Indiana University South Bend. Presenter: Roma Colwell-Steinke

Indiana University South Bend Presenter: Roma Colwell-Steinke

Option Strategies Outline Covered Call Protective Put The Collar Cash Secured Put Vertical Spreads Iron Butterfly Iron Condor ITM, ATM, OTM and Option Deltas Intrinsic and Time Value Earnings and Implied volatility CBOE OPTIONS INSTITUTE 2

Covered Call Terminology Long Stock + Short Call = Covered Call When you sell a call option you take on the obligation to sell shares When you own the shares the obligation to sell is covered by the long stock position CBOE OPTIONS INSTITUTE 4

Covered Call Overview You own 100 Shares of stock VRM trading at 48.50 You would be willing to sell your shares at 5 over the next few weeks Trade Sell 1 1-Month 50 Strike Call for 1.75 Total Premium Received = 100 x $1.75 = $175 CBOE OPTIONS INSTITUTE 5

Covered Call Long VRM at 48.50 + Short 1 50 Call at 1.75 Payoff Table Stock Price at Stock Profit / Expiration Loss 4 (8.50) 45.00 (3.50) 48.50 5 1.50 51.75 3.25 55.00 6.50 Short 50 Call Value (1.75) (5.00) Short 50 Call Income 1.75 1.75 1.75 1.75 1.75 1.75 Total Profit / Loss (6.75) (1.75) 1.75 3.25 3.25 3.25 CBOE OPTIONS INSTITUTE 6

Covered Call Long VRM at 48.50 + Short VRM 50 Call at 1.75 Payoff Diagram 8 6 4 2 0-2 -4 Covered Call 45 50 55 Long Stock at 48.50 Effective Selling Price = 51.75-6 -8 CBOE OPTIONS INSTITUTE 7

Covered Call Summary For a new option trader the covered call is a great first trade with a stock that is close to a target price The strategy may also be used to generate portfolio income if you believe a stock will be below a certain price at expiration CBOE OPTIONS INSTITUTE 8

Protective Put Overview You own 100 Shares of stock OKST trading at 62.50 You are concerned that OKST is going to drop 10% or more in the next four weeks Trade Buy 1 OKST 1-Month 60 Put at 1.00 Total Cost = 100 x $1.00 = $100 CBOE OPTIONS INSTITUTE 10

Protective Put Long OKST at 62.50 + Long 1 60 Put at 1.00 Payoff Table Stock Price at Stock Profit / Long 60 Long 60 Expiration Loss Put Value Put Cost 55.00 (7.50) 5.00 (1.00) 57.50 (5.00) 2.50 (1.00) 6 (2.50) (1.00) 62.50 (1.00) 65.00 2.50 (1.00) 67.50 5.00 (1.00) Total Profit / Loss (3.50) (3.50) (3.50) (1.00) 1.50 4.00 CBOE OPTIONS INSTITUTE 11

Protective Put Long OKST at 62.50 + Long 1 OKST 60 Put at 1.00 Payoff Diagram 10 8 6 4 Break-Even 63.50 2 0 52.50 55.00 57.50 6 62.50 65.00 67.50-2 -4-6 Max Loss (3.50) -8 CBOE OPTIONS INSTITUTE 12

Protective Put Long OKST at 62.50 + Long 1 OKST 60 Put at 1.00 Payoff Diagram 10 8 6 4 Unhedged Long Stock 2 0 52.50 55.00 57.50 6 62.50 65.00 67.50-2 -4-6 Protected from losses -8 CBOE OPTIONS INSTITUTE 13

Protective Put Summary The protective put is a good strategy if you are bullish long term on a stock but concerned about near term price behavior Some upside is sacrificed but there is still the ability to benefit from price appreciation in the underlying market CBOE OPTIONS INSTITUTE 14

The Collar Overview You own 100 Shares of stock OKST trading at 62.50 You are concerned that OKST is going to drop 10% or more in the next four weeks but would be willing to sell a little higher Trades Buy 1 OKST 1-Month 60 Put at 1.00 Sell 1 OKST 1-Month 65 Call at 1.10 Total Income = 100 x ($1.10 $1.00) = $10 CBOE OPTIONS INSTITUTE 16

The Collar Long 100 OKST + Short 65 Call + Long 60 Put Payoff Table Stock Price at Expiration 55.00 57.50 6 62.50 65.00 67.50 7 Stock Long 60 Short 65 Initial Total Profit / Profit / Loss Put Value Call Value Credit Loss (7.50) 5.00 0.10 (2.40) (5.00) 2.50 0.10 (2.40) (2.50) 0.10 (2.40) 0.10 0.10 2.50 0.10 2.60 5.00 (2.50) 0.10 2.60 7.50 (5.00) 0.10 2.60 CBOE OPTIONS INSTITUTE 17

The Collar Long 100 OKST + Short 65 Call + Long 60 Put Payoff Diagram 8 6 4 2 Break-Even 62.60 Maximum Gain 2.60 0 57.50 6 62.50 65.00 67.50-2 -4-6 Maximum Loss (2.40) -8 CBOE OPTIONS INSTITUTE 18

The Collar Long 100 OKST + Short 65 Call + Long 60 Put Payoff Diagram 8 6 4 2 Unhedged Stock Profit / Loss 0 57.50 6 62.50 65.00 67.50-2 -4-6 -8 CBOE OPTIONS INSTITUTE 19

The Collar Summary A collar allows a trader to have low cost protection against a downside move in the underlying market This protection is paid for by giving up some upside CBOE OPTIONS INSTITUTE 20

Cash Secured Put Purchasing Stock A seller of a put option takes on the obligation to buy shares of the underlying stock Berkshire Hathaway has used this method in the past to acquire shares of companies they find attractive CBOE OPTIONS INSTITUTE 22

Cash Secured Put Trading Example IBM is trading at $174.00 a share January expiration is in 40 days Berkshire Hathaway s average cost in 2010 was just under $17 A 170 strike put option may be sold and the result is the obligation to purchase shares Sell 1 IBM Jan 170 Put @ 2.25 CBOE OPTIONS INSTITUTE 23

Cash Secured Put Trading Example Short 1 IBM Jan 170 Put at 2.25 Payoff Table IBM 160 165 170 175 180 185 Short 1 Jan 170 Put -1-5.00 Premium Received Profit / Loss 2.25-7.75 2.25-2.75 2.25 2.25 2.25 2.25 2.25 2.25 2.25 2.25 IBM Position Long 100 Long 100 Long 100 No Position No Position No Position CBOE OPTIONS INSTITUTE 24

Cash Secured Put Trading Example Short 1 Jan IBM 170 Put at 2.25 Payoff Diagram 4 2 0-2 -4-6 -8 165 170 175 180 Break Even 167.75 No IBM Position 2.25 Profit Long 100 IBM @ 167.75-10 CBOE OPTIONS INSTITUTE 25

Spread Trades Overview Spread trades are an effective method of trading a specific price and time outlook for an underlying (equity, index or ETF) A spread trade consists of buying and selling various options with the same underlying A spreads can be directional spread (Bullish Bearish) or A neutral spread when the forecast in the underlying is trading in a narrow range Spread trades have a range for maximum profit with a minimum amount of risk CBOE OPTIONS INSTITUTE 27

Bullish Vertical Spread Introduction A Bullish Vertical Spread may be structured in two ways All Call Options Long lower strike / short higher strike Pay a Debit for initiating the trade All Put Options Long lower strike / short higher strike Receive a Credit for initiating trade CBOE OPTIONS INSTITUTE 28

Bullish Vertical Spread Examples Bull Call Spread Long 1 XYZ 45 Call at 6.50 Short 1 XYZ 50 Call at 4.00 Pay Debit of 2.50 Bull Put Spread Long 1 XYZ 35 Put at 2.00 Short 1 XYZ 40 Put at 5.50 Receive Credit of 3.50 CBOE OPTIONS INSTITUTE 29

Bullish Vertical Spread Call Spread Example XYZ Trading at 44.00 Bullish outlook for XYZ Target price of 5 in 45 Days 45 Day Option Pricing Bid Ask 40 Call 4.70 4.75 45 Call 1.75 1.80 50 Call 0.45 0.50 Buy 1 45 Call at 1.80 Sell 1 50 Call at 0.45 Net Cost = 1.35 CBOE OPTIONS INSTITUTE 30

Bullish Vertical Spread Long 45 Call at 1.80 / Short 50 Call at 0.45 Payoff at Expiration Stock 45 Call 50 Call Trade Cost P/L 40 45 50 55 60 5.00 1 15.00 (5.00) (1) (1.35) (1.35) (1.35) (1.35) (1.35) (1.35) (1.35) 3.65 3.65 3.65 Recall Target Price = 5 CBOE OPTIONS INSTITUTE 31

Bullish Vertical Spread Long 45 Call at 1.80 / Short 50 Call at 0.45 Payoff Diagram 4 Max Gain +3.65 3 2 1 XYZ 44.00 Break even 45.00 + 1.35 = 46.35 Target price 5 0 45.00 5-1 Max Loss -1.35-2 CBOE OPTIONS INSTITUTE 32

Bullish Vertical Spread Long 45 Put at 2.50 / Short 50 Put at 6.15 XYZ Trading at 44.00 Bullish outlook for XYZ Target price of 5 in 45 Days 45 Day Option Pricing Bid Ask 40 Put 0.65 0.70 45 Put 2.45 2.50 50 Put 6.15 6.20 Buy 1 45 Put at 2.50 Sell 1 50 Put at 6.15 Net Credit = 3.65 CBOE OPTIONS INSTITUTE 33

Bullish Vertical Spread Long 45 Put at 2.50 / Short 50 Put at 6.15 Payoff at Expiration Stock 45 Put 50 Put Credit P/L 40 45 50 55 60 5.00 (1) (5.00) 3.65 3.65 3.65 3.65 3.65 (1.35) (1.35) 3.65 3.65 3.65 Recall (again) Target Price = 5 CBOE OPTIONS INSTITUTE 34

Bullish Vertical Spread Long 45 Put at 2.50 / Short 50 Put at 6.15 Payoff Diagram 4 Max Gain +3.65 3 2 1 XYZ 44.00 Break even 45.00 + 1.35 = 46.35 Target price 5 0-1 45.00 5 Max Loss -1.35 Yes it is all the same as the call spread example -2 CBOE OPTIONS INSTITUTE 35

Bullish Vertical Spread Call vs. Put Spread Two major differences Call spread initiated with a cost Put spread resulted in income The second difference relates to what happens at expiration CBOE OPTIONS INSTITUTE 36

Bullish Vertical Spread Call vs. Put Spread Target was 5 assume the stock is over 5 at expiration Call Spread Long 45 Call Exercised Buy 100 Shares Short 50 Call Assigned Sell 100 Shares Put Spread Long 45 Put Expires Short 50 Put Expires Many traders prefer this outcome CBOE OPTIONS INSTITUTE 37

Bearish Vertical Spread Introduction A Bearish Vertical Spread may be structured in two ways All Put Options Long higher strike / short lower strike Pay a Debit for initiating the trade All Call Options Long higher strike / short lower strike Receive a Credit for initiating trade CBOE OPTIONS INSTITUTE 38

Bearish Vertical Spread Examples Bear Put Spread Short 1 XYZ 25 Put at 5.20 Long 1 XYZ 30 Put at 7.50 Pay Debit of 2.50 Bear Call Spread Short 1 XYZ 55 Call at 7.00 Long 1 XYZ 60 Call at 5.00 Receive Credit of 2.00 CBOE OPTIONS INSTITUTE 39

Bearish Vertical Spread Call Spread Example XYZ Trading at 44.00 Bearish outlook for XYZ Target price of 4 in 45 Days 45 Day Option Pricing Bid Ask 40 Call 4.70 4.75 45 Call 1.75 1.80 50 Call 0.45 0.50 Sell 1 40 Call at 4.70 Buy 1 45 Call at 1.80 Net Credit = 2.90 CBOE OPTIONS INSTITUTE 40

Bearish Vertical Spread Short 1 40 Call at 4.70 / Long 1 45 Call at 1.80 Payoff at Expiration Stock 40 Call 45 Call Credit P/L 35 40 45 50 55 (5.00) (1) (15.00) 5.00 1 2.90 2.90 2.90 2.90 2.90 2.90 2.90 (2.10) (2.10) (2.10) Recall Target Price = 4 CBOE OPTIONS INSTITUTE 41

Bearish Vertical Spread Short 1 40 Call at 4.70 / Long 1 45 Call at 1.80 Payoff Diagram 4 3 Max Gain +2.90 XYZ 44.00 2 1 0 Target price 4 4 45.00-1 -2-3 Break even 4 + 2.90 = 42.90 Max Loss -2.10 CBOE OPTIONS INSTITUTE 42

Vertical Spreads Overview You may always exit a vertical spread trade (or any option trade) before expiration However, the maximum profit for a vertical spread is usually not achieved until expiration Because of this short dated options (weeklys) are ideal for trading vertical spreads Traders tend to focus more on credit than debit spreads The preference for credit spreads emanates from receiving a credit when the trade is initiated as well as the options expiring out of the money if the forecast is correct CBOE OPTIONS INSTITUTE 43

Iron Butterfly Introduction Consists of a position in four different option contracts It may also be thought of as a combination of a bear call spread and bull put spread A call and put with the same strike price are sold Two options are also purchased a lower strike put and a higher strike call The result is a neutral spread trade with a range where the maximum profit would be realized CBOE OPTIONS INSTITUTE 45

Iron Butterfly Basic Example XYZ at 5 Long 1 XYZ 45 Put Short 1 XYZ 50 Put Short 1 XYZ 50 Call Long 1 XYZ 55 Call Bull Put Spread Bear Call Spread Both Bull Put and Bear Call spreads are credit spreads Iron Butterfly will always bring in a credit CBOE OPTIONS INSTITUTE 46

Iron Butterfly Trading Example XYZ Trading at 4 Neutral outlook for XYZ Expect stock to trade in a tight range in 45 Days Buy 1 XYZ 35 Put at 0.25 Sell 1 XYZ 40 Put at 1.70 Sell 1 XYZ 40 Call at 1.65 Buy 1 XYZ 45 Call at 0.30-0.25 + 1.70 + 1.65-0.30 = 2.80 Net Credit = 2.80 CBOE OPTIONS INSTITUTE 47

Iron Condor Trading Example Payoff at Expiration Stock 35 Put 40 Put 40 Call 45 Call Credit P/L 30 35 40 45 50 5.00 (1) (5.00) (5.00) (1) (5.00) 2.80 2.80 2.80 2.80 2.80 (2.20) (2.20) 2.80 (2.20) (2.20) CBOE OPTIONS INSTITUTE 48

Iron Butterfly Trading Example Payoff Diagram 4 3 Max Gain +2.80 2 1 0 Break even 35.00-1.50 = 33.50 XYZ 4 35.00 4 45.00 Break even 4 + 1.50 = 41.50-1 -2 Max Loss -2.20-3 CBOE OPTIONS INSTITUTE 49

Iron Condor Introduction Consists of a position in four different option contracts It may also be thought of as a combination of a bear call spread and bull put spread Bull put strike prices are lower than the bear call strikes The center strike options are sold and outside strike are purchased The result is a neutral spread trade with a range where the maximum profit would be realized CBOE OPTIONS INSTITUTE 51

Iron Condor Basic Example XYZ at 47.50 Long 1 XYZ 40 Put Short 1 XYZ 45 Put Short 1 XYZ 50 Call Long 1 XYZ 55 Call Bull Put Spread Bear Call Spread Both Bull Put and Bear Call spreads are credit spreads Iron Condor will always bring in a credit CBOE OPTIONS INSTITUTE 52

Iron Condor Trading Example XYZ Trading at 37.50 Neutral outlook for XYZ Expect stock in 35.00 4 range in 45 Days Buy 1 XYZ 30 Put at 0.15 Sell 1 XYZ 35 Put at 0.90 Sell 1 XYZ 40 Call at 0.95 Buy 1 XYZ 45 Call at 0.20-0.15 + 0.90 + 0.95-0.20 = 1.50 Net Credit = 1.50 CBOE OPTIONS INSTITUTE 53

Iron Condor Trading Example Payoff at Expiration Stock 30 Put 35 Put 40 Call 45 Call Credit P/L 25 30 35 40 45 50 5.00 (1) (5.00) (5.00) (1) 5.00 1.50 1.50 1.50 1.50 1.50 1.50 (3.50) (3.50) 1.50 1.50 (3.50) (3.50) CBOE OPTIONS INSTITUTE 54

Iron Condor Trading Example Payoff Diagram 2 1 0 Break even 35.00-1.50 = 33.50 Max Gain +1.50 Break even 4 + 1.50 = 41.50 3 35.00 4 45.00-1 -2 XYZ 37.50-3 Max Loss -3.50-4 CBOE OPTIONS INSTITUTE 55

Iron Butterfly vs. Iron Condor Strategy Comparisons Iron Butterfly usually takes in more income than a comparable Iron Condor An Iron Condor will have a higher likelihood than the Iron Butterfly of realizing a maximum payoff The break even points are usually wider for an Iron Condor than an Iron Butterfly A picture may help with all this CBOE OPTIONS INSTITUTE 56

Iron Butterfly vs. Iron Condor Strategy Comparisons Payoff Diagrams CBOE OPTIONS INSTITUTE 57

ITM, ATM, OTM and Delta Price of Stock Stock at 3 Price Delta ITM 27 Call 3.40 0.85 ITM 28 Call 2.70 0.75 ITM 29 Call 2.00 0.60 ATM 30 Call 1.50 0.50 OTM 31 Call 1.05 0.45 OTM 32 Call 0.75 0.35 OTM 33 Call 0.50 0.25 1.00 CBOE OPTIONS INSTITUTE 59

ITM, ATM, OTM and Delta Price of Stock Stock at 3 Price Delta OTM 27 Put 0.35-0.15 OTM 28 Put 0.60-0.25 OTM 29 Put 0.95-0.40 ATM 30 Put 1.45-0.50 ITM 31 Put 2.00-0.55 ITM 32 Put 2.65-0.65 ITM 33 Put 3.40-0.75-1.00 CBOE OPTIONS INSTITUTE 60

Delta Price of Stock Delta Expected change in the price of an option based on a one-point change in the stock Delta for a call option is positive Range will be to 1.00 Delta for a put option is negative Range will be -1.00 to Option prices change less than the underlying market prices CBOE OPTIONS INSTITUTE 61

Intrinsic Value and Time Value Intrinsic Value The amount that an option is in the money Time Value The portion of an option price that is above the intrinsic value CBOE OPTIONS INSTITUTE 63

Intrinsic Value and Time Value XYZ at 55.00 XYZ 50 Call at 8.00 Price of 50 Call 8.00 Time Value 3.00 Stock Price 55.00 Intrinsic Value 5.00 + Time Value 3.00 Intrinsic Value 5.00 Market Value 8.00 Strike Price 5 CBOE OPTIONS INSTITUTE 64

Intrinsic Value and Time Value XYZ at 45.00 XYZ 50 Put at 7.00 Strike Price 5 Intrinsic Value 5.00 Stock Price 45.00 Time Value 2.00 Price of 50 Put 7.00 + Time Value 2.00 Intrinsic Value 5.00 Market Value 7.00 CBOE OPTIONS INSTITUTE 65

Intrinsic Value and Time Value Intrinsic Value Many consider intrinsic value to be the economic value of an option if it is exercised Only an in-the-money option will have intrinsic value Another term for intrinsic value that is often used is exercise value If there is no value in exercising an option then there is no intrinsic value for that option Time Value The market value of an option above the intrinsic value Several factors come into play to determine the time value of an option contract For an option with no intrinsic value the market value of the option is attributed 100% to time value CBOE OPTIONS INSTITUTE 66

Implied Volatility Six Option Pricing Factors Price of Stock Option Strike Price Time Until Expiration Interest Rates Dividends Implied Volatility CBOE OPTIONS INSTITUTE 68

Implied Volatility Two Types of Volatility Historical Volatility based on past stock price changes Implied Volatility expected volatility based option market pricing CBOE OPTIONS INSTITUTE 69

Earnings and Implied Volatility Implied Volatility: Volatility that is in the market price of an option Implied volatility is the market s forecast of the future volatility of the stock s price CBOE OPTIONS INSTITUTE 70

Why Does Volatility Change? Corporate Earnings News World Events Supply and Demand CBOE OPTIONS INSTITUTE 71

Earnings and Implied Volatility Stock IV 25 Strike Call (25 Strike Calls closed $1.00) Earnings Released $21 50% $1.00 $24 48% $2.10 CBOE OPTIONS INSTITUTE 72

Earnings and Implied Volatility Stock IV 25 Strike Call (25 Strike Calls closed $1.00) Earnings Released $21 50% $1.00 $24 35% $1.10 CBOE OPTIONS INSTITUTE 73

Summary When considering an option trade begin with a price forecast for the underlying market Long Call and Long Put trades are basic directional trades A covered call is the most basic spread trade that involves owning a stock and selling a call option against the stock position A put may be purchased against a long stock position to protect against a downside move The collar combines a covered call and protective put with the result being a position that has limited upside and downside A seller of a put option takes on the obligation to buy shares of the underlying stock ITM, ATM, OTM relationship to Delta Option Pricing: Intrinsic Value and Time Value Three Main Pricing Components: Underlying Stock Price, Time Until Expiration and Implied Volatility Different time periods, and changing volatility should be considered before a trading decision is made. CBOE OPTIONS INSTITUTE 74