OptionsLive Class 1 2
NetPicks Options Live! Brand New Live Options Training Course & Strategy
Professional Options Trading in Minutes Per Day
Week 1 – Sessions 1 and 2 • Session 1 – What is an option? • • • •
Derivative Calls and puts Types of options Contractual rights and responsibilities
– Relationship of strike price to underlying asset price – Pricing Models
• Session 2 – – – –
Effect of time decay on the value of an option Interest and dividends Volatility Parity charts
Options Basics • • • • • •
What is an option? Why trade options? What types of options? What style of options? What is an option’s relationship to price? How are options priced?
Definition of an Option • Traded security – Subject to security trading laws and regulations
• Derivative – Value is based on or derived from the value of the underlying asset or index • • • • •
Stocks Indexes Futures Forex Treasuries
• Depreciating Asset – It loses value (all else being equal) over time – It has a limited life, all options expire
Why Trade Options • Hedging – Protect the profits/value of a stock – Protect against sudden moves in price of an asset – Protect against sudden moves against an option position
• Premium collection – Collect premiums from an option sale protected by a stock • Covered call and buy-write positions • Naked options
– Credit spreads
• Speculation – Long calls – Long puts
Chart of IBM
Hedging and protecting gains – Buy a put
• Protect some of the gains in a stock by buying a put • Buy one Jan 11 135 Put for 100 x 1.44 = $144
Premium Collection – Sell a covered call
• Collect some premium on IBM stock by selling a call • Sell one Dec 10 150 Call for 100 x 0.68 = $68
Speculation - Buy IBM call
• • • •
Object is to profit from rising stock price Buy one Dec 10 145 call for 100 x 1.88 = $188 If IBM goes to 148 before Dec 18, call worth at least (148-145) x 100 = $300 Gain of 300-188 = $122 Profit: 60%
Financial Option Types • Exchange-traded (listed) options – Standardized contracts – Settled through a clearing house – Includes • • • •
Stock/ETF options Index options Bond options Futures options
• Over-the-counter (OTC) – Unrestricted – Loosely regulated – Includes • Forex (currency) options • Interest rate options
Options Contract • Stock option contract – 100 shares of a stock – Number of Contracts 1 2 5 20
Number of shares of stock 100 200 500 2000
• Option price quote is per share • Commission quoted per contract • Cost of an option trade: Total cost = (number of contacts) x ($ per contract) x 100 + commissions Example: 10 contracts quoted at $1.25 with $1.50 commission (10 x $1.25 x 100) + (10 x $1.50) = 1,250 + 15.00 = $1,265.00 equivalent to 1000 shares of stock
Call Options • Call option – A contract between a buyer and a seller for a specific period of time – Buyer has the right, but not the obligation, to purchase 100 shares of stock at a specific price by a specific date. This has the effect of locking in the purchase price for a period of time. • The buyer has rights • The buyer is considered long the option. • The buyer is considered long the position
– Seller has the obligation to sell 100 shares of stock at a specific price, when requested, up until a specific date. • The seller has obligations • The seller is considered short the option. • The seller is considered short the option.
Put Options • Put option – A contract between a buyer and a seller for a specific period of time – Buyer has the right, but not the obligation, to sell 100 shares of stock at a specific price by a specific date. This has the effect of locking in the sales price for a period of time. • The buyer has rights • The buyer is considered long the option. • The buyer is considered short the position.
– Seller has the obligation to buy 100 shares of stock at a specific price, when requested, up until a specific date. • The seller has obligations • The seller is considered short the put option. • The seller is considered long the position.
Options Clearing Corporation • Founded in 1973, the same year that CBOE started to list options • World’s largest options clearing organization • Provides clearing and settlement services to 14 exchanges for options • Under jurisdiction of – Securities and Exchange Commission (SEC) – Commodity Futures trading Commission (CFTC)
• Ensures that all option contract obligations are met – buyer does not need to worry about seller failing to meet obligations
Options Definitions • The specific price is known as the strike price or the exercise price • The specific date is known as the expiration date • The buyer is known as the holder of the option. – The option holder’s risk is limited to the premium paid for the option.
• The seller of an option is also know as the writer of the option. – The writer accepts the risk of losing more than the premium received for the option. – If the option is not hedged, the option is called a naked option because the seller assumes “unlimited risk” • Options are never worth less than zero, therefore risk of naked put is the strike price minus the premium
Options Definitions - continued • Exercise: Applies to option buyer – This is the process of converting the option into a long position for a call or a short position for a put – Call holder: buys 100 shares of the underlying stock for the strike price – Put holder: sells 100 shares of the underlying stock for the strike price
• Assignment: Applies to option writer – This is the process by which the seller of the option is notified of the buyer’s intention to exercise the option – Call writer: required to sell 100 shares of the underlying stock for the strike price – Put writer: required to buy 100 shares of the underlying stock for the strike price
Options Definitions - continued • Strike Price or Exercise Price – The price at which the option buyer/owner has the right to buy the underlying stock for a call or sell the underlying stock for a put – The price at which the option seller/writer is required to sell the underlying stock for a call or buy the underlying stock for a call
• Long positions – Go up in value as the underlying stock goes up in value – Long call – Short put
• Short positions – Go up in value as the underlying stock goes down in value – Long put – Short call
Long Positions Using Options profit
buy stock (long stock)
profit
stock price
strike
buy call (long call)
profit
Sell put (short put)
stock price
strike
stock price
Short Positions Using Options profit
Sell stock (short stock)
profit
stock price
strike
buy put (long put)
profit
Sell call (short call)
stock price
strike
stock price
End of Option Rights and Obligations • Rights of the buyer and obligations of the seller ends when – The option position is closed • • • •
Call option holder sells the option Put option holder sells the option Call writer buys call back Put writer buys put back
– The option is exercised • Call owner exercises option thus buying 100 shares of stock • Put owner exercises option thus selling 100 shares of stock
– The option expires • Call option may be automatically exercised if the underlying stock price is greater than the option strike price • Put option may be automatically exercised if the underlying stock price is less than the option strike price
Options Expiration • Monthly options – – – – –
expire on 3rd Friday of the month Front month Next month plus about 6 out months LEAPS©: Long-term Equity AnticiPation Securities, longer term options expiring a year to up to 2 years and 8 months out
• Weekly options, also called Weeklys, short-term or shortdated options – – – –
Recent product first released for major indexes First released for stocks in June 25, 2010: AAPL, BAC, BP, C Listed on Thursday 8 days before expiration More released each month
How Options are Identified • Option class – the identification of the underlying stock or security that the option is based on, e.g. IBM • Option series – the option type (call or put) expiration month (or week) and the strike price, e.g. Dec 120 call • Examples: – – – –
IBM Dec 130 call IBM Jan 130 put IBM Jan 12 130 call IBM Nov4 130 put
• Option Chain – the collection of all options currently available for the underlying stock
Options Chain for IBM
GE Dec 10 Calls GE Dec 10 Puts
GOOG Nov4 10 Calls GOOG Nov4 10 Calls
GOOG Dec 10 Calls GOOG Dec 10 Puts
GOOG Jan 13 Calls GOOG Jan 13 Puts
Option Relationship to Underlying Price • An option is often described by its relationship to the underlying stock price – At-The-Money (ATM) • The underlying stock price is the same as the option strike price • Applies to both calls and options
– In-The-Money (ITM) • Calls: The underlying stock price is higher than the option strike price • Puts: The underlying stock price is lower than the option strike price
– Out-Of-The-Money (OTM) • Calls: The underlying stock price is lower than the option strike price • Puts: The underlying stock price is higher than the option strike price
• The option whose strike price is closest to the underlying stock price is considered the ATM option
Premium, Intrinsic, and Extrinsic Value • Premium: the price of the option, excluding commissions • Intrinsic value (parity): the amount by which an option is in-the-money – Call: amount by which stock price is higher than strike price – Put: amount by which stock price is lower than strike price – There is no intrinsic value in an out-of-the-money call or put
• Extrinsic value: the time-value of the option – There is no extrinsic value at option expiration
• Premium = Intrinsic value + extrinsic value
Example: XYZ Jan 11 Calls and Puts 2 months to expiration Stock Price:
50.00
Expiration:
2 months
Strike Price 35 40 45 50 55 60 65
Call Status ITM ITM ITM ATM OTM OTM OTM
Option Price 15.10 10.30 5.80 1.60 0.80 0.30 0.10
Intrinsic Value 15.00 10.00 5.00 0.00 0.00 0.00 0.00
Extrinsic value 0.10 0.30 0.80 1.60 0.80 0.30 0.10
Strike Price 35 40 45 50 55 60 65
Put Status OTM OTM OTM ATM ITM ITM ITM
Option Price 0.10 0.30 0.80 1.60 5.80 10.30 15.10
Intrinsic Value 0.00 0.00 0.00 0.00 5.00 10.00 15.00
Extrinsic value 0.10 0.30 0.80 1.60 0.80 0.30 0.10
Example XYZ Jan 12 Calls and Puts 14 months to expiration Stock Price:
50.00
Expiration:
14 months
Strike Price 35 40 45 50 55 60 65
Call Status ITM ITM ITM ATM OTM OTM OTM
Option Price 15.30 10.90 7.10 4.20 2.10 0.90 0.30
Intrinsic Value 15.00 10.00 5.00 0.00 0.00 0.00 0.00
Extrinsic value 0.30 0.90 2.10 4.20 2.10 0.90 0.30
Strike Price 35 40 45 50 55 60 65
Put Status OTM OTM OTM ATM ITM ITM ITM
Option Price 0.30 0.90 2.10 4.20 7.10 10.90 15.30
Intrinsic Value 0.00 0.00 0.00 0.00 5.00 10.00 15.00
Extrinsic value 0.30 0.90 2.10 4.20 2.10 0.90 0.30
Styles of Options • American style – Can be exercised at any time before the expiration date – Most options are American style – All options on individual stocks are American style
• European style – Can be exercised only at the expiration date, at a pre-defined single point in time – Major index options are European style
• Exotic styles – Bermudan option, Canary option, Russian option, etc. – Various ways of calculating profit, various exercise dates,
American Style Options • Can be exercised at any time before the expiration date • When markets close for trading on the 3rd Friday of the month, the final price becomes the settlement price – Under current rules, if the option has intrinsic value (is in the money) it is automatically exercised – Owner may choose to instruct broker not to exercise – Call owner buys shares / call seller sells shares at the strike price – Put owner sells shares / put seller buys shares at the strike price – Example for 3rd Friday of December, IBM Dec 140 calls and puts: • If IBM closes 140.01 or higher, call owner pays $14,000 for 100 shares IBM, and call seller receives $14,000 in exchange for 100 shares IBM • If IBM closes 139.99 or lower, put owner receives $14,000 in exchange for 100 shares of IBM, and put seller pays $14,000 for 100 shares IBM
• Settlement takes place on Saturday
European Style Options • Options Clearing Corporation will Automatically exercise European style options that are ITM on expiration date • Options on major indexes are European – – – –
SPX: Standard & Poor’s 500 Index DJX: Dow Jones Industrial Average NDX: NASDAQ 100 Index RUT: Russell 2000 (small cap) Index
• Cash settled – no shares trade hands – Owners of options with intrinsic value receive the intrinsic value, and the funds are automatically deposited in their account – Sellers of options with intrinsic value have cash equal to the intrinsic value automatically removed from their account
European Style Options: Determination of Settlement Price • Trading stops at the close of market on Thursday before the 3rd Friday of the expiration month • The settlement price is determined Friday morning as each component of the index opens • Index is calculated once all components have opened, based on each opening price, as if they had all been opened at the same time • Settlement price is not a real price since components don’t all open at the exact same time • Official settlement price is published later in the day – May be higher than index high or lower than index low of day
European Style Options: Settlement Example • Intrinsic value is determined by how much the index is in the money • If OTM, the index option expires worthless and no cash is exchange • Example for SPX Dec 1200 calls and puts, and SPX settlement price on 3rd Friday of December is 1205.34 – – – –
Call owner receives (1205.34-1200.00) x 100 = $534 Call seller pays $534 Put owner receives nothing (loses premium) Put sell pays nothing (keeps premium)
Option Pricing Models • Evaluates the value of an option • Calculates the “Greeks” (delta, gamma, theta, vega, etc.) • Intrinsic value of an option is simply determined by the difference between the stock price and the strike price • Extrinsic (time value) much more complicated • Various pricing models account for following components – – – – – –
Underlying stock price Option strike price Time until expiration Volatility of stock Interest rates Dividends paid by stock during the time before expiration
Options Pricing Components • Underlying Stock Price – Calls: higher stock price => higher option price – Puts: higher stock price => lower option price
• Strike Price – Calls: higher strike price => lower option price – Puts: higher strike price => higher option price
• Time until expiration – More time to expiration (puts and calls) => higher option price – More time gives the underlying stock greater opportunity to move in a favorable direction – As time progresses, value of option decreases (never below intrinsic value)
Options Pricing Components - continued • Volatility of stock – The greater the volatility of the stock, the higher the value of the option – Volatility can change over the lifespan of the option
• Interest rates – Risk-free interest rates (Treasuries) – Calls: higher interest rates => higher option price • As interest rates rise, it becomes more attractive to tie up less capital in the option than in buying the stock
– Puts: higher interest rates => lower option price • As interest rates rise, it becomes less attractive to buy a put than it is to short the stock and receive the cash
– Interest rates not much of a factor in this market of low rates
Options Pricing Components - continued • Dividends – – – –
Calls: Higher dividends => lower call premiums Puts: Higher dividends => higher put premiums Dividends affect price of American style options: Dividends have an influence on the price of options that have an early exercise because stocks drop by the amount of dividend paid. Stocks may drop immediately after the dividend is paid, but the options market anticipates the drop in stock price days before the dividend is paid.
Options Pricing Models • Black-Scholes model • Binomial models • Other models – Monte Carlo: uses a random price simulation instead of solving partial differential equations – Finite difference models: derived from partial differential equations and allows for changing assumptions – Trinomial model: an application of a finite difference model that is the most accurate, but most complex, pricing model
Black-Scholes Options Pricing Model • Fischer Black, Harvard Ph.D. in applied math and economics • Myron Scholes, U. of Chicago Ph.D. in financial economics • 1973 paper: "The Pricing of Options and Corporate Liabilities” • Robert Merton and Myron Scholes were awarded 1997 Nobel prize in Economics for expanding the mathematical understanding of the options pricing model and coined the term Black–Scholes options pricing model. • Black-Scholes model did not account for: – early exercise – dividends
Binomial Options Pricing Models • John Cox, Stephen Ross and Mark Rubinstein developed the first binomial option pricing model soon after the Black-Scholes model • Models the dynamics of the option's theoretical value for discrete time intervals over the option's duration • Uses a binomial tree with discrete values of the underlying future stock prices and uses a formula to determine the option price at each node in the model • More accurate and more flexible than B-S model • With future prices and flexibility at each node, the binomial model accounts for dividends and early exercise
Options Pricing Models and Brokers • No options pricing model is perfect • Options pricing providers (brokers) can make use of multiple option pricing models • ThinkOrSwim (TD Ameritrade) uses – Black-Scholes options pricing model for European style options • Early exercise is not part of the model • Dividends don’t play a significant role with a single exercise date
– Binomial model for American style options • More flexible and accurate • Accounts for dividends and early exercise
Extrinsic (time) value of option
Time Decay
0 49
42
35
28
21
14
7
0
Number of days left before option expiration
GOOG Time Decay
Volatility • Volatility is a measure of the range that the underlying stock has fluctuated over a certain period of time – Important component of the pricing model – Helps us determine which options to select
• Historical or Statistical Volatility – The actual measure of how the underlying asset price fluctuates over time – Annual standard deviation of the stock price
• Implied Volatility – How much the marketplace “implies” or expects the underlying stock price to fluctuate – Reflected in the actual option price
Volatility - continued • Volatility is a measure of the risk, uncertainty, or variability of the underlying stock • It is the most subjective component of the pricing model and often difficult to determine • The higher the volatility: – Greater the expected stock fluctuation – in either direction – The higher the price for all options, calls and puts – Most noticeable with ATM options
Volatility and the Options Pricing Model Calculating Option Price with known historical Volatility Stock price
Strike price Time to expiration
Option Price
Volatility Interest rates Dividends
Calculating implied Volatility with known Option Price Stock price Strike price Time to expiration Volatility Interest rates Dividends
Option Price
Example: ABC Jan 11 Calls and Puts Low Volatility stock, 2 months to expiration Stock Price:
50.00
Expiration:
2 months
Strike Price 35 40 45 50 55 60 65
Call Status ITM ITM ITM ATM OTM OTM OTM
Option Price 15.10 10.30 5.80 1.60 0.80 0.30 0.10
Intrinsic Value 15.00 10.00 5.00 0.00 0.00 0.00 0.00
Extrinsic value 0.10 0.30 0.80 1.60 0.80 0.30 0.10
Strike Price 35 40 45 50 55 60 65
Put Status OTM OTM OTM ATM ITM ITM ITM
Option Price 0.10 0.30 0.80 1.60 5.80 10.30 15.10
Intrinsic Value 0.00 0.00 0.00 0.00 5.00 10.00 15.00
Extrinsic value 0.10 0.30 0.80 1.60 0.80 0.30 0.10
Example: XYZ Jan 11 Calls and Puts High Volatility stock, 2 months to expiration Stock Price:
50.00
Expiration:
2 months
Strike Price 35 40 45 50 55 60 65
Call Status ITM ITM ITM ATM OTM OTM OTM
Option Price 15.30 10.90 7.10 4.20 2.10 0.90 0.30
Intrinsic Value 15.00 10.00 5.00 0.00 0.00 0.00 0.00
Extrinsic value 0.30 0.90 2.10 4.20 2.10 0.90 0.30
Strike Price 35 40 45 50 55 60 65
Put Status OTM OTM OTM ATM ITM ITM ITM
Option Price 0.30 0.90 2.10 4.20 7.10 10.90 15.30
Intrinsic Value 0.00 0.00 0.00 0.00 5.00 10.00 15.00
Extrinsic value 0.30 0.90 2.10 4.20 2.10 0.90 0.30
WMT Chart (low volatility)
WMT Dec Options (1 month)
Stock price
Imp Vol
ATM
RIMM Chart (higher volatility)
RIMM Dec Options (1 month)
Stock price
18.48/ 0.12
0 .00/ 0.06
5.98/ 1.12
0 .00/ 1.05
0.98/ 2.77
0.00 / 2.73
0.00 / 0.69
9.02 / 0.73
0 / 0.10
Intrinsic value 80.00 - 58.48= 21.52 Extrinsic value: 21.65 - 21.52 = 0.13
21.52/0.13
Imp Vol
RIMM Sep Options (10 months)
Stock price
Imp Vol
Long Call Parity Graph profit
entry
strike
stock price
premium
profit
Increased time and/or volatility entry
strike
stock price premium
Long Call - Far OTM
profit
entry
premium
strike
stock price
Long Call - OTM
profit
entry
premium
strike
stock price
Long Call - ATM
profit
entry strike
stock price premium
Long Call - ITM
profit
strike entry
stock price premium
Long Call – Deep ITM
profit
strike
entry
stock price
premium
Long Put – Far OTM
profit
strike
premium
entry
stock price
Long Put - OTM
profit
strike
premium
entry
stock price
Long Put - ATM
profit
entry strike
stock price premium
Long Put - ITM
profit
entry strike
stock price premium
Long Put – Deep ITM
profit
entry
strike
stock price
premium
Professional Options Trading in Minutes Per Day
Week 1 – Sessions 1 and 2 • Session 1 – What is an option? • • • •
Derivative Calls and puts Types of options Contractual rights and responsibilities
– Relationship of strike price to underlying asset price – Pricing Models
• Session 2 – – – –
Effect of time decay on the value of an option Interest and dividends Volatility Parity charts
Options Basics • • • • • •
What is an option? Why trade options? What types of options? What style of options? What is an option’s relationship to price? How are options priced?
Definition of an Option • Traded security – Subject to security trading laws and regulations
• Derivative – Value is based on or derived from the value of the underlying asset or index • • • • •
Stocks Indexes Futures Forex Treasuries
• Depreciating Asset – It loses value (all else being equal) over time – It has a limited life, all options expire
Why Trade Options • Hedging – Protect the profits/value of a stock – Protect against sudden moves in price of an asset – Protect against sudden moves against an option position
• Premium collection – Collect premiums from an option sale protected by a stock • Covered call and buy-write positions • Naked options
– Credit spreads
• Speculation – Long calls – Long puts
Chart of IBM
Hedging and protecting gains – Buy a put
• Protect some of the gains in a stock by buying a put • Buy one Jan 11 135 Put for 100 x 1.44 = $144
Premium Collection – Sell a covered call
• Collect some premium on IBM stock by selling a call • Sell one Dec 10 150 Call for 100 x 0.68 = $68
Speculation - Buy IBM call
• • • •
Object is to profit from rising stock price Buy one Dec 10 145 call for 100 x 1.88 = $188 If IBM goes to 148 before Dec 18, call worth at least (148-145) x 100 = $300 Gain of 300-188 = $122 Profit: 60%
Financial Option Types • Exchange-traded (listed) options – Standardized contracts – Settled through a clearing house – Includes • • • •
Stock/ETF options Index options Bond options Futures options
• Over-the-counter (OTC) – Unrestricted – Loosely regulated – Includes • Forex (currency) options • Interest rate options
Options Contract • Stock option contract – 100 shares of a stock – Number of Contracts 1 2 5 20
Number of shares of stock 100 200 500 2000
• Option price quote is per share • Commission quoted per contract • Cost of an option trade: Total cost = (number of contacts) x ($ per contract) x 100 + commissions Example: 10 contracts quoted at $1.25 with $1.50 commission (10 x $1.25 x 100) + (10 x $1.50) = 1,250 + 15.00 = $1,265.00 equivalent to 1000 shares of stock
Call Options • Call option – A contract between a buyer and a seller for a specific period of time – Buyer has the right, but not the obligation, to purchase 100 shares of stock at a specific price by a specific date. This has the effect of locking in the purchase price for a period of time. • The buyer has rights • The buyer is considered long the option. • The buyer is considered long the position
– Seller has the obligation to sell 100 shares of stock at a specific price, when requested, up until a specific date. • The seller has obligations • The seller is considered short the option. • The seller is considered short the option.
Put Options • Put option – A contract between a buyer and a seller for a specific period of time – Buyer has the right, but not the obligation, to sell 100 shares of stock at a specific price by a specific date. This has the effect of locking in the sales price for a period of time. • The buyer has rights • The buyer is considered long the option. • The buyer is considered short the position.
– Seller has the obligation to buy 100 shares of stock at a specific price, when requested, up until a specific date. • The seller has obligations • The seller is considered short the put option. • The seller is considered long the position.
Options Clearing Corporation • Founded in 1973, the same year that CBOE started to list options • World’s largest options clearing organization • Provides clearing and settlement services to 14 exchanges for options • Under jurisdiction of – Securities and Exchange Commission (SEC) – Commodity Futures trading Commission (CFTC)
• Ensures that all option contract obligations are met – buyer does not need to worry about seller failing to meet obligations
Options Definitions • The specific price is known as the strike price or the exercise price • The specific date is known as the expiration date • The buyer is known as the holder of the option. – The option holder’s risk is limited to the premium paid for the option.
• The seller of an option is also know as the writer of the option. – The writer accepts the risk of losing more than the premium received for the option. – If the option is not hedged, the option is called a naked option because the seller assumes “unlimited risk” • Options are never worth less than zero, therefore risk of naked put is the strike price minus the premium
Options Definitions - continued • Exercise: Applies to option buyer – This is the process of converting the option into a long position for a call or a short position for a put – Call holder: buys 100 shares of the underlying stock for the strike price – Put holder: sells 100 shares of the underlying stock for the strike price
• Assignment: Applies to option writer – This is the process by which the seller of the option is notified of the buyer’s intention to exercise the option – Call writer: required to sell 100 shares of the underlying stock for the strike price – Put writer: required to buy 100 shares of the underlying stock for the strike price
Options Definitions - continued • Strike Price or Exercise Price – The price at which the option buyer/owner has the right to buy the underlying stock for a call or sell the underlying stock for a put – The price at which the option seller/writer is required to sell the underlying stock for a call or buy the underlying stock for a call
• Long positions – Go up in value as the underlying stock goes up in value – Long call – Short put
• Short positions – Go up in value as the underlying stock goes down in value – Long put – Short call
Long Positions Using Options profit
buy stock (long stock)
profit
stock price
strike
buy call (long call)
profit
Sell put (short put)
stock price
strike
stock price
Short Positions Using Options profit
Sell stock (short stock)
profit
stock price
strike
buy put (long put)
profit
Sell call (short call)
stock price
strike
stock price
End of Option Rights and Obligations • Rights of the buyer and obligations of the seller ends when – The option position is closed • • • •
Call option holder sells the option Put option holder sells the option Call writer buys call back Put writer buys put back
– The option is exercised • Call owner exercises option thus buying 100 shares of stock • Put owner exercises option thus selling 100 shares of stock
– The option expires • Call option may be automatically exercised if the underlying stock price is greater than the option strike price • Put option may be automatically exercised if the underlying stock price is less than the option strike price
Options Expiration • Monthly options – – – – –
expire on 3rd Friday of the month Front month Next month plus about 6 out months LEAPS©: Long-term Equity AnticiPation Securities, longer term options expiring a year to up to 2 years and 8 months out
• Weekly options, also called Weeklys, short-term or shortdated options – – – –
Recent product first released for major indexes First released for stocks in June 25, 2010: AAPL, BAC, BP, C Listed on Thursday 8 days before expiration More released each month
How Options are Identified • Option class – the identification of the underlying stock or security that the option is based on, e.g. IBM • Option series – the option type (call or put) expiration month (or week) and the strike price, e.g. Dec 120 call • Examples: – – – –
IBM Dec 130 call IBM Jan 130 put IBM Jan 12 130 call IBM Nov4 130 put
• Option Chain – the collection of all options currently available for the underlying stock
Options Chain for IBM
GE Dec 10 Calls GE Dec 10 Puts
GOOG Nov4 10 Calls GOOG Nov4 10 Calls
GOOG Dec 10 Calls GOOG Dec 10 Puts
GOOG Jan 13 Calls GOOG Jan 13 Puts
Option Relationship to Underlying Price • An option is often described by its relationship to the underlying stock price – At-The-Money (ATM) • The underlying stock price is the same as the option strike price • Applies to both calls and options
– In-The-Money (ITM) • Calls: The underlying stock price is higher than the option strike price • Puts: The underlying stock price is lower than the option strike price
– Out-Of-The-Money (OTM) • Calls: The underlying stock price is lower than the option strike price • Puts: The underlying stock price is higher than the option strike price
• The option whose strike price is closest to the underlying stock price is considered the ATM option
Premium, Intrinsic, and Extrinsic Value • Premium: the price of the option, excluding commissions • Intrinsic value (parity): the amount by which an option is in-the-money – Call: amount by which stock price is higher than strike price – Put: amount by which stock price is lower than strike price – There is no intrinsic value in an out-of-the-money call or put
• Extrinsic value: the time-value of the option – There is no extrinsic value at option expiration
• Premium = Intrinsic value + extrinsic value
Example: XYZ Jan 11 Calls and Puts 2 months to expiration Stock Price:
50.00
Expiration:
2 months
Strike Price 35 40 45 50 55 60 65
Call Status ITM ITM ITM ATM OTM OTM OTM
Option Price 15.10 10.30 5.80 1.60 0.80 0.30 0.10
Intrinsic Value 15.00 10.00 5.00 0.00 0.00 0.00 0.00
Extrinsic value 0.10 0.30 0.80 1.60 0.80 0.30 0.10
Strike Price 35 40 45 50 55 60 65
Put Status OTM OTM OTM ATM ITM ITM ITM
Option Price 0.10 0.30 0.80 1.60 5.80 10.30 15.10
Intrinsic Value 0.00 0.00 0.00 0.00 5.00 10.00 15.00
Extrinsic value 0.10 0.30 0.80 1.60 0.80 0.30 0.10
Example XYZ Jan 12 Calls and Puts 14 months to expiration Stock Price:
50.00
Expiration:
14 months
Strike Price 35 40 45 50 55 60 65
Call Status ITM ITM ITM ATM OTM OTM OTM
Option Price 15.30 10.90 7.10 4.20 2.10 0.90 0.30
Intrinsic Value 15.00 10.00 5.00 0.00 0.00 0.00 0.00
Extrinsic value 0.30 0.90 2.10 4.20 2.10 0.90 0.30
Strike Price 35 40 45 50 55 60 65
Put Status OTM OTM OTM ATM ITM ITM ITM
Option Price 0.30 0.90 2.10 4.20 7.10 10.90 15.30
Intrinsic Value 0.00 0.00 0.00 0.00 5.00 10.00 15.00
Extrinsic value 0.30 0.90 2.10 4.20 2.10 0.90 0.30
Styles of Options • American style – Can be exercised at any time before the expiration date – Most options are American style – All options on individual stocks are American style
• European style – Can be exercised only at the expiration date, at a pre-defined single point in time – Major index options are European style
• Exotic styles – Bermudan option, Canary option, Russian option, etc. – Various ways of calculating profit, various exercise dates,
American Style Options • Can be exercised at any time before the expiration date • When markets close for trading on the 3rd Friday of the month, the final price becomes the settlement price – Under current rules, if the option has intrinsic value (is in the money) it is automatically exercised – Owner may choose to instruct broker not to exercise – Call owner buys shares / call seller sells shares at the strike price – Put owner sells shares / put seller buys shares at the strike price – Example for 3rd Friday of December, IBM Dec 140 calls and puts: • If IBM closes 140.01 or higher, call owner pays $14,000 for 100 shares IBM, and call seller receives $14,000 in exchange for 100 shares IBM • If IBM closes 139.99 or lower, put owner receives $14,000 in exchange for 100 shares of IBM, and put seller pays $14,000 for 100 shares IBM
• Settlement takes place on Saturday
European Style Options • Options Clearing Corporation will Automatically exercise European style options that are ITM on expiration date • Options on major indexes are European – – – –
SPX: Standard & Poor’s 500 Index DJX: Dow Jones Industrial Average NDX: NASDAQ 100 Index RUT: Russell 2000 (small cap) Index
• Cash settled – no shares trade hands – Owners of options with intrinsic value receive the intrinsic value, and the funds are automatically deposited in their account – Sellers of options with intrinsic value have cash equal to the intrinsic value automatically removed from their account
European Style Options: Determination of Settlement Price • Trading stops at the close of market on Thursday before the 3rd Friday of the expiration month • The settlement price is determined Friday morning as each component of the index opens • Index is calculated once all components have opened, based on each opening price, as if they had all been opened at the same time • Settlement price is not a real price since components don’t all open at the exact same time • Official settlement price is published later in the day – May be higher than index high or lower than index low of day
European Style Options: Settlement Example • Intrinsic value is determined by how much the index is in the money • If OTM, the index option expires worthless and no cash is exchange • Example for SPX Dec 1200 calls and puts, and SPX settlement price on 3rd Friday of December is 1205.34 – – – –
Call owner receives (1205.34-1200.00) x 100 = $534 Call seller pays $534 Put owner receives nothing (loses premium) Put sell pays nothing (keeps premium)
Option Pricing Models • Evaluates the value of an option • Calculates the “Greeks” (delta, gamma, theta, vega, etc.) • Intrinsic value of an option is simply determined by the difference between the stock price and the strike price • Extrinsic (time value) much more complicated • Various pricing models account for following components – – – – – –
Underlying stock price Option strike price Time until expiration Volatility of stock Interest rates Dividends paid by stock during the time before expiration
Options Pricing Components • Underlying Stock Price – Calls: higher stock price => higher option price – Puts: higher stock price => lower option price
• Strike Price – Calls: higher strike price => lower option price – Puts: higher strike price => higher option price
• Time until expiration – More time to expiration (puts and calls) => higher option price – More time gives the underlying stock greater opportunity to move in a favorable direction – As time progresses, value of option decreases (never below intrinsic value)
Options Pricing Components - continued • Volatility of stock – The greater the volatility of the stock, the higher the value of the option – Volatility can change over the lifespan of the option
• Interest rates – Risk-free interest rates (Treasuries) – Calls: higher interest rates => higher option price • As interest rates rise, it becomes more attractive to tie up less capital in the option than in buying the stock
– Puts: higher interest rates => lower option price • As interest rates rise, it becomes less attractive to buy a put than it is to short the stock and receive the cash
– Interest rates not much of a factor in this market of low rates
Options Pricing Components - continued • Dividends – – – –
Calls: Higher dividends => lower call premiums Puts: Higher dividends => higher put premiums Dividends affect price of American style options: Dividends have an influence on the price of options that have an early exercise because stocks drop by the amount of dividend paid. Stocks may drop immediately after the dividend is paid, but the options market anticipates the drop in stock price days before the dividend is paid.
Options Pricing Models • Black-Scholes model • Binomial models • Other models – Monte Carlo: uses a random price simulation instead of solving partial differential equations – Finite difference models: derived from partial differential equations and allows for changing assumptions – Trinomial model: an application of a finite difference model that is the most accurate, but most complex, pricing model
Black-Scholes Options Pricing Model • Fischer Black, Harvard Ph.D. in applied math and economics • Myron Scholes, U. of Chicago Ph.D. in financial economics • 1973 paper: "The Pricing of Options and Corporate Liabilities” • Robert Merton and Myron Scholes were awarded 1997 Nobel prize in Economics for expanding the mathematical understanding of the options pricing model and coined the term Black–Scholes options pricing model. • Black-Scholes model did not account for: – early exercise – dividends
Binomial Options Pricing Models • John Cox, Stephen Ross and Mark Rubinstein developed the first binomial option pricing model soon after the Black-Scholes model • Models the dynamics of the option's theoretical value for discrete time intervals over the option's duration • Uses a binomial tree with discrete values of the underlying future stock prices and uses a formula to determine the option price at each node in the model • More accurate and more flexible than B-S model • With future prices and flexibility at each node, the binomial model accounts for dividends and early exercise
Options Pricing Models and Brokers • No options pricing model is perfect • Options pricing providers (brokers) can make use of multiple option pricing models • ThinkOrSwim (TD Ameritrade) uses – Black-Scholes options pricing model for European style options • Early exercise is not part of the model • Dividends don’t play a significant role with a single exercise date
– Binomial model for American style options • More flexible and accurate • Accounts for dividends and early exercise
Extrinsic (time) value of option
Time Decay
0 49
42
35
28
21
14
7
0
Number of days left before option expiration
GOOG Time Decay
Volatility • Volatility is a measure of the range that the underlying stock has fluctuated over a certain period of time – Important component of the pricing model – Helps us determine which options to select
• Historical or Statistical Volatility – The actual measure of how the underlying asset price fluctuates over time – Annual standard deviation of the stock price
• Implied Volatility – How much the marketplace “implies” or expects the underlying stock price to fluctuate – Reflected in the actual option price
Volatility - continued • Volatility is a measure of the risk, uncertainty, or variability of the underlying stock • It is the most subjective component of the pricing model and often difficult to determine • The higher the volatility: – Greater the expected stock fluctuation – in either direction – The higher the price for all options, calls and puts – Most noticeable with ATM options
Volatility and the Options Pricing Model Calculating Option Price with known historical Volatility Stock price
Strike price Time to expiration
Option Price
Volatility Interest rates Dividends
Calculating implied Volatility with known Option Price Stock price Strike price Time to expiration Volatility Interest rates Dividends
Option Price
Example: ABC Jan 11 Calls and Puts Low Volatility stock, 2 months to expiration Stock Price:
50.00
Expiration:
2 months
Strike Price 35 40 45 50 55 60 65
Call Status ITM ITM ITM ATM OTM OTM OTM
Option Price 15.10 10.30 5.80 1.60 0.80 0.30 0.10
Intrinsic Value 15.00 10.00 5.00 0.00 0.00 0.00 0.00
Extrinsic value 0.10 0.30 0.80 1.60 0.80 0.30 0.10
Strike Price 35 40 45 50 55 60 65
Put Status OTM OTM OTM ATM ITM ITM ITM
Option Price 0.10 0.30 0.80 1.60 5.80 10.30 15.10
Intrinsic Value 0.00 0.00 0.00 0.00 5.00 10.00 15.00
Extrinsic value 0.10 0.30 0.80 1.60 0.80 0.30 0.10
Example: XYZ Jan 11 Calls and Puts High Volatility stock, 2 months to expiration Stock Price:
50.00
Expiration:
2 months
Strike Price 35 40 45 50 55 60 65
Call Status ITM ITM ITM ATM OTM OTM OTM
Option Price 15.30 10.90 7.10 4.20 2.10 0.90 0.30
Intrinsic Value 15.00 10.00 5.00 0.00 0.00 0.00 0.00
Extrinsic value 0.30 0.90 2.10 4.20 2.10 0.90 0.30
Strike Price 35 40 45 50 55 60 65
Put Status OTM OTM OTM ATM ITM ITM ITM
Option Price 0.30 0.90 2.10 4.20 7.10 10.90 15.30
Intrinsic Value 0.00 0.00 0.00 0.00 5.00 10.00 15.00
Extrinsic value 0.30 0.90 2.10 4.20 2.10 0.90 0.30
WMT Chart (low volatility)
WMT Dec Options (1 month)
Stock price
Imp Vol
ATM
RIMM Chart (higher volatility)
RIMM Dec Options (1 month)
Stock price
18.48/ 0.12
0 .00/ 0.06
5.98/ 1.12
0 .00/ 1.05
0.98/ 2.77
0.00 / 2.73
0.00 / 0.69
9.02 / 0.73
0 / 0.10
Intrinsic value 80.00 - 58.48= 21.52 Extrinsic value: 21.65 - 21.52 = 0.13
21.52/0.13
Imp Vol
RIMM Sep Options (10 months)
Stock price
Imp Vol
Long Call Parity Graph profit
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Increased time and/or volatility entry
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Long Call - Far OTM
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Long Call - OTM
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Long Call - ATM
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Long Call - ITM
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Long Call – Deep ITM
profit
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Long Put – Far OTM
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Long Put - OTM
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Long Put - ATM
profit
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Long Put - ITM
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Long Put – Deep ITM
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