11/27/12

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)

Examples:
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 (KTM Puts: In the money puts are when the strike price is above the the spot price (K>St)

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

Q2a) In the NFLX long call example, was it ATM , ITM or OTM
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 is trading at $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 trading at $20, this combo must be worth $5 to us. This concept is called Parity.

Put-Call 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)

Comments (26)

11/26/12

1) $1
2)a.ITM
b.ITM
3)2.55
4)Put value decreases, call value increases
5)1 yr because of theta decay

11/28/12

Love this! I am considering to start trading options (never traded anything before) starting next month. Definitely will follow your series

11/28/12

Can you explain the last part of the parity? I understand everything else no problem, but I don't understand the part where the parity has to be worth $5 to us. Can you go a little more in depth here?

In reply to Mr.Saxman
11/28/12

Mr.Saxman:
Love this! I am considering to start trading options (never traded anything before) starting next month. Definitely will follow your series

Read Natenberg before you make that decision - don't base it off an abbreviated and oversimplified series like this
11/28/12

... not another presentation deck to summer interns please...

In reply to dest149
11/28/12

dest149:
Can you explain the last part of the parity? I understand everything else no problem, but I don't understand the part where the parity has to be worth $5 to us. Can you go a little more in depth here?

Sure, Let's take a look at the current stock price as seen above in the Put-Call Parity explanation. Since Parity= Stock - Strike and the stock price is $20, Strike Price(K) is $15, Parity is $5. Are you confused about the ITM/OTM parts?

~~ Fortune favours the brave ~~

My WSO Blog

In reply to gammaovertheta
11/28/12

gammaovertheta:
Mr.Saxman:
Love this! I am considering to start trading options (never traded anything before) starting next month. Definitely will follow your series

Read Natenberg before you make that decision - don't base it off an abbreviated and oversimplified series like this

Absolutely read Sheldon Natenberg's book! Brilliant work!
http://www.amazon.com/Option-Volatility-Pricing-St...

In fact having an understanding of the basics of options will certainly help when you read his book

~~ Fortune favours the brave ~~

My WSO Blog

11/28/12

Am an options market maker - if you are a retail investor or a sole investore, DONT trade options, you haven't got the pockets to make the strategies work.

Furthermore, aside from german equities and a few index options, bid offer spreads are too wide

1percentblog.com

In reply to redrut
11/28/12

redrut:
Am an options market maker - if you are a retail investor or a sole investore, DONT trade options, you haven't got the pockets to make the strategies work.

Furthermore, aside from german equities and a few index options, bid offer spreads are too wide

What advice do you have for the students who want to be brokers/market makers or trade for example fx/equity options at a large Inv. bank's trading desk?

~~ Fortune favours the brave ~~

My WSO Blog

In reply to Mr.Saxman
11/28/12

Mr.Saxman:
Love this! I am considering to start trading options (never traded anything before) starting next month. Definitely will follow your series

Did you do the homework qtns?

~~ Fortune favours the brave ~~

My WSO Blog

In reply to LaFemmeFinancière
11/28/12
In reply to LaFemmeFinancière
11/28/12

LaFemmeFinanciere:
dest149:
Can you explain the last part of the parity? I understand everything else no problem, but I don't understand the part where the parity has to be worth $5 to us. Can you go a little more in depth here?

Sure, Let's take a look at the current stock price as seen above in the Put-Call Parity explanation. Since Parity= Stock - Strike and the stock price is $20, Strike Price(K) is $15, Parity is $5. Are you confused about the ITM/OTM parts?

Right I understand the math of it. I guess I what I was trying to ask is what a parity actually is. Not how it is calculated. For example, the parity is $5, but what does that $5 signify? Is that profit per option so you get $500 (since 100 shares/contract) is it a sort of premium that you would implement if you think the shares are going no where? Yes I understand ITM and OTM, although I am not sure what the point of buying ITM is....

In reply to LaFemmeFinancière
11/28/12
In reply to dest149
11/28/12

dest149:
LaFemmeFinanciere:
dest149:
Can you explain the last part of the parity? I understand everything else no problem, but I don't understand the part where the parity has to be worth $5 to us. Can you go a little more in depth here?

Sure, Let's take a look at the current stock price as seen above in the Put-Call Parity explanation. Since Parity= Stock - Strike and the stock price is $20, Strike Price(K) is $15, Parity is $5. Are you confused about the ITM/OTM parts?

Right I understand the math of it. I guess I what I was trying to ask is what a parity actually is. Not how it is calculated. For example, the parity is $5, but what does that $5 signify? Is that profit per option so you get $500 (since 100 shares/contract) is it a sort of premium that you would implement if you think the shares are going no where? Yes I understand ITM and OTM, although I am not sure what the point of buying ITM is....

The whole point is that in a delta neutral portfolio, puts and calls are the same thing. As a corollary, the implied vol for the same strike therefore must be the same irrespective of whether it is a put or a call. With some deviation for american options or assets with dividends, of course.

Jack: They're all former investment bankers who were laid off from that economic crisis that Nancy Pelosi caused. They have zero real world skills, but God they work hard.
-30 Rock

11/29/12

Advice for getting into options on a inv bank market making or broking desk...I work for a smaller market maker and we play in listed derivatives only.

Derivatives volumes are heavily down, there isn't as much money in the system as there used to be, the overload of brokers and mkt makers have tightened prices quite signficiantly. It's a very cyclical business where the gov bond desk is having a great year but the Equities is doing F all.

My advice, steer clear of single stocks derivs desks, closing down at a fast rate. Short end used to be great but with interest rates bounded to 0 for the considerable future, there may be less reason for trades to be put on, so less edge for a market maker.

For a market maker, practice your short and medium memory skills. Not joking at all! We quote every 40 seconds for strategies (I am on the govt bond desk) over 10 products each with for active months. We have to know whats trading, how much of it, whats the current market position - you can use software aids to help but you need to be quick with pricing so you need a good recall of numbers.

Brokers - I can't comment, interdealer brokers seem to be earning a lot more than you would think considering they take no risk but if you want to use your brain, this is probably not the job for you.

Finally be aware that more complicated derivatives may see vastly reduced markets in the future while you should keep an eye on the swaps/swaptions market as it slow comes on exchange.

Sorry I have nothing specific

1percentblog.com

In reply to rockstarlive
11/29/12

rockstarlive:
What are the answers though?

you are correct

~~ Fortune favours the brave ~~

My WSO Blog

In reply to LaFemmeFinancière
11/29/12

LaFemmeFinanciere:
rockstarlive:
What are the answers though?

you are correct

Awesome! Can we cover option strategies or Black-Scholes next?

In reply to rockstarlive
12/1/12

rockstarlive:
LaFemmeFinanciere:
rockstarlive:
What are the answers though?

you are correct

Awesome! Can we cover option strategies or Black-Scholes next?

Sure, after we do the Greeks though.

~~ Fortune favours the brave ~~

My WSO Blog

In reply to dest149
12/1/12

dest149:
LaFemmeFinanciere:
dest149:
Can you explain the last part of the parity? I understand everything else no problem, but I don't understand the part where the parity has to be worth $5 to us. Can you go a little more in depth here?

Sure, Let's take a look at the current stock price as seen above in the Put-Call Parity explanation. Since Parity= Stock - Strike and the stock price is $20, Strike Price(K) is $15, Parity is $5. Are you confused about the ITM/OTM parts?

Right I understand the math of it. I guess I what I was trying to ask is what a parity actually is. Not how it is calculated. For example, the parity is $5, but what does that $5 signify? Is that profit per option so you get $500 (since 100 shares/contract) is it a sort of premium that you would implement if you think the shares are going no where? Yes I understand ITM and OTM, although I am not sure what the point of buying ITM is....

You don't buy ITM, you want it to be in the money at or before expiration. So for a long call you want (St>K) - P in order for it to be ITM
Yes $500 profit is correct.

Parity is the amount by which an option is in the money. (aka moneyness of the option) Parity refers to the option trading in unison with the stock. This also means that parity and intrinsic value are closely related. When we say that an option is trading at parity, we mean that the option's premium consists of only its intrinsic value. (we will cover Intrinsic value next post)

For example, if Microsoft was trading at $53.00 and the January K=50 calls were trading at $3.00, then the January 50 calls are said to be trading at parity. Under the same guidelines, the January K=45 call would be trading at parity if they were trading at $8.00. So, parity for the January 50 calls is $3.00 while parity for the January 45 calls is $8.00

~~ Fortune favours the brave ~~

My WSO Blog

In reply to LaFemmeFinancière
12/2/12

LaFemmeFinanciere:

You don't buy ITM, you want it to be in the money at or before expiration. So for a long call you want (St>K) - P in order for it to be ITM
Yes $500 profit is correct.

But some people do buy ITM and my question is why.... I recognize that you want the option to fall ITM at or before the time of expiration. Thanks for the post on parity. Just to be clear, parity is just the amount the option is in the money, but it does not take into account the premium.
In reply to LaFemmeFinancière
12/2/12

LaFemmeFinanciere:
You don't buy ITM, you want it to be in the money at or before expiration.

There are so many things wrong with these generalizations. Many people buy ITM options for a number of reasons across a variety of strategies - maybe they want to go long synthetically at a certain strike, so they buy an ITM call and write a put against it, or maybe they want to leg into a spread that requires an ITM put, or maybe they have a view on volatility at that strike (volatility trading is the most common options strategy at financial institutions after all). It doesn't matter why, but it happens all the time.

Similarly there's no reason to say that "[being] in the money at or before expiration" is the only way to make money in options. If you buy a way OTM option with a delta value of 2 and sell it a few weeks later when it's trading with a 45-delta, then you have most likely made triple digit returns! Who gives a shit if it's ITM or ATM as long has it increased in price? Making money in options is the same as making money in any investment - you enter a position and you want it to increase in value. Assuming you aren't holding these to the moment of expiration, passing the 50-delta threshold has no cash significance.

12/5/12

This is a great post and so is your subsequent post on options. Really appreciate it, even if only for personal interest.

It would be great (and forgive me if this already exists and I just haven't found it) if WSO could have an educational, or basic finance forum for great stuff like this.

Remember, once you're inside you're on your own.
Oh, you mean I can't count on you?
No.
Good!

In reply to redrut
12/7/12

redrut:
Am an options market maker - if you are a retail investor or a sole investore, DONT trade options, you haven't got the pockets to make the strategies work.

Furthermore, aside from german equities and a few index options, bid offer spreads are too wide

Disagree, options can be very useful when executing levered directional bets in certain equities. Selling covered calls is also a tried and true retail strategy for the buy and hold investor. However, market making in vol requires deep pockets yes.

12/8/12

There's a problem with the analogy - you purchased the underlying asset (the artwork). Had you simplistically agreed via a contract to purchase the artwork at a specific price at a future date, now that's an option!

In reply to motionfx
12/8/12

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12/8/12

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