Introduction to Options - VantagePoint

Copyright © 2016 Market Technologies, LLC. 1

Introduction to Options

Course 3.1


Option Basics – Part IAgenda

Option Basics and Lingo

Call and Put Attributes

Profit and Loss Diagrams

Call and Puts in Action


Option Contract Basic Value

Options originally developed to hedge risk Call Options developed in 1973

Put Options developed in 1977

Option Purpose Hedge against commodity loss

Reduce income fluctuation

Options allows the trader to be extremely versatile Bullish

Bearish

Neutral

Direction Indifferent


Option Lingo 1 Option Contract is worth:

Equity (Stocks) = 100 Shares

Futures = 1 Future Contract

LEAPS:(Long Term Anticipation Securities) Options that have an

expiration period greater than 1 year

Strike Price: The price at which an underlying stock can be

purchased or sold

Expiration Date (Expiry) The date of that Option Contract Expiration.

Most Options Expire on the Saturday following the 3rd Friday of each

month

In-the-Money (ITM) That portion of an option that has value if the

contract were to expire

At-the-Money (ATM) When an Option’s Strike price is the same as

the current price of the underlying security

Out-the-Money (OTM) If there is no value should an Option expire at

that time


ITM – ATM – OTM

Option Examples

CALLS STRIKES PUTS

100

105

110

115

120

125

Sample Option Chain Layout


Option Lingo Exercise: Option owner (Holder) who invokes their right to buy or

sell is said to Exercise their Option Contract [note that Call Option

Holders exercise their right to buy; Put Option Holders exercise their

right to sell]

Assignment: When the Option Holder Exercises their rights, the

Option Writer is then Assigned

American Style Options: These options can be exercised any time by

the option Holder [most options are American Style].

European Style Options: These are options that can only be

exercised upon contract expiration. [examples include options on

stock indexes like the S&P 500 [SPX] or the Russell 2000 [RUT]

Parity: An option is said to be trading at Parity with the underlying

security if it is trading for its intrinsic value

Open Interest: Unlike stocks where there are a fixed number of

shares traded, option trading involves the creation of option

contracts. Open Interest tells you the number of option contracts

currently open.


Participants in the Option Markets

Buyers of Calls

Call Option Holder

Sellers of Calls

Call Option Writer

Buyers of Puts

Put Option Holder

Sellers of Puts

Put Option Writer


Options Basics

Only 2 Option trade positions you can take

Opening Position (Buy to open, Sell to open)

Closing Position (Buy to close, Sell to close)

Expressed as BTO, BTC, STO, STC

ROI example using Stock vs. Options

Owning Stock Using an Option

Purchased 100 shares = $5,000 Purchased 1 Call Option at $4.00 = $400

Risk = $5,000 Risk = $400

Stock Increases in Value by $2.00 per share

Stock profit = $2 or 4% ROI Option Value = $4.50 = %12.50

XYZ Company @ $50.00 per share


Option Review

Long Call Right to buy

Expectation is Bullish

Debit Trade (pay to play)

Buy to Open (BTO)

Long Put Right to sell

Expectation is Bearish


Buy to Open (BTO)

Short Call Obligation to sell


Credit Trade (paid to play)

Sell to Open (STO)

Short Put Obligation to buy



Sell to Open (STO)


Option Pricing Theory

Option Pricing is based upon a mathematical

formula define in the Black-Scholes Model (and

others)

Option Price is composed to 2 components:1. Intrinsic Value

2. Extrinsic Value

Option Price Components

XYZ Stock = $50 per share

Call Option with a strike price of 45 due to expire in 3 months = $8.50 per contact

Intrinsic Value = $5.00

Extrinsic Value = $3.50

Extrisnic Value Components

Time Decay

Volatility

Interest Rates


Option P&L Graph

Profit

Loss

$0

-$0

+$0

$20 $60$40 $80


Option P&L GraphBullish Positions – Long Stock

Profit

Loss

$0

-$0

+$0

$20 $60$40 $80


Option P&L GraphBearish Positions – Short Stock

Profit

Loss

$0

-$0

+$0

$20 $60$40 $80


Option P&L GraphBullish Positions – Long Call

Profit

Loss

$0

-$0

+$0

$20 $60$40 $80

Long Call•Right to buy•Expectation is Bullish•Debit Trade (pay to play)


Option P&L GraphBearish Positions – Short Call

Profit

Loss

$0

-$0

+$0

$20 $60$40 $80

Short Call•Obligation to sell•Expectation is Bearish•Credit Trade (paid to play)


Option P&L GraphBearish Positions – Long Put

Profit

Loss

$0

-$0

+$0

$20 $60$40 $80

Long Put•Right to sell•Expectation is Bearish•Debit Trade (pay to play)


Option P&L GraphBullish Positions – Short Put

Profit

Loss

$0

-$0

+$0

$20 $60$40 $80

Short Put•Obligation to buy•Expectation is Bullish•Credit Trade (paid to play)


Option GreeksWhat are They?

Statistical references that are calculated by the Option

Pricing Model

Measurements of an individual option’s sensitivities to

the changes in the component variables that effect

option pricing1. Underlying price

2. (K) Strike price

3. Time to Expiration

4. Volatility

5. Dividends

6. Interest Rates

Used to determine risk in an individual option or the

entire portfolio


Option Greeks – Delta (Δ)

Delta (Δ) can be defined 4 ways:

1. The rate of change of an option value relative to a change in

the underlying

2. The derivative of the graph of an option value in relation to

the stock price

3. The equivalent of the underlying shares represented by an

option position (Hedge Ratio)

4. The estimate of the likelihood of an option expiring ITM

Most watched and common Greek

In-the-Money (ITM) options have higher Delta

Out-of-the-Money (OTM) options have lower Delta

At-the-Money (ATM) options have medium Delta



Definition 1 – Rate of Change

This is the most used definition of Delta

It defines the size of the option price move per $1 move in the

underlying price



Underlying Price Movement

Long Calls

Stock Price $60.00 $61.00

Call Value 3.00 3.50

Delta 0.50 0.54

UNDERLYING STOCK PRICE MOVE


Call Value 3.00 2.50

Delta 0.50 0.46





Long Puts


Put Value 2.25 1.85

Delta -0.40 -0.36


Put Value 2.25 2.65

Delta -0.40 -0.44





Definition 2 – Derivative of option price

Mathematically, for any given point on graph below the derivative will show the rate of

change of the option price

CALL

VALUE

STOCK PRICE

Call

Price

Stock Price



Definition 3 – Underlying shares equivalent (Hedge Ratio)

In absolute terms the Delta of an option is between 0.00 – 1.00

A Call with a delta of .60 means that a dollar rise in the stock price causes the option price to go up $0.60

1 Contract = 100 shares to = $60.00 =60 shares

If you Buy to Open 5 contracts with a 0.43 Delta you have the equivalent of 215 Deltas (5 x .43 x 100)

The share equivalent is 215 shares



Definition 4 – Likelihood of expiring ITM

It is not exactly/mathematically precise, but the option delta projects the probability

of the option finishing ITM

A option with a delta of .60 = 60% probability of ITM

An option with a delta of .34 – 34% probability of ITM



Option deltas are not constant and are based upon the dynamic

inputs of the pricing model – stock price, time to expiration,

volatility

Call and Put pairs – the delta’s are closely correlated

As a general rule, the absolute value of a call delta + the absolute

value of the put delta add up close to 1.00

The reason is the mathematical relationship between Put-Call

Parity (we explain this in more detail in our Option Synthetics

video)

Options ITM have higher delta’s

Options ATM have delta’s approx .50

Options OTM have delta’s less than .50



Effect of Time on Delta

The more time left until an option expires the less certain it is whether

the option will be ITM or OTM

Therefore, the Delta’s of both ITM & OTM options reflect that

uncertainty

ITM Option Delta’s increase as expiration approaches

OTM Option Delta’s decrease as expiration approaches

Effect of Volatility on Delta

As Volatility increases OTM Delta’s increase & ITM Delta’s decrease

As Volatility decreases OTM Delta’s decrease & ITM Delta’s increase


Option Greeks – Gamma (Г)

Gamma (Г) can be defined:1. Gamma is the rate of change of an option’s delta given a change in the price of

the underlying security

2. Gamma is stated in terms of deltas per dollar move

Gamma is the second derivative of the graph of the option price relative to the stock price

Gamma (like Delta) is not constant

ITM & OTM options have lower gamma

ATM options have higher gamma


Option Greeks – Gamma (Г) Underlying

Price Movement

Long Calls

Stock Price $60.00 $61.00 $62.00

Call Value 3.00 3.50 4.04

Delta 0.50 0.54 0.58

Gamma 0.04 0.04 0.04

Stock Price $60.00 $59.00 $58.00

Call Value 3.00 2.50 2.04

Delta 0.50 0.46 0.42

Gamma 0.04 0.04 0.04






Long Puts

Stock Price $60.00 $61.00 $62.00

Put Value 2.25 1.85 1.49

Delta -0.40 -0.36 -0.32

Gamma 0.04 0.04 0.04

Stock Price $60.00 $59.00 $58.00

Put Value 2.25 2.65 3.09

Delta -0.40 -0.44 -0.48

Gamma 0.04 0.04 0.04





When you buy (Long) options you acquire positive gamma Positive gamma helps you – causes options to gain value at a faster rate and lose

value at a slower rate

When you sell (Short) options you acquire negative gamma

Negative gamma works against you as a short seller – it will

accelerate your losses


Option Greeks – Theta (θ)

Option Prices/value are broken into 2 components; Intrinsic & Extrinsic…Intrinsic is easily measurable [the ITM part of premium]

Extrinsic value is considered the time value [the premium paid over parity for the option]

The decay in option value because of time passage is called time decay or Theta in the Greeks

Long Options = Negative Theta

Short Options = Positive Theta

If interest rates are above zero then call theta is higher than put theta

ATM options have highest theta

Only the option’s extrinsic value is subject to Theta

Higher Volatility also increases an Options premiums thus also increasing Theta decay


Option Greeks – Theta (θ)

Theta is not constant...it is non-linear

The higher the extrinsic value the higher the Theta


Option Greeks - Vega Vega measures the rate of change of an options theoretical value relative

to a change in Implied Volatility (IV)

This is the value that, when entered into an option pricing model returns the option’s theoretical value

When IV rises or falls, option prices rise or fall in line with it (Vega is the rate of this change)

A Call (Put) with the same expiration month & the same strike on the same underlying will have the same Vega value as its corresponding Put (Call)

Long options have Positive Vega/Short options have Negative Vega

The higher the time premium, the higher the Vega

ATM options have the highest Vega since Vega only effects extrinsic value

If an option is valued at 1.68 and it’s Vega is .06 then the following price change can occur with a change in Volatility

Volatility increases from 22% to 25%; Option value increases by .18 to 1.86 (10.7% increase in value)

Volatility decreases from 45% to 28%; Option value decreases by 1.02 to .66 (60.7% decrease in value)


Option Volatility

Historical Volatility (HV) [Also known as Statistical or Realized Volatility]

Is defined as the Annualized Standard Deviation of daily returns

HV is a simple measure of how volatile the price movement of a security has been during a certain period of time

Example: (Both Stock A and Stock B are trading around 100 per share)

Stock A moves up/down $5 to $7 per share

Stock B moves up/down $1 to $2 per share

Stock A has tended to move more than Stock B as a percentage of price without regard to direction

Therefore Stock A is more volatile than Stock B

Therefore Stock A has a higher HV than Stock B

So HV is a measure of how volatile the price movement of a security has been during a certain period of time

But exactly how much higher is Stock A’s HV than Stock B’s HV?

Well, first Volatility of any given stock is measured in terms of Standard Deviation


Option Volatility – Standard Deviation

Standard Deviation [Std. Dev] (σ or sigma is the Greek symbol)

Is a mathematical calculation that measures the dispersion of data from a mean value

The mean is the average stock price over a certain period of time

And the further from the mean the dispersion of the occurrences (daily close) was during the period, the greater the Standard Deviation

The most common time frame is the past 20 days (weekends do not count) to calculate HV

And understanding the timeframe in question is important to understanding what the output represents…

Standard Deviation is stated as a percentage move in the price of an asset.

For example, Stock 1 is at $100 per share has a standard deviation of 15% (when you are given a standard deviation measure, it is always assumed to be a Std. Dev of 1) then on an annualized basis the stock can move up to $115 or down to $85 per share

So on any given stock that has a Std. Dev of 15% is considered more volatile than a stock that has a Std. Dev of 6%

The graph of the data that represents the closing price dispersion of any given stock which is reflected in its 1 Std. Dev of movement is called a distribution curve.


Random Walk Theory

* ** * *

* * * ** * * * *

* * * * * ** * * * * * *

* * * * * * * *

68%95%

Std Dev tells us not only how fast the distribution spreads out; -it tells us about the probability of a

ball ending up in a specific trough...it measures the dispersion of data from a mean value


Option Greeks – Rho (ρ)

Rho is the rate of change in an option value relative to a change in the interest

rate

If interest rates go up = Call Value rises

If interest rates go down = Call Value decreases

Usually the least followed Greek since it takes a very large move in interest rates

to effect Rho to an extinct that moves the option value…mostly in Leaps is where

Rho can be a factor

For example, a Call with a Rho of 0.12 will increase $0.12 if interest rates rise a

full point (100 basis points)


Dividends Effect on Options

Dividends paid decrease Call value & increase Put value

4 Key dates you must be aware of:

1) Declaration date: when company formally declares a dividend

2) Ex-Dividend date: 2 days before the record date [due to stock settlement]

3) Record date: date of record for who gets the dividend payment

4) Payable date: date of payment

ABC Corp announces on March 31st (declaration date) it will pay a $0.25 dividend to shareholders of record on April 3rd (the record date) payable on April 23rd (the payable date)...the market participates wishing to get the dividend must own the stock on April 1st (the ex-dividend date).

Option holders or writers do not receive or pay dividends


Dividends Effect on OptionsCall Value with $0.10 Dividend

Price 61

Strike 60

Days to Expiry 528

Volatility

25.5%

Interest

5.00%

Call Value

9.65

Call Value with $0.50 Dividend Price 61

Strike 60

Days to Expiry 528

Volatility

25.5%

Interest

5.00%

Call Value

8.13

Put Value with $0.10 Dividend

Price

61

Strike

60

Days to Expiry 528

Volatility

25.5%

Interest

5.00%

Put Value

5.42

Put Value with $0.50 Dividend

Price

61

Strike

60

Days to Expiry 528

Volatility

25.5%

Interest

5.00%

Put Value

6.08


If You AreYour Delta

Position is

Your Gamma

Position is

Your Theta

Position is

Your Vega

Position is

Long Stock Positive 0 0 0

Short Stock Negative 0 0 0

Long Calls Positive Positive Negative Positive

Short Calls Negative Negative Positive Negative

Long Puts Negative Positive Negative Positive

Short Puts Positive Negative Positive Negative

Greek Effects on the Underlying


If Your Greek Postion is…. You Want Your Stock Postion to….

If your Delta Postion is positive

If your Delta Position is negative

Rise in Price

Fall in Price

If your Gamma position is positive

If your Gamma position is negative

Move very swiftly, regardless of the direction

Move very slowly, regardless of the direction

If your Theta position is positive

If your Theta position is negative

If your Vega position is positive

If your Vega position is negative

Greek Effects on the Underlying

If your Rho position is positive

If your Rhoa position is negative

You want interest rates to rise which will increase value

You want interest rates to fall which will increase value

The passage of time will generally increase your value

The passage of time will generally decrease your value

You want volatility to rise which raises your value

You want volatility to fall which raises your value


Trade Selection Strategy Checklist1. Security Selection Process

2. What is your current bias

a. Neutral

b. Mildly Bullish

c. Strongly Bullish

d. Mildly Bearish

e. Strongly Bearish

f. Unknown (Breakouts; up or down) and Volatility Trades

3. What is the magnitude of the forecasted move

4. What is the timeframe of the forecasted move

5. Is there a Trigger price for the move

6. What is the support & resistant for the security

7. How will I know if my original bias is wrong during the trade

8. What is the current IV and HV of the security

9. What is your current Risk Appetitea. Position Size

b. Primary Exit Point (PE)

c. Secondary Exit Point (SE)

d. Trade Stops/taking profits & losses

10. Trade Objectives1. Income

2. Downsize Protection

3. Revenue Gain (+20%)


Option Strategies

“Make everything as simple as possible, but not simpler”

Albert Einstein


Option Strategies

Single Leg Strategies – Calls & Puts

Vertical Spreads


Option Review

Long Call Right to buy



Buy to Open (BTO)

Long Put Right to sell



Buy to Open (BTO)

Short Call Obligation to sell



Sell to Open (STO)

Short Put Obligation to buy



Sell to Open (STO)


Vertical Spreads

Strategy Overviews

Description

Vertical Spreads are 2 legged option strategies designed to play

either a bullish or bearish bias with either Calls or Puts in the

same contract month. Two major Vertical Spread Types: Debit

Spreads where you “pay to play” meaning your account is

debited for the cost of the trade since you are long the more

expensive option and short the less expense option in the same

month and Credit Spreads where you get “paid to play” meaning

you are shorting the higher priced option contract and going long

the lower priced contract.

ObjectiveYour goal is to have the price action move to and through the

short option strike price.

Trade OutlookTrade is executed when your bias is Bullish using Call options or

Bearish using Puts.

Trade

Rationale

Vertical Spreads are designed to capture a Bullish or Bearish

Play while reducing the effect of delta on your overall option

position and enhancing your odds of success. Typical returns

can be anywhere from 20% to well over 400% depending upon

strike selection.

CompositionAll Calls or all Puts in the same contract month at different

strikes


Vertical Spreads

Four Types

1) Bull Call Spread Vertical Debit Spread or just Debit Spread

Vertical Bull Spread or just Bull Spread

2) Bear Call Spread Vertical Credit Spread or just Credit Spread

Vertical Bear Spread or just Bear Spread

3) Bear Put Spread Vertical Debit Spread or just Debit Spread

Vertical Bear Spread or just Bear Spread

4) Bull Put Spread Vertical Credit Spread or just Credit Spread

Vertical Bull Spread or just Bull Spread


Vertical SpreadsStrategy Highlights

Bullish Bearish Sideways Limited Unlimited Limited Unlimited

1 XX XX XX

2 Bear Call Spread

3 Bull Call Spread

4 Bear Put Spread

Option Strategies

Bull Put Spread

Directional Bias Risk Reward




1 XX XX XX

2 Bear Call Spread XX XX XX

3 Bull Call Spread

4 Bear Put Spread

Option Strategies

Bull Put Spread





1 XX XX XX


3 Bull Call Spread XX XX XX

4 Bear Put Spread

Option Strategies

Bull Put Spread





1 XX XX XX


3 Bull Call Spread XX XX XX

4 Bear Put Spread XX XX XX

Option Strategies

Bull Put Spread




Spread Type Trade Rationale Construction BiasDebit

CreditMax Risk Max Reward Breakeven

Bull Call Spread

Reduces trade BE and costs of

a bullish option trade plus

reduces delta and theta effect

BTO lower strike Call

STO higher strike CallBullish Debit Debit

Diff between strikes

minus Debit

Lower Strike +

Debit

Bear Call Spread

Creates premium based strategy

whereby you are using theta

decay to your advantage

STO lower strike Call

BTO higher strike CallBearish Credit

Diff in Strikes

minus CreditCredit

Lower Strike +

Credit

Bear Put Spread

Raises trade BE and costs of a

bearish option trade plus

reduces delta and theta effect

BTO higher strike Put

STO lower strike PutBearish Debit Debit

Diff between strikes

minus Debit

Higher Strike -

Debit

Bull Put Spread

Creates premium based strategy

whereby you are using theta

decay to your advantage

STO higher strike Put

BTO lower strike PutBullish Credit

Diff in Strikes

minus CreditCredit

Higher Strike -

Credit


Vertical Bull Spreads

Bullish Vertical Spreads can be constructed using either Calls or Puts

Bull Call Spread Construction [Debit Spread]

Bull Put Spread Construction [Credit Spread]

These are synthetically equivalent if same expiry/same strike

Bull Call Spread

CALLS STRIKES PUTS

100

+1 105

-1 110

Bull Put Spread

CALLS STRIKES PUTS

100

105 +1

110 -1


Bullish Vertical Spreads

Risks & Rewards

• Bull Call Spread

– Max Loss = Debit Paid for the Spread

– Max Gain = Difference between K’s minus price paid

– Breakeven = Lower K + price paid for spread

• Bull Put Spread

– Max Loss = Difference between K’s less Credit

– Max Gain = Credit Received

– Breakeven = Higher K – Credit Received


Vertical Bear Spreads

• Bearish Vertical Spreads can be constructed using either Calls or Puts• Bear Call Spread Construction [Credit Spread]

• Bear Put Spread Construction [Debit Spread]

• These are synthetically equivalent if same expiry/same strikes

Bear Call Spread

CALLS STRIKES PUTS

100

-1 105

+1 110

Bear Put Spread

CALLS STRIKES PUTS

100

105 -1

110 +1


Vertical Bear Spreads

Risks & Rewards

• Bear Call Spread

– Max Loss = Difference between K’s less Credit

– Max Gain = Credit Received

– Breakeven = Lower K + Credit Received

• Bear Put Spread

– Max Loss = Debit Paid for the Spread

– Max Gain = Difference between K’s minus price paid

– Breakeven = Higher K - price paid for spread


Vertical Option Spread Summary

• Designed to reduce risk while holding an option

position

• Delta in the position is reduced due to short call

position

• Can generate very good returns in excess of 25%

while also allowing for stock pullback (by using

ITM Spreads)

• The stock can make a smaller move in your

direction and you will make more money than by

holding a single leg option or put position


Trade Selection Strategy Checklist1. Security Selection Process

2. What is your current bias

a. Neutral

b. Mildly Bullish

c. Strongly Bullish

d. Mildly Bearish

e. Strongly Bearish

f. Unknown (Breakouts; up or down) and Volatility Trades

3. What is the magnitude of the forecasted move

4. What is the timeframe of the forecasted move

5. Is there a Trigger price for the move

6. What is the support & resistant for the security

7. How will I know if my original bias is wrong during the trade

8. What is the current IV and HV of the security

9. What is your current Risk Appetitea. Position Size

b. Primary Exit Point (PE)

c. Secondary Exit Point (SE)

d. Trade Stops/taking profits & losses

10. Trade Objectives1. Income

2. Downsize Protection

3. Revenue Gain (+20%)

Introduction to Options - VantagePoint

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Transcript of Introduction to Options - VantagePoint