1 options graham o’brien. disclaimer this material contains information only. asx does not...
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OPTIONS
GRAHAM O’BRIEN
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Disclaimer
This material contains information only. ASX does not represent or warrant that it is complete or accurate. The information is for education purposes only and any advice should be sought from a professional adviser. If you are seeking advice (including a recommendation or opinion) about a financial product you should consult an Australian financial services licensee. To the extent permitted by law, no responsibility for any loss arising in any way (including by way of negligence) suffered by anyone acting or refraining from acting as a result of this material is accepted by ASX. This disclaimer extends to any private discussions or correspondence with the presenter of this information.
©Copyright ASX Operations Pty Limited ABN 42 004 523 782 (‘ASXO’). All rights reserved. This publication should not be reproduced, stored in a retrieval system or transmitted in any form, whether in whole or in part, without the prior written consent of ASXO.
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What are options?Exchange Traded OptionsCalls v Puts Options pricingThree common strategies
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What are options?
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Exchange Traded Options create unique payoffs
Prior to the creation of options, only three choices existed:
Options give you options!
CashLong a position
B
Short a position
S
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Share price
Pay-off diagram
Loss
Profit
Current share price
Long stock
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Share price
Pay-off diagram
Current share price
Loss
Profit Short stock
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Share price
Pay-off diagram
Cash
Loss
Profit
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Share price
Pay-off diagram
Loss
Profit
Earn income (Premium)
Protect losses
Current share price
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What are Exchange Traded Options?
A contract between two parties conveying a right, but not an obligation, to buy (call) or sell (put) an underlying
security at a specified price within a specified time for an agreed premium
B S
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Components of an Option
Loss
Profit
An expiration date December, January 2015 etc.
An underlying security ANZ, BHP, RIO, TLS, XJO
Premium or Price
Strike price
Every option contract has:
Type Put or Call
Pay-off diagram for a call
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75 stocks and 1 index
AGL BSL GMG NCM SGM WES
AIO BXB GPT NWS SGP WFD
AMC CBA HVN ORG SHL WOR
AMP CCL IAG ORI STO WOW
ANN CIM IFL OSH SUN WPL
ANZ CPU ILU OZL SYD XJO
ARI CSL IPL QAN TAH
ASX CSR JHX QBE TCL
AWC CTX LLC RIO TEN
AZJ CWN MPL RMD TLS
BEN EGP MQG RRL TOL
BHP FLT MTS S32 TTS
BLD FMG MYR SCG TWE
BOQ FXJ NAB SEK WBC
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Calls v puts
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B
Call Put
Calls vs Puts (rights vs obligations)
The right (but not the obligation)
to buy
The right (but not the obligation)
to sell
The option buyer (holder of a long position) has the right to purchase or sell the underlying instrument at a:
Specified time (until the
expiration date)
The option buyer pays a premium
for this right
Specific price (the strike price)
B
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B
Call Put
Calls vs Puts (rights vs obligations)
Once you have purchased an option (established a long position) you can:
Sell it
Exercise your right
Let it expire
The right (but not the obligation)
to buy
The right (but not the obligation)
to sell
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S
Calls vs Puts (rights vs obligations)
The potential obligation
to buy
The potential obligation
to sell
The option seller (creator of a short position) is obligated to sell or purchase the underlying instrument at a:
Call Put
Specified time (until the
expiration date)
The option seller receives a premium
for assuming this obligation
Specific price (the strike price)
S
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Calls vs Puts (rights vs obligations)
Once you have sold an option (established a short position) you can:
Buy it back
Let it expire
Be assigned to fulfill your obligation
S
The potential obligation
to buy
The potential obligation
to sell
Call Put
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Calls vs Puts (rights vs obligations)
S
The potential obligation
to buy
The potential obligation
to sell
Call Put
B
Call PutThe right
(but not the obligation)
to buy
The right (but not the obligation)
to sellB
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Call options – Recap
Share price
Loss
Profit
Strike price
Long call
Premium
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Call options – Recap
Share price
Loss
Profit Short callStrike price
Premium
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Call options – Recap
Gives the buyer the right, but not the obligation, to buy a standard quantity of shares at the exercise price, on or before the expiry date
Seller obligated to deliver
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Put options – Recap
Share price
Loss
Profit
Strike price
Long put
Premium
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Put options – Recap
Share price
Loss
Profit Short put
Premium
Strike price
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Put options – Recap
Gives the buyer the right, but not the obligation, to sell a standard quantity of shares for the exercise price on, or before, the expiry date
Seller obligated to buy
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ASX options – key points
Equity optionsContract size: 100 shares
Expiry day: Last Thursday of the month
American style (some Euro style)
Physically settled
Index optionsContract value: $10 per point
Expiry day: Third Thursday of the month
European style
Cash settled
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What are Options?
Exchange Traded Options (ETOs)
Calls v Puts
Options Pricing?
Top 3 Strategies
Options pricing
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Major pricing factors
$4.00
$3.50
Share price
Exercise price
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Major pricing factors
$4.00
$3.50
50c
Intrinsic value
Share price
Exercise price
Share price
Exercise price
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Major pricing factors
$4.00
$3.50 50c 22c
Intrinsic value
Share price
Exercise price Time value
Time to expiry
Dividends
Interest rates
Volatility
Supply and demand
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30
50c
Major pricing factors
$4.00
$3.50
Share price
Exercise price
22c72c
Premium
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Out of the money
In the money
$4.00
$4.50
$5.00
$3.50
In, at or out of the money – calls
$3.00 Series
At the money
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The Greeks
Theta Delta
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Theta
The change in an option’s price given a change in the time to expiration:
Is not constant Accelerates as expiry approaches
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Theta – time decay
Lose 1/3
time value
Lose 2/3
time value
Option life
First half Second half
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The Greeks
Theta Delta
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Delta
The change in an option’s price given a change in the price of the underlying stock or index:
For a $1 change in the price of the underlying stock
Is not constant Calls have positive deltas
Puts have negative deltas
Is highest for “In-the-money”
options
Expressed as 50 delta = .50 delta
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Delta – Call options
0.1
0.5
0.8
Out of the money
Option moves 1/5 as much as share
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Delta – Call options
At the money
0.1
0.5
0.8
Option moves 1/2 as much as share
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Delta – Call options
0.1
0.5
0.8
In the money
Option moves 1 for 1 with share
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Option terminology
Taker/writer
Exchange traded options
Call/put options
Exercise price
Expiry month
Expiry date
Premium
Intrinsic value
Time value
In-the-money
At-the-money
Out-of-the-money
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What are Options?
Exchange Traded Options (ETOs)
Calls v Puts
Options Pricing?
Top 3 Strategies
Three common strategies
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Three common strategies
Selling Calls
Buy-writeGenerating income
Buying Puts
Protecting shares
Buying Calls
Leverage or low-risk?
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Three common strategies
1. Bought Call
Market view:
Bullish
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Buying Calls
Is buying calls risky?
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Buying Calls
Buying Calls ensures you only buy stock after the market confirms your decision
Buys leverage up(calls)
So you only buy stocks when the market confirms your decisions
Go long with limited risk
You don’t get closed out before expiry!
1
2
3
4
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Example – AML MAR/400/CALL
Call Option
Buyer has the right to buy a standard quantity of shares
Shares AML
Exercise price $4.00
Expiry date June
Contracts 10
If the buyer/taker exercises the option, on or before the September expiry date, the writer/seller must sell those shares at $4.00
The writer receives the premium
SB
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Exercise price
The life cycle of a call option
5.00
4.80
4.60
4.40
4.20
4.00
3.80
3.60
3.40
3.20
3.00
Share price ($)
Shares
Options
Time value
Intrinsic value
Months 1 2 3 4 5 6 7 8 9
1.00
0.80
0.60
0.40
0.20
0
Option price ($)
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First rule of call buying
You would not consider buying call options as a sole strategy unlessyou are bullish about the underlying stock
B
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Payoff example
$4.00AML shares
Exercise price
$3.50 72c
Premium
AML/Jun/350 calls
$4.50 16cAML/Jun/450 calls
$4.00AML/Jun/400 calls 38c
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50c
$1.50
Expiry value
$4.00
$1.00
Payoff example
$5.00
Exercise price
$3.50
$4.00
$4.50
AML shares on expiry
AML/Jun/350 calls
AML/Jun/400 calls
AML/Jun/450 calls
$620
$340
$780
Profit
163
213
108
% Return
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50c
$1.50
$1.00
Breakeven points – Bought Call
$4.00
Exercise price
$3.50
$4.00
$4.50
AML shares
AML/Jun/350 calls
AML/Jun/400 calls
AML/Jun/450 calls
72c
Premium
16c
38c
$5.00
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$4.38 P.S.
$4.66 P.S.
Breakeven points – Bought Call
$4.00
$4.22 P.S.
Breakeven price
AML shares
AML/Jun/350 calls
AML/Jun/400 calls
AML/Jun/450 calls
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66c
38c
Increase over current
22c
Breakeven points – Bought Call
$4.00AML shares
AML/Jun/350 calls
AML/Jun/400 calls
AML/Jun/450 calls
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Second rule of call buying
The more bullish you are the more you will consider out-of-the money series
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Leverage
$380$670
$4,000
$4,500
Bought October
Sold December
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68
Leverage
$290
76.3%*
12.5%*
Return on investment
$500
Shares Options
*Not Including Transaction Charges*Not Annualised
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Leverage
$380
$0
$4,000
$3,500
Bought October
Sold December
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70
Leverage
-$380
-100%*
-12.5%*
Return on Investment
-$500
Shares Options
*Not Including Transaction Charges*Not Annualised
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Bought call
Share price
Loss
Profit
$4.00
B
C
A
-0.38
$4.38
Call at expiry
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Bought call – summary
Break even
Exercise price plus premium
Position
Pay premium in full
Risk/reward
Limited riskUnlimited reward
Market view
Bullish
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Three common strategies
2. Portfolio protection
Market view:
Bearish
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Put Options/Protective Puts
Assume bullish on the market
S&P/ASX 200 indexworth $59,500
at 5,950 points
Share
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Put Options/Protective Puts
S&P/ASX 200 indexworth $59,500 at 5,950 points
Nervous about another market correction
Put Options can hedge the portfolio against market hiccups
Share
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Put Options/Protective Puts
S&P/ASX 200 indexworth $59,500 at 5,950 points
1 S&P/ASX 200 September 5950 Puts
Assume price is 160 points each or $1,600 per contract
Share
Consider buying
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Protective Put Purchase
$59,500
Own shares
$1,600
5950 put
$61,100
Position investment (b/e)
Share
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Protective Put Purchase
$61,100
Raise break-even level from $59,500 to $61,100
Incur cost to purchase puts
Limit downside risk to $1,600
$1,600
$1,600
$59,500
$61,100
Position investment (b/e)
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Protective Put Purchase
Puts expire worthless
Lose $1,600 (may be offset by stock gain)
Receive cash ($10) for every point below 5,950
Loss is limited to $1,600 (premium paid for put)Loss
Profit
5,950
XJO at expiration
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Protective Put Purchase
4,950
Stock
Option
Total P&L
XJO at expiration
Loss
Profit
($10,000)
($8,400)
($1,600)
$10,000
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Protective Put Purchase
5,450
Stock
Option
Total P&L
Loss
Profit
($5,000)
($3,400)
($1,600)
$5,000
XJO at expiration
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Protective Put Purchase
5,950
Stock
Option
Total P&L
Loss
Profit
($0)
($1,600)
($1,600)
$0XJO at expiration
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Protective Put Purchase
6,450
Stock
Option
Total P&L
Loss
Profit
($5,000)
($1,600)
($3,400)
$5,000
XJO at expiration
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Protective Put Purchase
6,950
Stock
Option
Total P&L
Loss
Profit
($10,000)
($1,600)
($8,400)
$10,000
XJO at expiration
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The Protective Put Strategy
Acts like insurance
Maximum risk/loss in this example is the
“cost of insurance” $1,600 or 3%
Insurance expires in September
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Benefits – Protective Put Purchase
Benefits Risks
Implement protection only if you need it
Simplicity Expensive when volatility is high
Premium paid for flexibility can result in under-performance
Limit risk to a pre-determined amount
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Three common strategies
3. Buy-writecovered call
Market view:
Neutral
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Buy-Write or Covered Calls
Share price
Loss
Profit
By a certain date (the expiration date)
Receives premium
Call seller agrees to sell shares at an agreed upon price (the strike price)
A call is covered if the investor owns the underlying shares
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89
Selling Calls
Reasons for selling calls against shares currently owned:
Enhance returns from investment
Pre-set sale price for shares
Provide limited downside protection
When to use:
Neutral to moderately bullish on the shares
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Buy-Write
Selecting the opportunity
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Selling Calls
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Buy-Write
Placing the trade
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Selling Calls
Buy 2,000 XYZ shares trading at $39.81/share
Share
Outlook is neutral to moderately bullish on XYZ
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Selling Calls
Buy 2,000 XYZ shares trading at $39.81/share
Share
Want to increase stock return if market is level
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Selling Calls
Sell 20 XYZ December $41.00 Calls at $1.00 each
BS
Share
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Selling Calls
Short 20 XYZ December $41.00 Call at $1.00
Long 2,000 shares in XYZ at $39.81
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Selling Calls
Loss
Profit
Share price
Own 2,000 shares at $39.81
Sell 20 December $41.00 call at $1.00
Overall Position investment (break-even) $38.81
Maximum profit $4,380 ($2.19 per share)
37.81 39.81 41.00
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Selling Calls
Break-even lowered from $39.81 to $38.81
Limited downside protection
Maximum gain = Premium + Gain on stock ($2.19 = $1.00 + $1.19)
There is no further profit participation above $41.00
Called away return
$2.19 or 4.5%
in 90 days
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Loss
Profit
$41.00
XYZ at expiration
At expiry
Option is assigned
Investor must sell shares at $41.00
Seller keeps call premium $1.00
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$41.00
Loss
Profit
XYZ at expiration
At expiry
Call expires worthless
Seller keeps shares and call premium $1.00
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Loss
Profit
XYZ at expiration
At expiry
Option premium provides limited downside protection
Losses will occur below break-even point of $38.81
$37.81
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Selling Covered Calls
Benefits Risks
Income from selling call
Partial hedge Downside risk if stock falls
Caps upside
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Exchange Traded Options
Graham O’BrienFebruary 2014
103
OPTIONS
Thank you ……………………………………
……………………………………