Option Strategies Russell Rhoads, CFA
Disclosure In order to simplify the computations, commissions have not been included in the examples used in these materials. Commission costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Multiple-leg strategies involve multiple commission charges. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Options involve risks and are not suitable for all investors. Prior to buying or selling an option, an investor must receive a copy of Characteristics and Risks of Standardized Options. Copies are available from your broker or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606. Investors considering options should consult their tax advisor as to how taxes may affect the outcome of contemplated options transactions. Cboe and Chicago Board Options Exchange are registered trademarks and The Options Institute is a servicemark of Cboe. All other trademarks and servicemarks are the property of their respective owners. This presentation should not be construed as an endorsement or an indication by Cboe of the value of any non-cboe product or service described in this presentation. Copyright 2017 Cboe Global Markets, Incorporated. All rights reserved. 2
Option Strategies Time Decay Covered Call Cash Secured Put Winged Spreads Buffett Put Trade 3
Time Decay A good portion of professional option trading is implemented by professionals selling calls or puts One of the goals behind these sorts of trades is to take advantage of the time decay of option prices Not all time decay is the same and the biggest bang for the buck comes from selling at-the-money options 4
Option Premium Time Decay 60 Days of Time Decay 45 40 35 30 25 20 15 10 5 0 60 55 50 45 40 35 30 25 20 15 10 5 0 Days to Expiration 5
Covered Call The covered call is one of the most common uses of the options market by all levels of market participants This trade combines a long stock position with a short call option The obligation to sell shares is covered by the long stock position There are two potential motivations creating a covered call, as an exit strategy or to increase performance intending to hold shares 6
Covered Call DR Horton (DHI) Daily Price Action 40 39 38 37 36 35 34 7/26/17 8/8/17 8/21/17 9/1/17 9/15/17 9/28/17 Data Source: Bloomberg 7
Covered Call DHI may be considered a little extended rising over 5% in the last four days As a holder of 100 shares of DHI we either believe the move is overdone or would be happy selling just over current levels Based on this outlook we decide to explore selling a call option against our shares 8
Covered Call DHI @ 39.00 Expiration Date Trading Days 39.00 Call 40.00 Call 6-Oct 6 0.40 0.10 13-Oct 11 0.55 0.20 20-Oct 16 0.75 0.30 27-Oct 21 0.85 0.45 3-Nov 26 0.95 0.55 10-Nov 31 1.35 0.90 17-Nov 36 1.45 1.05 Sell 1 DHI Oct 27 th 40.00 Call at 0.45 Data Source: www.livevolpro.com 9
Covered Call Long 100 DHI at 39.00 + Short 1 Oct 27 th 40.00 Call at 0.45 6 4 2 0 37 38 39 40 41 42 43-2 -4 10
Cash Secured Put The cash secured put has been rising in popularity over the past few years as investor knowledge of the option market has increased A cash secured put combines a short put position with cash The cash portion of this spread results in the position holder having the ability to make good on the obligation to buy shares that accompanies a short put Two potential motivations behind a cash secured put may be either to purchase shares at a discount to current prices or receive income from selling the put with out purchasing shares 11
Cash Secured Put October 20, 2017 SPX at 2568.88 Sell SPX Nov 17 th 2565 Put at 16.80 12
Cash Secured Put Cash + Short Nov 2565 Put Payoff At Expiration 30 20 10 0-10 -20 2515 2540 2565 2590 November 17 th Settlement 2571.76-30 -40-50 -60-70 13
Winged Spreads Iron butterflies and iron condors are a type of spread known as a winged spread These trades target a range of price levels for the underlying stock or index Typically these are neutral trades, but can be directional as well In order to realize the full profit of a condor or butterfly it will need to held until just before or through expiration 14
Winged Spreads Iron Butterfly Example 11/29/2017 SPX @ 2626.07 Buy SPX Dec 22 nd 2600 Put at 13.60 Sell SPX Dec 22 nd 2625 Put at 21.30 Sell SPX Dec 22 nd 2625 Call at 22.10 Buy SPX Dec 22 nd 2650 Call at 10.60 Net Credit = 19.20 15
Winged Spreads SPX Dec 22 nd 2600 2625 2650 Iron Butterfly Payoff Diagram 25 20 At Expiration 15 10 5 2 Days to Expiration 0 2590 2595 2600 2605 2610 2615 2620 2625 2630 2635 2640 2645 2650 2655 2660-5 -10 16
Winged Spreads SPX Dec 22 nd 2600 2625 2650 Iron Butterfly Time Decay 25 20 At-The-Money Options 15 Out-of-The-Money Options 10 5 0 16 14 12 10 8 6 4 2 0 17
Winged Spreads Iron Condor Example 11/29/2017 RUT @ 1542.30 Buy RUT Dec 22 nd 1520 Put at 13.80 Sell RUT Dec 22 nd 1530 Put at 16.80 Sell RUT Dec 22 nd 1555 Call at 15.30 Buy RUT Dec 22 nd 1565 Call at 11.40 Net Credit = 6.90 18
Winged Spreads RUT Dec 22 nd 1520 1530 1555 1565 Iron Condor Payoff 8 6 At Expiration 4 2 2 Days to Expiration 0 1510 1515 1520 1525 1530 1535 1540 1545 1550 1555 1560 1565 1570 1575-2 -4 19
The Warren Buffett Put Trade In his 2002 annual letter Warren Buffett stated this, In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal And ever since it has been used incorrectly by the financial press. 20
The Warren Buffett Put Trade In the 2008 annual letter Buffett let us know this, From 2004 and 2008 Berkshire Hathaway entered into a few dozen over the counter option trades. They sold at the money puts on four broad based equity market indexes; the S&P 500, FTSE 100, Euro Stoxx 50, and Nikkei 225 taking in a total of $4.5 billion in premiums. The financial press sort of missed this one. 21
The Warren Buffett Put Trade Index Price Chart 250 200 Buffett Selling Puts S&P 500 Nikkei 225 FTSE 100 EuroStoxx 50 150 100 50 2003 2006 2008 2011 2013 2016 Data Source: Bloomberg 22
The Warren Buffett Put Trade A few years ago some of the trades were taken off and a profit of $222 million was realized Currently index puts that were sold for $4.2 billion remain outstanding As of the end of the 3 rd quarter the value of the remaining options, using a pricing model, was $2.19 million placing the unrealized profit at about $2 billion The intrinsic value of these options is down to $640 million These options begin to expire on June 2018 23
The Warren Buffett Put Trade $3.00 Put Trade Performance $2.00 $1.00 $0.00 2008 2009 2010 2011 2012 2013 2014 2015 2016 3Q2017 ($1.00) ($2.00) ($3.00) ($4.00) ($5.00) ($6.00) Data Source: www.berkshirehathaway.com 24
Summary All levels of successful option traders find a way to have time decay work for them Cboe has several indexes that show how these strategies have worked over time, but also in certain market environments Option strategies are appropriate for all levels of traders, even older gentlemen living in Nebraska Contact for future questions rhoads@cboe.com 25