strategies using options,futures-derivatives,hedging
...k and sell her a VCR for the advertised price of $129.95. Jane has just saved $50. Her long call option was in-the-money. Scenario 2: A few weeks later, Jane returns to the store and finds the VCR on sale for $119.95? Her rain check is now worthless because she can simply purchase the VCR at the reduced price. In this case, Jane's call option expired worthless because it was out-of-the-money. Just because you own a long call option doesn't mean you are under any obligation to use it. Scenario 3: Jane's friend Jeff phones and mentions that his VCR has just broken. She tells him about her rain-check and agrees to sell it to Jeff for $5 (the option premium). The strike price is still $129.95 and the expiration date is 2 months out. However, Jeff is taking a risk. The VCR might be priced lower than the $129.95 strike price in which case the rain-check is worthless and Jeff loses $5. Put Options Put options give the buyer the right, but not the obligation, to sell an underlying asset at the strike price until market close on the 3rd Friday of the expiration month. Just like call options, put options come in various strike prices depending on the current market price of the underlying instrument with a variety of expiration dates. Expiration dates can vary from one month out to more than a year (LEAPS options). However, unlike call options, you might consider going long a put option if you expect market prices to fall (bearish). In contrast, if you are bullish (expect the market to rise), you might consider selling a put option. If you choose to buy or go long a put option, you are purchasing the right to sell the underlying instrument at whatever strike price you choose until the expiration date. The premium of the long put option will show up as a debit in your trading account. The cost of the premium is the maximum loss you risk by purchasing a put option. The maximum profit is limited to the downside as the underlying stock falls to zero. A profit can be made in one of two ways if the underlying market declines. By exercising a put option, you are short 100 shares of the underlying stock. If and when the underlying stock falls below the put strike price, you can exercise the put to short the shares at a higher price and then buy the underlying stock at a cheaper price to cover the short and exit the trade (strike price - current price = profit). The second technique for profiting on a put comes from offsetting it. If the price of the underlying stock falls, the corresponding put premium increases and can then be sold at a profit. If you go long a put option in a bull market, the value of the put will diminish. Then your only choices are to sell it at a loss or let it expire worthless. If you choose to sell or go short a put option, you are selling the right to sell the underlying stock at a particular strike price to an option holder. The premium of the short put will show up as a credit in your trading account. In most cases, you are anticipating that the short put option will simply expire worthless on the expiration date so that you can keep the premium received. The premium amount is the maximum profit you can receive by selling a put option. If the underlying stock falls below the put strike price, the put will most likely be assigned to an option holder who may choose to exercise the option. The option seller then has an obligation to buy 100 shares (per option) of the underlying stock at the put strike price from the option holder. You will then be long 100 shares of the underlying stock and your loss depends on how low the price of the underlying stock falls as you try to sell the shares to exit the position. Experienced traders who choose to go short put options do so in a stable or bull market because the put will not be exercised unless the market falls. Put options give you the right to sell something at a specific price for a fixed amount of time. A put option is in-the-money (ITM) when the strike price is higher than the market price of the underlying asset. A put option is at-the-money (ATM) when the price of the underlying is equal (or closes) to its strike price. A put option is out-of-the-money (OTM) when the price of the underlying security is greater than the strike price. Example: Jane opens a small travel business that specializes in island vacations. The manager of a a local business agrees to purchase 100 trips to Hawaii in January for $300 round-trip as perks for his employees. Jane's computed total cost of each trip is $200-a $100 profit on each trip which locks in a guaranteed profit of $10,000 for her initial period of operation. In effect, the guaranteed order is a put option. Scenario 1: As luck would have it, just as November rolls around, a competitor offers the same trip for only $250. If Jane didn't have a put option agreement, she would have to drop her price to meet the competition's price, and thereby lose a significant amount of profit. Luckily, she exercises her right to sell the trips to Hawaii for $300 each and enjoys a healthy profit in the new year. Jane's put option was in-the-money in comparison to the price of her competitor. Scenario 2: Jane gets a call from another client who needs to set up 100 trips in January to fulfill obligations to his management team and is willing to pay up to $400 per trip. Since Jane is under no obligation to sell the trips to her first customer, she agrees to sell them for the higher market price and makes a total profit of $20,000 on the deal Intrinsic Value and Time Value Intrinsic value and time value are two of the primary determinants of an option's price. Intrinsic value can be defined as the amount by which the strike price of an option is in-the-money. It is actually the portion of an option's price that is not lost due to the passage of time. The following equations will allow you to calculate the intrinsic value of call and put options: Call Options: Intrinsic value = Underlying Stock's Current Price - Call Strike Price Time Value = Call Premium - Intrinsic Value Put Options: Intrinsic value = Put Strike Price - Underlying Stock's Current Price Time Value = Put Premium - Intrinsic Value ATM and OTM options don't have any intrinsic value because they do not have any real value. You are simply buying time value, which decreases as an option approaches expiration. The intrinsic value of an option is not dependent on the time left until expiration. It is simply an option's minimum value; it tells you the minimum amount an option is worth. Time value is the amount by which the price of an option exceeds its intrinsic value. Also referred to as extrinsic value, time value decays over time. In other words, the time value of an option is directly related to how much time an option has until expiration. The more time an option has until expiration, the greater the option's chance of ending up in-the-money. Time value has a snowball effect. If you have ever bought options, you may have noticed that at a certain point close to expiration, the market seems to stop moving anywhere. That's because option prices are exponential-the closer you get to expiration, the more money you're going to lose if the market doesn't move. On the expiration day, all an option is worth is its intrinsic value. It's either in-the-money, or it isn't. Example: Let's use the table below to calculate the intrinsic value and time value of a few call options. PRICE OF ABC = 106 CALL STRIKE PRICE JAN APRIL JULY 100 6 3/8 7 ½ 8 ¼ 105 2 3 7/8 4 ¾ 110 3/8 1 9/16 2 ¾ If the current market price of ABC is 106, use the table to calculate the intrinsic value and time value of a few call option premiums. 1) StrikePrice=100 Intrinsic value = Underlying price - Strike price = $106 - $100 = $6 Time value = Call premium - Intrinsic value = $ 7 ½ - $6 = $ 1 ½ 2) Strike Price = 105 Intrinsic value = Underlying price - Strike price = $106 - $105 = $1 Time value = Call premium - Intrinsic value = $3 7/8 - $1 = $2 7/8 3) Strike Price = 110 Intrinsic value = Underlying price - Strike price = $106 - $110 = - $4 = Zero Intrinsic Value Time value = Call premium - Intrinsic value = $1 9/16 - $0 = $1 9/16 = All Time Value The intrinsic value of an option is the same regardless of how much time is left until expiration. However, since theoretically an option with 3 months till expiration has a better chance of ending up in-the-money than an option expiring in the present month, it is worth more because of the time value component. That's why an OTM option consists of nothing but time value and the more out-of-the-money an option is, the less it costs (i.e. OTM options are cheap, and get even cheaper further out). To many traders, this looks good because of the inexpensive price one has to lay out in order to buy such an option. However, the probability that an extremely OTM option will turn profitable is really quite slim. The following table helps to demonstrate the chance an option has of turning a profit by expiration. PRICE OF ABC = 106 STRIKE JAN INTRINSIC VALUE TIME VALUE 90 17 16 1 95 13 ½ 11 2 ½ 100 10 ¾ 6 4 ¾ 105 6 ½ 0 6 ½ 110 3 0 3 With the price of ABC at 106, a January 110 call would cost $3. The breakeven of a long call is equal to the strike price plus the option premium. In this case, ABC would have to be at 113 in order for the trade to breakeven (110 + 3 = 113). If you were to buy a January 95 call and pay 13 ½ for it, ABC would only have to be at 108 ½ in order to break even (95 + 13 ½ = 108 ½). As you can see, the further out an OTM option is, the less chance it has of turning a profit. The deeper in-the-money an option is, the less time value and more intrinsic value it has. That's because the option has more real value and you pay less for time. Therefore, the option moves more like the underlying asset. This very important concept helps to create the delta of an option. Understanding the delta is the key to creating delta neutral strategies-one of the main approaches to nondirectional Optionetics trading. One of the reasons it's important to know the minimum value of an option is to confirm how much real value and how much time value you are paying for in a premium. Since you can exercise an American style call or put anytime you want, its price should not be less than its intrinsic value. If an option's price is less than its exercise value, an investor could buy the call and exercise it, making a guaranteed arbitrage profit before commissions. How To Use Options Options can be used in a variety of ways to profit from a rise or fall in the underlying market. The most basic strategies employ put and call options as a low capital means of garnering a profit on market movement. Options can also be used as insurance policies in a wide variety of trading scenarios. You probably have insurance on your car or house because it is the responsible and safe thing to do. Options provide the same kind of safety net for trades and investments. They also increase your leverage by enabling you to control the shares of a specific stock without tying up a large amount of capital in your trading account. The amazing versatility that an option offers in today's highly volatile markets is welcome relief from the uncertainties of traditional investing practices. Options can be used to offer protection from a decline in the market price of a long underlying stock or an increase in the market price of a short underlying stock. They can enable you to buy a stock at a lower price, sell a stock at a higher price, or create additional income against a long or short stock position. You can also use option strategies to profit from a move in the price of the underlying asset regardless of market direction. There are three general market directions: market up, market down, and market sideways. It is important to assess potential market movement when you are placing a trade. If the market is going up, you can buy calls, sell puts or buy stocks. Do you have any other available choices? Yes, you can combine long and short options and underlying assets in a wide variety of strategies. These strategies limit your risk while taking advantage of market movement. The following tables show the variety of options strategies that can be applied to profit on market movement: Bullish Limited Risk Strategies Bullish Unlimited Risk Strategies Bearish Limited Risk Strategies Buy Call Bull Call Spread Bull Put Spread Call Ratio Backspread Buy Stock Sell Put Covered Call Call Ratio Spread Buy Put Bear Put Spread Bear Call Spread Put Ratio Backspread Bearish Unlimited Risk Strategies Neutral Limited Risk Strategies Neutral Unlimited Risk Strategies Sell Stock Sell Call Covered Put Put Ratio Spread Long Straddle Long Strangle Long Synthetic Straddle Put Ratio Spread Long Butterfly Long Condor Long Iron Butterfly Short Straddle Short Strangle Call Ratio Spread Put Ratio Spread It is of paramount importance to be creative with your trading. Creativity is rare in the stock and options market. That's why it's such a winning tactic. It has the potential to beat the next person down the street. You have a chance to look at different scenarios that they do not have the knowledge to construct. All you need to do is take one step above the next guy for you to start making money. Luckily the next person, typically, does not know how to trade creatively. Strategies involving a single option and a stock: There are number of trading strategies involving a single option on a stock and the stock itself. The profits from these are illustrated in the following figures. In the figure the dashed line shows the relationship between profit and the stock price for the individual securities constituting the portfolio, where as the solid line shows the relationship between profit and the stock price for the whole portfolio. The following figure consists of a long position in a stock plus a short position in the call option. This is known as writing a covered call. The long stock position ?covers? or protects the investor from the payoff on the short call that becomes necessary if there is sharp rise in the stock price In figure (b) a short position in a stock is combined with a long position in a call option. This is the reverse of writing a covered call. In figure (c) the investment strategy involves buying a put option on a stock and the stock itself. The approach is sometimes referred to a protective put strategy. In figure (d) a short position in a put option is combined with a short position in the stock. This is reverse of protective put. The profit patterns in all the above figures have the same general shape. We cab explain this through put-call parity, according to which, Where p is the price of European put, is the stock price, c is the price of European call, X is the strike price of both call and put, r is the risk-free interest rate , T is the time to maturity of both call and put, And D is the present value of dividends anticipated during the life of the option. The above equation shows that a long position in a put combined with long position in the stock is equivalent to a long call position plus a certain amount of (= )cash. This explains why the profit pattern in figure (c) is similar to the profit pattern from along call position. The position in figure (d) is the reverse of that in (c) and therefore leads to profit pattern similar to that of a short call position. The above equation can be rearranged to become in other words, a long position in the stock combined with a short position in a call is equivalent to a short put position plus a certain amount(= ) of cash. This equality explains why the profit pattern in figure (a) is similar to the profit pattern from a short put position. The position in figure (b) is the reverse of that in figure (a) and therefore leads to a profit pattern similar to that from a long put position. PHASE - II ADVANCED OPTION STRATEGIES: Option Spreads: Basic Concepts: A spread is a purchase of one option and sale of another. There are two general types of spreads. 1. Vertical strike or Money Spread: This strategy involves purchase of an option with particular exercise price and the sale of another option differing only by exercise price. 2. Horizontal, Time or Calendar Spread: In this spread, the investor purchases an option with an expiration of a given month and sells an otherwise identical option with a different expiration month Why option Spreads? Spreads offer the potential for a small profit while limiting the risk. They can be very useful in modifying risk while allowing profits if market forecasts prove accurate. Types of Money Spreads: Bull spread Bear spread Butterfly spread BULL SPREADS: Consider two call options differing only by exercise price, and , where < . Their premiums are and , and we know that > . A bull spreads consists of the purchase of the option with lower exercise price and sale of the option with the higher exercise price. Assuming that one option of each, = 1 and = -1, the profit equations are The stock price at expiration can fall in one of the three ranges: less than or equal to , greater than but less than or equal to , or greater than . The profits for the three ranges are as follows: = - + if = - - + =-c1+ (st-x1) +c2 if < = - - - + + =-c1+st-x1+c2-(st-x2) if < < = - - + In case where the stock price ends up equal to or below the lower exercise price, both options expire out-of-money. The spreader loses the premium on the long call and retains the premium on the short call. The profit is same regards less of how far below the exercise price the stock price is. Because the premium on the long call is greater than the premium on the short call, however this profit is actually a loss. In the third case where both options end up in- the-money, the short call is exercised on the spreader, who exercises the long call and then delivers the stock. The effect of the stock price cancels and the profit is constant for any stock price above the higher exercise price. The spreader paid a premium of , received a premium of , and thus obtained the spread for a net investment of - . The maximum pay off from the spread is - . No one would pay more than the maximum payoff from an investment. Therefore the profit is positive. Only in the second case, where the long call ends up in-the-money and short call is out-of-money, is there any uncertainty. The equation shows that the profit increases dollar for dollar with the stock price at expiration. Here correspond to and respectively. Establishing a bull call spread involves the purchase of a call option on a particular underlying stock, while simultaneously writing a call option on the same underlying stock with the same expiration month, at a higher strike price. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. This spread is sometimes more broadly categorized as a "vertical spread": a family of spreads involving options of the same stock, same expiration month, but different strike prices. They can be created with either all calls or all puts, and be bullish or bearish. The bull call spread, as any spread, can be executed as a "unit" in one single transaction, not as separate buy and sell transactions. For this bullish vertical spread, a bid and offer for the whole package can be requested through your brokerage firm from an exchange where the options are listed and traded. Market opinion: Moderately bullish to bullish. Moderately Bullish: An investor often employs the bull call spread in moderately bullish market environments, and wants to capitalize on a modest advance in price of the underlying stock. If the investor's opinion is very bullish on a stock it will generally prove more profitable to make a simple call purchase. Risk Reduction: An investor will also turn to this spread when there is discomfort with either the cost of purchasing and holding the long call alone, or with the conviction of his bullish market opinion. Benefits: The bull call spread can be considered a doubly hedged strategy. The price paid for the call with the lower strike price is partially offset by the premium received from writing the call with a higher strike price. Thus, the investor's investment in the long call, and the risk of losing the entire premium paid for it, is reduced or hedged. On the other hand, the long call with the lower strike price caps or hedges the financial risk of the written call with the higher strike price. If the investor is assigned an exercise notice on the written call and must sell an equivalent number of underlying shares at the strike price, those shares can be purchased at a predetermined price by exercising the purchased call with the lower strike price. As a trade-off for the hedge it offers, this written call limits the potential maximum profit for the strategy. Risk vs. Reward: Upside Maximum Profit: Limited Difference between Strike Prices - Net Debit Paid Maximum Loss: Limited Net Debit Paid A bull call spread tends to be profitable when the underlying stock increases in price. It can be established in one transaction, but always at a debit (net cash outflow). The call with the lower strike price will always be purchased at a price greater than the offsetting premium received from writing the call with the higher strike price. Maximum loss for this spread will generally occur as the underlying stock price declines below the lower strike price. If both options expire out-of-the-money with no value, the entire net debit paid for the spread will be lost. The maximum profit for this spread will generally occur as the underlying stock price rises above the higher strike price, and both options expire in-the-money. The investor can exercise the long call, buy stock at its lower strike price, and sell that stock at the written call's higher strike price if assigned an exercise notice. This will be the case no matter how high the underlying stock has risen in price. If the underlying stock price is in between the strike prices when the calls expire, the long call will be in-the-money and worth its intrinsic value. The written call will be out-of-the-money, and have no value. Break Even Point (BEP) BEP: Strike Price of Purchased Call + Net Debit Paid Effect of Volatility: The effect of an increase or decrease in the volatility of the underlying stock may be noticed in the time value portion of the options' premiums. The net effect on the strategy will depend on whether the long and/or short options are in-the-money or out-of-the-money, and the time remaining until expiration. Time Decay: The effect of time decay on this strategy varies with the underlying stock's price level in relation to the strike prices of the long and short options. If the stock price is midway between the strike prices, the effect can be minimal. If the stock price is closer to the lower strike price of the long call, losses generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the higher strike price of the written call, profits generally increase at a faster rate as time passes. Alternatives before expiration: A bull call spread purchased as a unit for a net debit in one transaction can be sold as a unit in one transaction in the options marketplace for a credit, if it has value. This is generally the manner in which investors close out a spread before its options expire, in order to cut a loss or realize profit. Alternatives at Expiration: If both options have value, investors will generally close out a spread in the marketplace as the options expire. This will be less expensive than incurring the commissions and transaction costs from a transfer of stock resulting from either an exercise of and/or an assignment on the calls. If only the purchased call is in-the-money as it expires, the investor can either sell it in the marketplace if it has value or exercise the call and purchase an equivalent number of shares. In either of these cases, the transaction(s) must occur before the close of the market on the options' last trading day. An Example: Because the profit and loss from the two calls are used to offset one another, the most you can ever lose with a bull spread is the cost of the spread itself, in this example $2. In addition, the most you can ever gain from a bull spread is the difference between the two strike prices less the cost of the spread, in this case $3 (35 - 30 - 2). Note that a bull spread reaches its maximum loss when the stock is below the lower strike price, and its maximum profit when the stock is above the higher strike price. Here are the returns based on the stock price at expiration: BEAR SPREAD A bear spread is the mirror image of a bull spread. The trader is long the high-exercise ?price call and short the low-exercise-price call. Since N1= -1 and N2= 1, the profit equation is simply = -Max (0, ST ? E1) + C1 + Max (0, ST ? E2) ? C2 The outcomes are a...