pay-off diagram of stock? K generally looks like that at the current 50 dollars a share. K so if the stock price goes up a buck, I have a hundred shares, I make a hundred dollars. It goes up two, I make two, right. But if it loses a dollar to 49, then I lose a hundred dollars. If the stock price goes down to 48, I lose so. The stock payoff diagram is a straight line. So if I have this straight line cause I have a hundred shares of stock and I also write a call option, I have this one. We just have to add these two lines together to create the combined position, which is a covered call. You can see at this point at 50 dollars, for every dollar the stock price gains, I get a dollar in the stock but I lose a dollar in my option so they cancel each other out. So at that point, we re not getting any more profits or losses. Figure 18.3 Call Options Are Popular with Bullish Investors A. Extremely Bullish Investors Buy Calls to Leverage Upside Potential [Image of graph of Stock Price at Expiration vs. Profit/Loss] [John Nofsinger]: So to look at the position, you see here that a covered call, we make 200 dollars if the stock price ends up being over 50 dollars a share. We still own the stock. But as it goes up, our profits that are above the 200 dollars get taken away from us because the person that bought our call option is gonna call it and take our stock away. And so we ll just end up keeping the 200 dollars we got as the premium. If the price falls, then I still get to keep the 200 dollars. But my stock value keeps going down right. And I still own the stock. It doesn t get called away from me when the price goes down. B. Moderately Bullish Investors Sells Calls against a Stock Position to Increase Income [Image of Graph of Stock Price at Expiration vs. Profit/Loss with a Covered Call] [John Nofsinger]: Let s look at the same things for put options. Remember if you own the put option, you re in the long position. You make money when the prices go down-below the strike price. One of the popular strategies is a protective put. And that is buying a put option-so it costs you money so it s like buying insurance on stock that you own as downside protection. 2

3 Put option strategies Long position: the right, but not obligation, to sell an underlying asset at strike price o The right to sell stock at a fixed price becomes valuable as price of the stock decreases (in the money when current price < exercise price) o Risk for buyer is limited to the premium and profit is also limited (price cannot be below zero) Short position: mirror image of long position, but involves obligation to transact if buyer so chooses Protective put: insurance against a sharp correction. Purchase of a stock and put option [John Nofsinger]: Here is the profit/loss diagram. If you buy a put, costs you 200 again-200 dollars. If the stock price goes up, you don t get any profit out of your option, right. You only make money when the price goes below-goes down. So that s when you start making money. If it drops below 48 dollars a share, then you actually start making a profit. The person who wrote the option or is in the short position, they have the exact opposite picture of course because it s a zero sum game. Figure 18.4 Put Options Are Popular with Bearish Investors A. Extremely Bearish Investors Buy Puts to Profit from Declining Share Prices [Image of graph of Stock Price at Expiration vs. Profit/Loss with Short and Long Put] [John Nofsinger]: This is what the protective put looks like. Notice that that is that you boughtyou own a hundred shares-right and then you buy a put. And what happens is the price falls for every dollar you lose in your stock, you gain in your put option. And therefore it stabilizes your losses to only 200. But you can still gain a lot of money if the stocks go way up. So that s the protective put. The interesting thing is that you ve created an option and we look at the picture. See 200 flat and then goes up. The protective put position looks a lot like owning a call option. Doesn t it? Right there. And that is true. A protective put is very similar to just owning a call option. And the covered call position looks a lot like being short put option. So the puts and the calls and owning of the stock, they are all related and that s part of how option pricing is all figured out as well. 3

4 B. Moderately Bearish Investors Buy Puts to Give Price Protection for Portfolio Holdings [Image of graph of Stock Price at Expiration vs. Profit/Loss with Protective Put] [John Nofsinger]: Okay so all we ve done so far is created combinations where we have one option and stock. But you can do positions and strategies with multiple options called spreads. A price spread is when you buy or sell options that have the same asset or the same time period, but you use different strike prices. A time spread is where you often have the same strike prices but you have the combination over different expiration time periods. Some common ones are a bull call spread. That s where I buy a low strike price and I sell a high strike price call. Low strike prices are gonna cost more money, right. The right to buy a stock at a low price is gonna cost you a lot more money than you re gonna get when you sell the high stock price one. So this is gonna have a net cost to you to get into it. Combinations Spread: both buyer and writer of the same type of option on the same underlying asset o Price spread: purchase or sale of options on the same underlying asset but different exercise price o Time spread: purchase or sale of options on the same underlying asset but different expiration dates Bull call spread: purchase of a low strike price call and sale of a high strike price call Bull put spread: sale of high strike price put and purchase or a low strike price put [John Nofsinger]: This is without the actual net cost part. This is just the payoff part at the end. The call option on the strike price that you wrote, right, payoff is here. The one that you bought the payoff is here. And so the combination-this middle ground-this is your payoff diagram for the bull call spread. Now you d have to shift this whole thing down a little bit if you wanted to make a profit diagram it cost you a little bit of money to get into it. In other words, if you wanted to make it a profit diagram instead of a payoff diagram, this axis right here would probably more likely be about right here. And essentially this is a position where you make a little bit of money if prices go up, and you lose a little bit of money if prices go down. But it s all very hedged, and you re not gonna gain or lose very much money. A bull put spread is the sell of the high strike price put and the purchase of a low strike put. And you end up with this particular diagram. So a very kind of similar type of picture. A straddle is when you purchase a call and write a put on the same asset, same exercise price, and same expiration date. Ok and that showed up here. But let s change that to a profited diagram just to get a little bit better idea. So here s the strike price. You re actual profit diagram is gonna look kind of like this right here. Ok and why would you do 4

5 a straddle? Well you make money on a straddle if prices go up. You make money if prices go down. But you lose money if prices stay around the same as the strike price, k. So you would do a straddle if you think for example that maybe there is a-let s say a company has been sued by the US government for you know noncompetitive practices and all that kind of stuff and it s a big case and all of that. And the case is about to end, and you don t know who s gonna win. If the company wins, the price is gonna go up. If the government wins, the price is gonna go down. And so you want to make money either way. And so you would do a straddle like this. You could do the opposite straddle too by the way right by reversing you could sell the call and write a put or and buy the put. Right and you would have the exact opposite shape, right, zero sum game. So those are straddles. And this concludes the second options video. Stradde: purchasing a call and writing a put on the same asset, exercise price, and expiration date. [Image of graph of Bull Call Spread vs. Payoff with long and short call] [Image of graph of Bull Put Spread vs. Payoff with long and short put] [Image of graph of Straddle vs. Payoff for long call and short put] 5

Basic Option Strategies

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