options basics

7/31/2019 Options Basics

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CHICAGO BOARD OPTIONS EXCHANGE4

Why Options? Why Bother?

Without options,

there are three strategy choices.

Short Stock T-BillLong Stock


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Options Give You Options!

Ratio Call Spread Call Volatility Spread Split-strike Synthetic Put Volatility Spread

Long Straddle Short Straddle Long Strangle Short Strangle

Long Call Short Call Long Put Short Put

Options offer many strategy choices.


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Possible Portfolio Objectives

Generate income

Limit risk Reduce variability of returns

Lower the cost of protection Increase exposure to equities

without increasing risk

Buy equities during the next sixmonths at lower prices


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What are Options?WHAT ARE OPTIONS?

Options are _________

Option buyers get ______

Option sellers get __________

contracts

rights

obligations

Options Basics


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Contract Terms

Buyers of calls get the __________

Sellers of calls get the _______________

Buyers of puts get the __________

Sellers of puts get the _______________

right to buy

obligation to buy

right to sell

obligation to sell


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LONG PUT

Bearish

Protect a stock or portfolio

SHORT PUT

Collect premium (income)Establish a purchase price

LONG CALL

Bullish

Buy stock and limit risk

SHORT CALL

Collect premium (income)Establish a selling price

Basic Strategies at Expiration


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Rule 1 for Pricing Options

At expiration, an option is worth its

intrinsic value or zeroCall = Max (0, Stock Price Strike Price)

Put = Max (0, Strike Price Stock Price)


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Rule 2 for Pricing Options

Prior to expiration, there are no rules

Prices reflect the balancing of supply anddemand

Yet, there are tendencies in options pricesthat we can generally rely upon


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3 Option Pricing Concepts

Time Decay: Option prices decrease asexpiration approaches.

Delta: Options prices change to a lesserdegree than changes in the underlyingstock or index price; Delta measures thedegree.

Volatility: Options prices increase as themarkets expectations of underlyingvolatility increase.


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Time Decay is Complicated

At-the-money (ATM) options decay lessinitially and more as expirationapproaches.

Out-of-the-money (OTM) options decay in a

more linear fashion (least erosion nearexpiration).


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Time Decay ATM vs. OTM

0.00

5.00

10.00

15.00

20.00

25.00

35 Days 28 Days 21 Days 14 Days 7 Days Exp.

1300 Call (ATM)

1350 Call (OTM)

SPX @ 1,300

Assumes SPX remains @1,300, and volatility expectations remain constant .


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Call Prices vs. Index Prices

Option

Value

X = 1300 Index Price

Long 1300 Call

* Stylistic presentation; drawing is not to scale

Several days prior to expiration

At expiration

Intrinsic Value

Time Value


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Put Prices vs. Index Prices

Option

Value

X = 1300 Index Price

Long 1300 Put



At expiration

Intrinsic

Value

Time Value


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Delta: A Measure of Exposure

Option

Value

X = 1300

Index PriceS = 1200 S = 1300 S = 1400

= .10

= .50

= .95

OTM

ATM

ITM

* Stylistic presentation; drawing is not to scale & deltas are approximated

Long 1300 Call, several days before expiration

Call value several days

before expiration


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Delta vs. Moneyness

In-the-Money Calls Delta > 50%At-the-Money Calls Delta 50%

Out-of-the-Money Calls Delta < 50%

When index

moves up 1 point

Call price moves up

less than 1 point


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Deltas change as time passes

Option

Value

Index Price

Long 1300 Call: At expiration, delta is either 0.00 or 1.00



At expiration

S = 1200 S = 1300 S = 1400

= 0.0

= 1.00

OTM

ITM


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Volatility Defined

Volatility means __________movementprice fluctuation

uncertainty

risk (like in insurance)

Types of volatility: Name:

Past stock price movement _____________

Reflected in option prices _____________

Future stock price movement _____________

Historical volatility

Implied volatility

Realized volatility


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Volatility Uncertainty

Five primary factors that influencean options value:

1. Underlying Price (today)

2. Strike Price

3. Expiration Date4. Interest Rate (for $1 invested

today through expiration)

5. Volatility of the Underlying Price(from today until expiration)

Assuming no dividends

Where do

we find

these inputs?

#1 - #4

are easy!

#5???


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Imply Volatility from Option Prices

SPX 1,300 1,350 1,350

Days to Exp. 28 21 14

1300 Call 20.00 52.00 51.00

1350 Call 5.00 18.50 15.00

Implied Volatility 14% 14% 14%

What if implied volatility drops to 11%?


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SPX 1,300 1,350 1,350

Days to Exp. 28 21 14

1300 Call @ 14% 20.00 52.00 51.00

Volatility @ 11% 50.50 50.00

1350 Call @ 14% 5.00 18.50 15.00

Volatility @ 11% 14.63 12.20

Prices are sensitive to Volatility


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The Risk of Changing Volatility

Changing volatility can have a

significant impact on option prices!- A profit might become a loss.

- The best option may change.- Another strategy might be better.


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Option Pricing - Summary

Time Decay impacts everyoption; the degreeof impact depends moneyness.

Delta concept: Option prices change to alesser degree than index prices.

Volatility expectations directly impact optionsprices. Options prices can be used to implythat expectation. Expectations change daily!

Option strategy construction involvescontemplating the effects of all three

options basics

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