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Introduction to Options

Andrew WilkinsonAndrew Wilkinson

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Options involve risk and are not suitable for all investors. For more information, read the “Characteristics and Risks of Standardized Options” before investing in options. For a copy call 203 618-5800 or click here. There is no guarantee of execution. Orders will be routed to US options exchanges.

Interactive Brokers LLC is a member of NYSE, NASD, SIPC

In order to simplify the computations, commissions, fees, margin interest and taxes have not been included in the examples used in these materials. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences.

Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities. Past performance is not a guarantee of future results.

Most strategies involving futures and/or options spreads require a margin account.

Supporting documentation for any claims and statistical information will be provided upon request.

Disclosure of Risk

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Bulls & Bears…

First, understanding the descriptive graphA word on volatility and options pricingThen look at some directional trades for bullish or bearish outlooksNext, some direction-neutral trades when the trader wants prices to stagnate or explode

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What does the graph show me?

X-axis depicts price of underlying ($)Y-axis measures profit and lossCombines price variation with cost & P/L of tradeAllows trader to immediately visualize:

Trade costMaximum lossMaximum profitBreakeven points

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What does the graph show me?

Buying any option costs a ‘premium’(debit)Maximum loss can be shown visually as a horizontal line parallel to (and below) the X-axisSelling an option creates a credit

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Points to Remember

These basic strategies don’t changeSkill is knowing when to apply themEach strategy needs a buyer and a sellerRule of thumb:

Long strategies will show an initial cost BELOW the zero line (DEBIT)Short strategies will show an initial ‘gain’ ABOVE the zero line (CREDIT)

Calculating the breakevens and P/L max-mins flows from thereWhat IS different is the HEIGHT of the debit or credit in each market or even between equitiesPrimary reason is VOLATILITY

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Volatility

Historic volatility measures the annualized standard deviation in price of underlyingImplied volatility attempts to predict perceived price movement in the futureIt’s a KEY determinant of option priceShare prices sit across a spectrum ranging from low risk to high riskThe amount of risk determines the volatility

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Volatility

Nasdaq composite versus Dow industrialsiShares Technology ETF (IYW)

Historic volatility = 18.4Implied volatility = 20.1

iShares Industrials ETF (IYJ)Historic volatility = 13.7Implied volatility = 13.6

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Long Call Examples

Just to reiterate earlier point about risk and volatility, take two similar priced stocks from the risk spectrum to see how it impacts option pricingNext slide discusses intrinsic and extrinsic values of a call optionSimply stated INTRINSIC is that portion of an option that is “in-the-money”Extrinsic value is the price of the possibility that the option will become intrinsic during its life

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Qualcomm calls cost 30 percent more than Home Depot

Qualcomm Inc. (QCOM) $39.60Historic volatility = 30.6Implied volatility = 32.7April 37.5 call = 3.30Intrinsic value = 39.60 – 37.50 = 2.10Extrinsic = 3.30 – 2.10 = 1.20

Home Depot Inc. (HD) $38.60Historic volatility = 13.1Implied volatility = 21.2April 37.5 call is 2.00Intrinsic value = 38.60 – 37.50 = 1.10Extrinsic = 2.00 – 1.10 = 0.90

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Long Call

Buying a call implies a bullish viewMaximum loss is cost of call optionBreakeven is strike price plus premium paidBeyond here the maximum profit is unlimited with chart having 45° biasThe more underlying price increases the greater the profit –shares could rise infinitely

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Long Call ExampleQualcomm Shares trading at $39.60April 40.0 call quoted at 1.80One month to expirationCall option nearly is at-the-money Premium is totally extrinsic (40.0 - 39.60)Maximum loss is premium of 1.80 no matter where shares settle (beneath strike)Breakeven is strike price PLUS premium = 40.0+1.80 = 41.80Above here profit increases in line with share priceIf by expiration shares rise to $45.20, profit is 45.20 – 41.80 = 3.40 per contract

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Long Put

Buying a put implies a bearish viewMaximum loss is cost of put optionBreakeven is strike price minus premiumBeyond here the maximum profit is unlimited with chart having 45° biasThe more underlying price declines the greater the profit – shares could fall to zero

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Long Put Example

Home Depot Shs trading at $38.60April 40.0 put quoted at 1.90One month to expirationPut option is in-the-money Premium has 1.40 points intrinsic value (40.0 - 38.60)Maximum loss is premium of 1.90 if shares settle above strikeBreakeven is strike price MINUS premium = 40.0 -1.90 = 38.10Beneath here profit increases in line with share priceIf by expiration shares fall to $34.90, profit is 38.10 – 34.90 = 3.20 per contract

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Covered Call

Buy 100 shares and sell a call option with a higher strike priceIf shares rise the trader is making moneyWhen share price reaches strike price the call option starts to rise penny by penny in line with the shares and offsets the share price gainIf shares fall, the falling equity value is offset in part by the call premiumShares could fall to zero

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Covered Call Example

Most options contracts = 100 shares of stockBuy 100 shares of Apple at $87.95Sell 1 April 95.0 call option at 1.40 points

Shares cost $8,795Option generates $ 140Net cost $8,655

Breakeven is share price MINUS premium = $86.55 (in other words cost basis is reduced)Maximum profit is AT or above strike priceAbove the strike price the positions offset one another so profit is cappedBeneath $86.55 the value declines in line in line with the stock pricewith the stock price

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Protective Put

Buy 100 shares and buy a put with a slightly HIGHER strike priceIf shares continue to rise, the trader sees his or her equity grow – minus the cost of the putIf shares fall the put will offset by each penny the loss of value of the decline below the breakeven pointWhile shares could fall to zero, the put rises commensurately

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Protective Put Example

Most options contracts = 100 shares of stockBuy 100 shares of Oracle at $16.60Buy 1 April 17.0 put option at 0.80 points

Shares cost $1,660Option cost $ 80Net cost $1,740

Breakeven is share price PLUS premium = $17.40 (in other words cost basis is increased)Maximum profit is unlimited and occurs as shares increase above $17.40The put option protects trader against share price decline below strike price minus cost or 17.0 –0.80 = 16.20Beneath $16.20 the put value increases in line with the stock price decline

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Bull Call Spread

Used when shares are expected to riseBuy a call with a strike above the current underlying priceTrade established as a debitSell a call with an even higher strike price with the same underlying and expiration dateThe net cost is the maximum lossMaximum gain is capped at the higher strike price = difference in strikes – premium paidAbove higher strike the gain from the long lower strike is exactly offset by losses from the higher strike

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Currency Futures – Bull Calls

Let’s move to currency futuresHow does one capture the potential unwinding of the “carry-trade?”A call spread is a less risky solution but limits the upside to the tradeLet’s look at how call options were priced before the recent surge in the yenFeb 14, June yen futures trading at 84.16

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June Japanese Yen Future

March 5 – June contract closed at 87.49

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Bull Calls Example

Action: Feb 14. June future closed @ 84.16Buy 1 June 86.0 call @ 0.60 pointsSell 1 June 88.00 call @ 0.30 pointsLong 1 June 86/88 bull call spread @ 0.30Result: March 5. June future closed @ 87.49Sell 1 June 86.0 call @ 2.29 pointsBuy 1 June 88.0 call @1.31 pointsClosed June 86/88 bull call spread @ 0.98Profit is 0.98-0.30 * $12.50 = $850

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June Bull Call - Metrics

Had we had the foresight to play this trade via the underlying we’d have bought outright – long June yen future @ 84.16The profit had we sold at 87.49 would have been 333 * $12.5 = $4.162.50Maximum drawdown two days into the trade was 83 pips when June fell to 83.33Loss would have been $1,037.50By using a bull call spread our loss was pinned to just 30 points or $375 at the startMaximum profit in this case would be distance between the upper and lower strikes (88-86=200) LESS net premium or 200-30 =170That would occur at upper strike price of 88.0Maximum loss is our cost of $375, which occurs at any level beneath lower strike price of 86.0

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Bear Put Spread

Used when underlying is expected to fallBuy a put with a strike below the current underlying price Sell a put with an even lower strike price and the same underlying and expiration dateThe trade is established as a debitThe net cost is the maximum lossMaximum gain is at the lower strike price = difference in strikes – premium paid Below the lower strike the gain from the long higher strike is exactly offset by losses from the lower strike

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Bear Spread Example

A trader believes the price of May crude oil might fall from current $62.04Buy 1 May 60.0 put @ 2.08Sell 1 May 57.0 put @ 1.08Net cost of May 60/57 bear put spread 100 pointsMaximum loss is 100 points * $10= $1,000 at values of 60 and aboveMaximum profit is strike spread (60-57=3) minus cost of spread = 3-1 or 200 points or $2,000Occurs at values from 57 and lowerBreakeven occurs at 59 (after the long put value exceeds trade cost)

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Closing Thoughts

Plan your tradesPlan your tradesCreate a visual image to assist youCreate a visual image to assist youThink Think –– ““premium profilingpremium profiling””Consider alternative strategies and Consider alternative strategies and ““whatwhat--ifif”” scenariosscenariosQuestions?Questions?