options basic

8/7/2019 options basic

1/46

Options

Tnno Vhk

October 12th 2005, Vilnius


2/46

2

Options are not for everyone!

Have you ever traded shares? Do you make your own investment decisions?

Can you act quickly in the market?

Do you follow market more than just closing prices?

Do you know anything about technical and fundamentalanalysis?

Do you have basic mathematical skills?

Good stock traders are also successful in options!

More opportunities, bigger return and smaller risk!


3/46

3

What are we talking about?

Basic option theory and terminology

Factors affecting option price and pricing of options

Time value

Volatility

Delta

Dividends

How to start trading?

How to get information?

How to measure risks?

How to formulate strategy?

Exercises and examples

Inefficiencies and opportunities in the market


4/46

4

Complex and risky?

Complexity is in terminology!

Lack of knowledge is a big threat

Risks are easier to control and often smaller than with shares

Options expire, shares and bonds dont

Knowledge, strategy and discipline are necessary!


5/46

5

What is an option?

An option is part of a class of securities called derivatives

They derive their value from the worth of an underlying investment

The right (but not the obligation) to buy or sell securities at

a given price before a given date

o Right to buy (CALL) or right to sell (PUT)

o EXERCISE PRICE or STRIKE given price for future transaction

o UNDERLYING any asset or security

o MATURITY DATE, EXPIRY DATE time when option ends

o PREMIUM - Option price


6/46

6

Terminology

1 option = contract on 100 shares

Option premium per one share or total

premium

Exercise vs selling option to market

Option style: American or Europeano American options can be exercised

always during the life of the option!

o European options can be exercised only

at the Maturity Date! Option buyer and Option seller (writer)


7/46

7

Option Price or Premium

Share price today - 100

Call (right to buy) with Strike price 70

What is it worth today?

o 30 is the option price if we need to decide now

Put (right to sell) with Strike price 110, 80


Call at 100, 200


This is the INTRINSIC VALUE of the option!


8/46

8

ITM, ATM, OTM

In the money - ITM

o STRIKE is more favourable to the option holder than marketprice of the share

o Intrinsic value is positive

At the money - ATM

o STRIKE = Market price of the shareo Intrinsic value is 0

Out of the money - OTM

o STRIKE is less favourable to the option holder than market

price of the shareo Intrinsic value is 0


9/46

9

Payoff diagram Stock Position

pikk aktsia positsioon

-50

-25

0

25

50

0 50 100 150 200

Hind

Kasu

m

aktsia


10/46

10

Payoff Diagram Call Option

pikk positsioon ostuoptsioonis

-50

-25

0

25

50

0 50 100 150 200

Hind

Kasum

ostuoptsioon


11/46

11

What if we dont have to decide today?

Share price at market 100

Call option with Strike Price 70

Maturity 5 days from today what is it worth?

But if Strike is 90, 100?

Option has obviously additional value as share price might move!

Intrinsic value does not change

Time Value emerges!

Time Value = Premium Intrinsic Value


12/46

12

Time Value

Time Value decreases as the Time to Maturity decreases Time Value depends on the probability that Option is ITM when it

expires

Time Value is largest when uncertainty is largest with ATM options

Time Value also depends on how much the share price moves The bigger the VOLATILITY the more you can win with the option

and the bigger the Time Value


13/46

13

Time Value decreases as Time to Maturity decreases!

ajavrtus

0

10

20

30

40

50

60

70

80

90

100

020406080100

time value


14/46

14

Time Value

-10

0

10

20

30

40

50

60

30 40 50 60 70 80 90 100 110 120 130 1 40 150 160

Aktsia turuhind

Optsioonipreemia

Optsiooni preemia ajavrtusega T=3 kuud

Optsiooni vrtus lppthtpeval


15/46

15

Theta

Theta is the change in the price of an option for a 1-day decrease

in the time remaining to expiration Theta is almost always negative time is the option buyers

enemy!

Time Value drops fastest during the last 30 days and for ATM

options


16/46

16

Theta Exercise

ETL11P117.5 today Oct 12th, 1.87 kroons

Share price 119, implied volatility 18%

What will the premium of the option be in 3 weeks time if the

share price and volatility will not change?

1.11 time value has declined by 0.76 Nov 18th 37 from now

with 21 days the Time value drops about 41%


17/46

17

Factors affecting Option Premium

CALL or PUT SHARE PRICE

STRIKE

MATURITY DATE

VOLATILITY INTEREST RATE

DIVIDENDS


18/46

18

Volatility

Why is volatility so important?o All the other inputs are fixed and given

o By trading options you are trading actually volatility

o Volatility reflects markets opinion about the share price

movements in the future!o Volatility determines the Time Value!


19/46

19

Historical vs Implied Volatility

Historical reflects history!

Historical is calculated from historical share price movements

It may not be the best indicator for future

Still often gives us a guideline about what to expect


20/46

20

Historical Volatilities

Implied volatilities: ETL 18%, TV 20%, MZN 40%

30 day historical volatility

0,0%

10,0%20,0%

30,0%

40,0%

50,0%

60,0%

70,0%

11.1

0.2

005

19.0

9.2

005

26.0

8.2

005

4.0

8.2

005

13.0

7.2

005

21.0

6.2

005

30.0

5.2

005

6.0

5.2

005

14.0

4.2

005

23.0

3.2

005

28.0

2.2

005

4.0

2.2

005

13.0

1.2

005

22.1

2.2

004

30.1

1.2

004

ETL

TV

MZN


21/46

21

Option Price Movement

If there is any Time Value in the Option Price then it nevermoves 1:1 to share price but always LESS!

Option Price moves according to the PROBALITY of being In-

The-Money at Maturity!

That probability is called DELTA

o Share Price 100

o Strike 100

o Option Premium 5

o Delta?o Share Price 100 -> 101, how much Premium changes?


22/46

22

Delta

Delta is the change in the option value for every point change in

the stock price Long stock position: delta 1.0

Short stock position: delta -1.0

Deeply ITM PUT

o Bought: delta 1

o Sold: delta 1

Deeply ITM CALL

o Bought: delta 1

o Sold: delta 1

Deeply OTM Options DELTA = 0


23/46

23

Delta Exercise

Investor has today Oct 12th, 30 contracts of LTL10C2.7

Share price today 2.73, implied volatility 30%

What is the delta of this option? Premium?

Delta is 0.61 and premium 6.98 cents

Share price rises to 2.75 tomorrow, what is premium then?

7.97 (if it rose today then 8.26), new delta 0.68

How big is gamma??


24/46

24

How do dividends affect the price of the option?

Dividends are only for shareholders!

Call option owner does not get dividends, he has to exercise

option before the ex-date to get dividends

Put option holder would be stupid to exercise before the

dividends

Option price in the market reflects its value so you can always

sell the option back instead of exercising


25/46

25

Put Option

Time to Maturity: 2 weeks

Share Price: 100 Litas

Strike: 150 Litas

Dividends: 10 Litas in 1 week

European type what is price?

American type what is price?

European=American=c.a. 60 Litas

What if dividends are not known?


26/46

26

Call Option

Time to Maturity: 2 weeks

Share Price: 100 Litas

Strike: 50 Litas

Dividends: 10 Litas in 1 week

European type what is price?

American type what is price?

European=40 and American=50 Litas

Right to exercise earlier becomes veryvaluable!


27/46

27

Dividends

For European option holder the effective share price is always:

o Share price in the market minus dividends during the life of the

option

Same situation is with American Put as the early exercise right is

worthless

But American Call owner has a choice and the answer is not always

clear!


28/46

28

American Call

Time to Maturity: 3 months Share Price: 100 Litas

Strike: 95 Litas

Dividends: 3 Litas tomorrow (EX-DATE)

What to do? To exercise today or not??

A: exercise value 5 Litas

B: no exercise value ? Litas

? = c(share price 97, strike 95, TTM 3 months) = 7-8 LTL?


29/46

29

American Call

Owner actually can choose the more valuable between two

options:

o American Call till dividends

o European Call till Maturity

Pricing is complicated

o Easy method: look which is more valueable now

o Analytical formula: Roll-Geske-Whaley


30/46

30

Dividend Exercise

It is 20.04.2006, a day before options Friday

MZN price is 21 Litas in the market and 21.04.2006 is EX-DATE

Dividends are 0.4 Litas

Investor has MZN4C20.5, MZN5C21, MZN6C20.5, MZN5P21.5

American options

What should we do with them today?

Hint: MZN5C20.5 trades at 0.63 Litas in the market


31/46

31

How to start?

Get basic knowledge!

Observe market price movements!

Analyse underlying!

Understand all the risks involved!

Determine your strategy, aim and risk limits!

Determine the investment amount according to your risk limits!


32/46

32

Basics

Terminology

Option parameters

Price determining factors

Payoff diagrams

Time Value and Theta

Historical and Implied Volatility

Delta and its dynamics


33/46

33

Market and Prices

How to find and read prices?

LHV Investor main page

o Enter Stock Symbol and pick Options

EBAY:

EBAY Call Oct05- 40XBAJH

o First 3 letters is stock symbol

o Forth is period and Call-Put

o Fifth is Strike


34/46

34

Examples of Use

Investor believes the rise of the share price in long term but

considers the risks too big He buys 1 year ATM call (leap) Investor believes the rise of the share price but is afraid of short

term fall of the market due to external risks He buys 3 month

ATM call or buys share and 3 month put

Investor owns a share that is not traded very actively and isstable. He thinks the rise in the next half a year will not be more

than 5-10% but he does not want to sell the stock He sells 10%OTM Covered Call and pledges the shares as collateral


35/46

35

Examples of Use

Investor is convinced that share that trades at 53 can not fall below

50 (e.g. BV) and he would be happy to buy at 50 He sells 3 monthPut at Strike 50 and places deposit (margin) as colleteral

Investor foresees big jumps in share price in the near future due to

important news coming out He buys 1-2 month Straddle or

Strangle


36/46

36

Underlying

The same factors that affect share price affect also option price

Fundamental analysis

Volatility

Management

Dividends

Profit history

Technical analysis especially in short term perspective


37/46

37

Make risks certain!

Share price does not move in the right direction or moves too little

You will be short of time

Sold option will be exercised

Volatility moves in wrong direction

Trading with share will be stopped

Technological risks

Dividends


38/46

38

To sell back earlier or hold till end?

What this decision will be based at? Minimal profit/maximal loss?

What is the return on the trade?

Where is Break-even?

What kind of options to buy and why?

How much cash to invest?

How big part of the portfolio into the trade?

Are the specific risks acceptable?

Strategy


39/46

39

Risk Limits and Goals

What kind of investor are you today and which in the future?

Risk tolerance levelo How much capital do you have? How much can you put under

risk?

o Personal factors age, income, debt burden

o Investment experienceo Personal goals yearly return, pension insurance, inflation

cover, short term profit...


40/46

40

Criteria of Successful Investing

Patience

Perseverance Knowledge

Honesty dont cheat yourself and accuse the others

Planning strategy

Discipline follow the rules you have set, use experience, dont

deviate from plan!


41/46

41

Threats and Recommendations

It is easy to see opportunities but they are always accompanied

by risks Greed and inablitity to decide are biggest problems

Dont count on unrealized profit take profit!

Exotic combinations are good for learning but not for real trading

use

When return is limited is it worth the risk?

Draw payoff diagramm risk profile


42/46

42

How to pick an option?

What is the motive of the trade? (leverage, risk reduction)

Which Strike?o Which gives the best return when the vision is right?

How much time value?

o As little as possible when you know the movement!

Which period?

o Little extra!

How big leverage, how big risk?

o The bigger the leverage the greater the threat to lose moneyo Find opportunities and inefficiencies in prices!


43/46

43

What to do with bought option?

What to follow?

o It is often enough to follow share price (spread, liquidity,volatility)

When to sell back?

o When vision has realized or situation changed!

o Limit orders good to use to minimize liquitity risk To exercise or sell back?

o Rather sell back!

What to do at the end?

o Selling back or cash settlemento If no intention to exercise then select cash settlement in

Portfolio overview


44/46

44

How to benefit from options?

Leverage

Hedging risks Planning future share transaction

Insuring profit

Enhancing return of the portfolio


45/46

45

Options with small time value are cheap!

Very short options are cheap! Buy on Monday/sell on Friday!

Buy in the morning/sell in the evening!

Market reacts slowly, volatilities change slowly, fast reaction

guarantees success

Liquidity often better in options than in underlying

Risk/return ratio often very good

Opportunities in Prices


46/46

46

Options in LHV

Tnno Vhk [email protected], 6 800 447

Mihkel Oja [email protected], 6 800 446 Kristjan Lepik [email protected], 6 800 440

options basic

Documents

Transcript of options basic