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.

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What are options?Exchange Traded OptionsCalls v Puts Options pricingThree common strategies

What are options?

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

6

Share price

Pay-off diagram

Loss

Profit

Current share price

Long stock

7

Share price

Pay-off diagram

Current share price

Loss

Profit Short stock

8

Share price

Pay-off diagram

Cash

Loss

Profit

9

Share price

Pay-off diagram

Loss

Profit

Earn income (Premium)

Protect losses

Current share price

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

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

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

B

Call Put

Calls vs Puts (rights vs obligations)

The right (but not the obligation)

to buy


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

B

Call Put


Once you have purchased an option (established a long position) you can:

Sell it

Exercise your right

Let it expire


to buy


to sell

S


The potential obligation

to buy


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


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


to buy


to sell

Call Put

18


S


to buy


to sell

Call Put

B

Call PutThe right

(but not the obligation)

to buy


to sellB

Call options – Recap

Share price

Loss

Profit

Strike price

Long call

Premium


Share price

Loss

Profit Short callStrike price

Premium


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

Put options – Recap

Share price

Loss

Profit

Strike price

Long put

Premium


Share price

Loss

Profit Short put

Premium

Strike price


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

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

What are Options?

Exchange Traded Options (ETOs)

Calls v Puts

Options Pricing?

Top 3 Strategies

Options pricing

27

Major pricing factors

$4.00

$3.50

Share price

Exercise price

28


$4.00

$3.50

50c

Intrinsic value

Share price

Exercise price

Share price

Exercise price

29


$4.00

$3.50 50c 22c

Intrinsic value

Share price

Exercise price Time value

Time to expiry

Dividends

Interest rates

Volatility

Supply and demand

30

50c


$4.00

$3.50

Share price

Exercise price

22c72c

Premium

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

Theta

The change in an option’s price given a change in the time to expiration:

Is not constant Accelerates as expiry approaches

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

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

Delta – Call options

0.1

0.5

0.8

Out of the money

Option moves 1/5 as much as share


At the money

0.1

0.5

0.8

Option moves 1/2 as much as share


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

What are Options?

Exchange Traded Options (ETOs)

Calls v Puts

Options Pricing?

Top 3 Strategies

Three common strategies

54


Selling Calls

Buy-writeGenerating income

Buying Puts

Protecting shares

Buying Calls

Leverage or low-risk?


1. Bought Call

Market view:

Bullish

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

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 ($)

First rule of call buying

You would not consider buying call options as a sole strategy unlessyou are bullish about the underlying stock

B

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

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

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

$4.38 P.S.

$4.66 P.S.


$4.00

$4.22 P.S.

Breakeven price

AML shares

AML/Jun/350 calls

AML/Jun/400 calls

AML/Jun/450 calls

66c

38c

Increase over current

22c


$4.00AML shares

AML/Jun/350 calls

AML/Jun/400 calls

AML/Jun/450 calls

Second rule of call buying

The more bullish you are the more you will consider out-of-the money series

Leverage

$380$670

$4,000

$4,500

Bought October

Sold December

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Leverage

$290

76.3%*

12.5%*

Return on investment

$500

Shares Options

*Not Including Transaction Charges*Not Annualised

Leverage

$380

$0

$4,000

$3,500

Bought October

Sold December

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Leverage

-$380

-100%*

-12.5%*

Return on Investment

-$500

Shares Options

*Not Including Transaction Charges*Not Annualised

Bought call

Share price

Loss

Profit

$4.00

B

C

A

-0.38

$4.38

Call at expiry

Bought call – summary

Break even

Exercise price plus premium

Position

Pay premium in full

Risk/reward

Limited riskUnlimited reward

Market view

Bullish


2. Portfolio protection

Market view:

Bearish

Put Options/Protective Puts

Assume bullish on the market

S&P/ASX 200 indexworth $59,500

at 5,950 points

Share


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


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

Protective Put Purchase

$59,500

Own shares

$1,600

5950 put

$61,100

Position investment (b/e)

Share


$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)


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


4,950

Stock

Option

Total P&L

XJO at expiration

Loss

Profit

($10,000)

($8,400)

($1,600)

$10,000


5,450

Stock

Option

Total P&L

Loss

Profit

($5,000)

($3,400)

($1,600)

$5,000

XJO at expiration


5,950

Stock

Option

Total P&L

Loss

Profit

($0)

($1,600)

($1,600)

$0XJO at expiration


6,450

Stock

Option

Total P&L

Loss

Profit

($5,000)

($1,600)

($3,400)

$5,000

XJO at expiration


6,950

Stock

Option

Total P&L

Loss

Profit

($10,000)

($1,600)

($8,400)

$10,000

XJO at expiration

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

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


3. Buy-writecovered call

Market view:

Neutral

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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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

Buy-Write

Selecting the opportunity

Selling Calls

Buy-Write

Placing the trade

Selling Calls

Buy 2,000 XYZ shares trading at $39.81/share

Share

Outlook is neutral to moderately bullish on XYZ

Selling Calls

Buy 2,000 XYZ shares trading at $39.81/share

Share

Want to increase stock return if market is level

Selling Calls

Sell 20 XYZ December $41.00 Calls at $1.00 each

BS

Share

Selling Calls

Short 20 XYZ December $41.00 Call at $1.00

Long 2,000 shares in XYZ at $39.81

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

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

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

$41.00

Loss

Profit

XYZ at expiration

At expiry

Call expires worthless

Seller keeps shares and call premium $1.00

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

Selling Covered Calls

Benefits Risks

Income from selling call

Partial hedge Downside risk if stock falls

Caps upside

Exchange Traded Options

Graham O’BrienFebruary 2014

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OPTIONS

Thank you ……………………………………

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1 OPTIONS GRAHAM O’BRIEN. Disclaimer This material contains information only. ASX does not...

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