Curious about Options? Wondering if the Greeks are the people fighting about austerity packages or that frat which always had hot girls at their parties? . What if your interviewer asked you what it means to Long a put or write a call? Let's take a look at the fundamental basics of options that you should know as you gear up for recruiting.
Options are everywhere. Every decision you make and risk you assume is a derivative that is being priced, bought or sold by somebody. How do you decide what school to attend, where to live, what job to take? It may not seem like these decisions contain embedded options, but each has a level of risk, reward and cost associated with it. Each has a variable range of favorable or unfavorable outcomes that may or may not be within your control.
Consider purchasing a piece of artwork from an unknown artist as an investment. The initial outlay is relatively small and the probability that the artist will be recognized is relatively slim. However, if the artist does become famous, your small initial investment may appreciate significantly. This is a call option. The investor participates in the potential upside in exchange for a small initial financial payment.
Call Option (Buyer or holder): The buyer of a call option has the right (but not the obligation) to buy a security(St) at a pre-specified time (expiration) and price (strike=K) . The buyer pays a fee (premium=P) to the seller to receive this right. Buyer's payout = (St-K)-P
Call Option (Seller or writer) : The seller of a call option has the obligation to sell a security(St) at a pre-specified time (expiration) and price (strike=K). The seller receives a fee (premium=P) from the buyer to take on this obligation. Seller's payout = -(St-K)+P
*Calls provide the buyer and seller full exposure to price movements above the strike. Like buying a speculative stock or that piece of artwork by the unknown artist, the initial outlay (premium) is small relative to the potential gain.
Put Option (Buyer or holder) : The buyer of a put option has the right (but not the obligation) to sell a security(St) at a pre-specified time (expiration) and price (strike=K). The buyer pays a fee (premium) to the seller to receive this right. Buyer's payout = (K-St)-P
Put Option (Seller or Writer) : The seller of a put has the obligation to buy a security(St) at a pre-specified time(expiration) and price(strike=K). The seller receives a fee (premium=P) from the buyer to take on this obligation. Seller's payout = (K-St)+P
*Puts provide the buyer and seller full exposure to price movements below the strike. Like purchasing insurance the premium paid provides protection from losses due to declining prices.
The difference between European and American Options include :
European Options may be exercised only on the expiration date
American options may be exercised at any time before expiration. (We will be focusing on American options)
Let's say the investor paid a $2 premium and is long a call on NFLX(netflix), Strike(K) = $85 expiration Dec 21 2012. If, at expiration NFLX is at $88. The investor would have made (St-K)-P = ($88-$85)-$2 = $1.
*Note that in the real world there are 100 shares per option contract so do you see what the $1 profit translates into.
Remember that the maximum loss for a buyer of a call option is the premium paid and the maximum gain is unlimited. The reverse is true for the seller of a call option.
Homework Q1) If you paid $2 premium and are long the put on NFLX, K=$81 expiration Dec 21 2012. If, at expiration NFLX is at $78. How much did I make or lose? (FYI you are a put buyer here)
Remember that the maximum gain for a buyer of a put option equals strike less the premium if the stock price goes to zero. The maximum loss is the premium paid.
Here are some simple shorthand descriptions to reflect the option's risk profile.
ATM: No this is not your father/Sugar Mommy/Sugar Daddy!
At the Money options simply mean the Strike price is he same as the spot/stock price (K=St)
ITM Calls: In the money calls are when the strike price is below the the spot price (K
OTM Calls : Out of the money calls have strike price above the spot price (K>St)
OTM Puts: Out of the money puts have strike price below the spot price (K
Q2b) Is HW Q1 ATM, ITM or OTM
So what happens if we buy a call and sell a put at the same time? This is called a Combo. Depending on the strike prices used in the combo, our initial cash outlay (or premium will change). If stock isat $20 and we purchase the ITM call at Strike (K) = $15 and sell the OTM K=$15 put, we have locked in the right and obligation to purchase the stock at $15. Since the stock is currently at $20, this combo must be worth $5 to us. This concept is called Parity.
Combo = Call - Put (C-P)
Parity = Stock - Strike (St-K)
Carry= Interest - Dividends
***** COMBO = PARITY + CARRY *****
C-P = (St-K)+ (Int-dvd)
By rearranging the above equation, we can solve for calls and puts in relation to each other.
C= (St-K) + (Int-dvd) + P
HW Q3) What is the value of parity for the put given the following?
Call (C) = 1.01 , Put (P) = 3.52, Stock(S) = 37.45, Strike(K)= 40, Interest(int)=0.04 and Dividends(dvd)=0
HW Q4) If the spot of an underlying asset increases, how does it affect the value of a call option vs that of a put option ? (*Hint, if St increases what happens to P & C)
HW Q5) Assume two call options have the same underlying security and the same strike but different expirations. Which would have a higher premium? (The one with expiration in 6mths or 1 year?)
If you understood the material post your answers to Q1-Q5 below and I'll be happy to reveal the answers.
If you are an options whizz give the others a chance to learn as Practice makes perfect!
**For more advanced Options Theory, Check back in next Tuesday as we take a look at the Option Greeks (Delta, Gamma, Theta, Vega and Rho)