options mu investment club spring 2013. basics mu investment club spring 2013

Options

MU Investment Club Spring 2013

Basics


What is an Option?

An option is a contract that gives Party A to buy or sell something to Party B at a predetermined price.

Stock Options are contracts that allow Party A to buy or sell 100 shares of a certain stock at a specified price per share, or strike price.

Call Option is the right to Buy the stockPut Option is the right to Sell the stock


Ancient History

350 B.C. Thales bought options on olive presses

Romans bought/sold options on cargoesEuropean Options Exchange opened in

Amsterdam in April of 1978Prior to 1963 all options were sold over the

counter


Modern History

In late 1960 Joseph W. Sullivan, Vice President of Planning for the CBOT proposed: standardizing the strike price, expiration, size, and other

relevant contract terms create a mediator to issue contracts and guarantee

settlement and performance (Options Clearing Corporation )April 26, 1973 CBOE began trading on standardized,

listed options. the first day of trading:

only call option 911 contracts traded on 16 underlying stocks.

By the end of 1974, average daily volume exceeded 200,000 contracts


Features of Stock Options

Strike Price (X): the price at which a the underlying stock can be bought or sold

Stock Price (S): the price of a share of the underlying stock

Expiration Date: day option expires; generally the third Friday of the month; options in or at the money will be automatically exercised

Value of Call/Put (C/P): the cost to buy or price to sell an option


Terminology

Long: BuyShort: Sell

In the Money (ITM): an option with intrinsic value and extrinsic value

At the Money (ATM): an option at the strike price

Out of the Money (OTM): an option with only extrinsic value

Terminology

Exercise: going through with an option If you bought a Put option and want to sell your

shares at that strike price, you can exercise your option and someone will have to buy your shares for that price.

Assigned: having to make good on an option contract If you sold a contract and someone on the other end

wants to exercise her right you are obligated to sell that person your shares at the strike price.

Intrinsic and Extrinsic Value


Definitions

Intrinsic Value: the value of the difference between the strike price and stock price that you would receive if you exercised the option today ( zero if at or out of the money)

Extrinsic Value: the difference between the value of the option and the intrinsic value


Examples

Example 1: A call option is selling for $4. It has a strike price of $50 and the stock is trading at $53.$53-$50 = $3 of Intrinsic Value$4-$3= $1 of Extrinsic Value

Example 2: A call option is selling for $2. It has a strike price of $50 and the stock is trading at $49.$50 > $49 = $0 of Intrinsic Value$2-$0= $2 of Extrinsic Value


Why does Extrinsic Value Exist?

Time is money.Extrinsic value is a measure of how likely the

stock price is to meet or exceed the strike price before the expiration date.


Extrinsic Value Decay Chart


Option Strategies


Long Call or Long Put

Level of Risk: cost of the option

Long Call: buy a call optionLong Put: buy a put option

Naked Call or Naked Put

Level of Risk: theoretically infinite

Naked Call: selling a call Naked Put: selling a put

Naked Calls are more risky than Naked Puts because whereas a stock price can theoretically increase to infinity, a stock price can only sink down to $0


Covered Call

Covered Call: sell a call option on the shares you own For example, if you owned 100 shares of AAPL you

could sell a call option against those shares, so if the option was assigned you would have to sell those shares and not have to buy shares at market price

Strategy: good way to make extra money on your holdings that are mostly flat or going through gradual appreciation, would have to be okay with selling the stock at the set target price


Covered Call Profits

Bought the Stock at $30, Strike Price of $35, Sold Call for $3

Ending Price $30Call Option $3$30-$30 $0Profit $3

Stock Stays the SameEnding Price $35Call Option $3$35-$30 $5Profit $8

Stock IncreasesEnding Price $29Call Option $3$30-$30 $0Profit $3

Stock Decreases

In short, selling a covered call will make you: price of the option * 100 * number of contracts sold- commission

If the option is assigned, you will make: price of the option * 100 * number of contracts sold – commission & assignment fees + difference between purchasing price of stock and strike


Covered Put

Sell a put option, but hold enough money to buy all the stock in reserve For example, if you sold a put option on AAPL with a strike

price of $450, if the option was assigned, you would have the $450*100, or $45,000 set aside to buy all 100 shares

Strategy: could use to buy a stock you think is overvalued at the price you would like to while making cash premiums while you wait for it to hit your price, works well for fundamentally strong stocks when you have a large amount of cash sitting in your portfolio


Spreads

Buy and Sell a Call or a Put option Can differ in strike price (vertical), expiration date

(horizontal), or both (diagonal) Profits and losses are capped


Straddles

Buy or Sell a Call and a Put Can differ in strike prices Long Straddles-losses capped, profit infinite Short Straddles – profits capped, losses infinite


Other Strategies

All other strategies are some combination of Spreads, Straddles, and the underlying stock

The Options Guide has a pretty extensive list of other strategies: http://www.theoptionsguide.com/neutral-trading-strategies.aspx


http://www.theoptionsguide.com/neutral-trading-strategies.aspx

http://www.theoptionsguide.com/neutral-trading-strategies.aspx

Other Areas of Interest

Black-Scholes Option Pricing: http://www.quickmba.com/finance/black-scholes/ http://www.hoadley.net/options/options.htm

Option Greeks: http://www.optionsplaybook.com/options-introduction/option-greeks/


http://www.quickmba.com/finance/black-scholes/



http://www.hoadley.net/options/options.htm



http://www.optionsplaybook.com/options-introduction/option-greeks/



options mu investment club spring 2013. basics mu investment club spring 2013

Documents