Copyright 2015 Craig E. Forman All Rights Reserved. Basic Options Review. A Real Financial Network for the Individual Investor

Disclosure All investments involve risk and are not suitable for all investors. The past performance of a security, industry, sector, or market of a financial product does not guarantee future results or returns. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies may be obtained from your broker or the Options Clearing Corporation at 1-888-OPTIONS or visit www.888options.com. Any strategies discussed here, including examples using actual securities and price data, are strictly for illustrative and education purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities. The author of this presentation, and the content of the website www.tastytrader.net are in no way approved, endorsed, supported, or affiliated with tastytrade. We are a third party with interest in the tastytrade content, and the purpose of the information presented here is for education only. The ideas presented here are solely the views of the author, and are meant to enhance the ability of the individual investor in managing personal investments using the strategies and ideas set forth by tastytrade. 2

Topic Summary Puts and Calls, Rights and Obligations Long and Short options Intrinsic and Extrinsic Value ATM, OTM, ITM Volume and Open Interest Option Spreads Profit and Loss Graphs The Normal Distribution, Standard Deviation, and Fat Tails The Option Pricing Model Volatility, Probability of Expiring, Probability of Touch Expected Move Calculations 3

Puts and Calls Puts and Calls are contracts between a buyer and a seller. A Call is the Right to Buy the underlying at a specific price on or before a specific date. A Put is the Right to Sell the underlying at a specific price on or before a specific date. The buyer of an option has the Right to buy or sell the underlying. The seller of an option has the Obligation to buy or sell the underlying Buyer of CALL Option Seller of CALL Option Buyer of PUT Option Seller of PUT Option RIGHT to BUY underlying Debit Transaction (Pay) OBLIGATION to SELL underlying Credit Transaction (Get Paid) RIGHT to SELL underlying Debit Transaction (Pay) OBLIGATION to BUY underlying Credit Transaction (Get Paid) 4

Long and Short We are LONG an underlying stock if we have PAID to acquire shares. We are SHORT an underlying stock if we have SOLD shares in a stock that we don t own, we have borrowed it. We have an obligation to acquire shares of the stock at a later date to return them to the party from whom we borrowed them. We are LONG an option if we have PAID for the RIGHT to buy or sell the underlying per the contract terms. We are SHORT an option if we have BEEN PAID to assume the OBLIGATION to buy or sell the underlying per the contract terms. 5

ATM, ITM, OTM and Intrinsic vs. Extrinsic A CALL option is AT THE MONEY (ATM) if underlying price = strike price. A PUT option is AT THE MONEY (ATM) if underlying price = strike price. A CALL option is IN THE MONEY (ITM) if underlying price > strike price. We say that the option has INTRINSIC as well as EXTRINSIC value. A CALL option is OUT OF THE MONEY (OTM) if underlying price < strike price. The option has only EXTRINSIC value. A PUT option is IN THE MONEY (ITM) if underlying price < strike price. We say that the option has INTRINSIC as well as EXTRINSIC value. A PUT option is OUT OF THE MONEY (OTM) if underlying price > strike price. The option has only EXTRINSIC value. 6

Volume and Open Interest When we buy or sell an option contract, the VOLUME increases by the number of contracts traded (bought and sold). If we bought or sold the option as an OPENING position, and the counterparty also bought or sold the option as an OPENING position, the OPEN INTEREST increases by the number of contracts that were traded. If we bought or sold the option as an OPENING position, and the counterparty bought or sold the option as a CLOSING position, the OPEN INTEREST remains unchanged. If we bought or sold the option as a CLOSING position, and the counterparty bought or sold the option as a CLOSING position, the OPEN INTEREST decreases by the number of contracts that were traded. The OPEN INTEREST is computed at the end of each trading session. The VOLUME is continuously updated throughout the trading session. 7

Option Spreads An option spread is a trade that is made up of more than one option leg. Each leg of a spread can be either a put or a call, and can be either short or long. Option spreads typically can have 2, 3, or 4 legs, and can be entered as a single order. More complex options spreads are possible, but would have to be entered as multiple orders. An option spread can be entered for either a net credit or net debit. For example, a vertical CALL CREDIT SPREAD on IBM might look like this: Sell 10 contracts IBM March 170 call at $.40 credit per contract Buy 10 contracts IBM March 180 call at $.10 debit per contract Net Credit is $.30 per contract, or $300 for 10 contracts, since each contract is for 100 shares. Max profit on the trade is $300, Max loss is $9700. 8

Profit and Loss Graphs Profit and Loss (P&L) graphs are a graphical way of showing us how an options position s value will change as the price of the underlying changes. 9

The Normal Distribution Assumes that price has an equal chance of moving up or down. One standard deviation contains expected price movement with 68.2% probability. Two standard deviations contains expected price movement with 95.4% probability. 10

Normal Distribution and the Fat Tails Normal distribution assumes that price has an equal chance of moving up or down. With stock prices, we find that there is a greater chance of making a large move than predicted by the normal distribution. We call these fat tails. 11

The Options Pricing Model Options pricing can be modeled, most common is called Black- Sholes. There are 5 inputs to the model: Underlying Price Strike Price Days to Expiration Volatility Cost of Carry (interest rates - dividends) Options Pricing Model Option Price Question: Which input is the least important / least relevant? The most? Question: Who sets the price of an option? 12

Volatility and Probability of Expiring The width of the normal distribution is a measure of VOLATILITY. Volatility is a synonym for the statistical term variance, and is mean reverting. As volatility increases, the expected movement of an underlying price increases, or one could say that uncertainty about price increases. There are 2 main types of volatility, Historical Vol and Implied Vol Volatility is 1 of the 5 INPUTS to the option pricing model, but it is the only one that we do not know accurately. This is most interesting to traders. Implied Volatility is calculated from the model based on option pricing, and changes based on market conditions, so it is really a model OUTPUT. IV tells us the expected percentage move in price (+/-) in one year. For a given IV, we can estimate probability of a stock price at expiration. Probability of Touch (POT) is approximately 2x Probability of expiring ITM. 13

Implied Volatility and % Expected Move % Expected Move = IV * Sqrt (DTE / 365) Lets you estimate the move based on the IV Quick Estimation from above formula: 1 Day expected move = IV / 19.1 1% daily move in price is expected with a 19.1% IV 30 Day expected move = IV / 3.5; 60 Day = IV / 2.5; 90 Day = IV / 2 Question: A stock has IV = 38. Current price is $200. How much can you expect the stock to move in one day? Question: A stock has IV = 25. Current price is $200. How much can you expect the stock to move in 60 days? 14

Homework Basic Options Answer the two questions on the previous slide. Watch these segments on basic probability, standard deviation and volatility: Market Measures 6/19/12 Standard Deviation, Part 2 What Else Ya Got 10/3/14 Market Measures 11/8/12 OTHER HOMEWORK: 1. Get familiar with both TOS and dough. Vol Products Explained Probability of Touching 2. If you don t already have one, open a FREE paper trading account on TOS (or another broker), so that you can practice trading without risking real $$. 3. Open up an account on dough, IT s FREE. 4. If you are new to options, do the doughjo sections 1-6 and do ALL the quizzes. An outline is posted at www.tastytrader.net in the downloads section. 5. Think about the discussion questions for next session (next slide). 15

Discussion: Questions for Next Session Why is volatility so important? If it is an input to the options pricing model, why don t we know what it is? If we say that a stock has an standard deviation of +/- $10 per share over the next year, what does that mean? What are the chances of a stock making a 2 standard deviation move? What are the chances of a stock making a 1 standard deviation UP move? What is the difference between historic and implied volatility? If volatility rises, will it help or hurt our options position? Is it better to be a buyer or seller of options? Can volume of options traded be greater than open interest? For a short options position, if prob of expiring ITM is 10%, what is POT? 16