High Tech Talents

Options

Understanding Options

Information on Call and Put Options

Options are called derivatives, which means an option derives its value from underlying asset like stock or an index. An option is a contract that gives buyer the right (not the obligation) to buy or sell an underlying asset at a particular price (called Strike Price) on or before a certain date (Expiry Date).

1.0)     Definitions

Long Position Buy first sell later:  (buy to open)   to  (sell to close)
Short Position Sell first buy later:  (sell to open)  to  (buy to close)
Call Buyer Long position
Call Seller Short position
Put Buyer Long position
Put Seller Short position
Calls & Puts Have expiry dates and strike price
Cost of Option Determined by the strike price, date/month of expiry. So it is set by intrinsic value, time vale and volatility. See table below.

 

Example: Amgen AMGN ($113.72 close on 04/24/14)

Strike Price May 2014 (Calls) July 2014 (calls) May 2014 (puts) July 2014 (puts)
$105 9.10-9.60 9.80-11.35 0.71-0.88 2.31-2.39
$110 5.05-5.50 7.05-7.35 1.73-1.95 3.85-4.00
$120 0.76-0.96 2.6-2.73 7.35-7.80 9.30-9.5
$130 0.05-0.15 0.76-0.82 15.60-18.65 16.70-19.45

 

Buy Call Option (bullish sentiments on stock) OPTION to buy (exercise) underlying stock at a predetermined price (strike price) until expiry
Sell Call Option (call writing) OBLIGATION to sell stocks to call buyer at strike price
Example: Call buyer of Intel stock with a strike price of $20.00 expiring in two  months Has right to exercise this option paying $20.00 per share. The writer of call (seller) has the obligation to sell at $20.00 to the buyer.
Buy Put Option (bearish sentiments on stock) OPTION to sell underlying stock at a predetermined price (strike price) until expiry
Sell put option (put writing) OBLIGATION to buy at strike price

 

Notes: Options trade like stocks except these have expiry dates. You can come out any time and close the transaction before the expiry date with loss or profit

 

 

2.0)         Option Value = Intrinsic Value (IV) + Time Value (TV)

Stock Price < Strike Price Stock Price>Strike Price Stock Price=Strike Price
Calls $0.00 Stock Price- Strike Price $0.00
Puts Strike price-stock price $0.00 $0.00

 

Example: Stock XYZ (price $ 30.00)

Strike Price Expiry Call option Price IV TV
$27.50 May $3.60 $2.50 $1.10
$27.50 July $4.30 $2.50 $1.80
$27.50 Oct. $5.10 $2.50 $2.60
$30.00 May $1.95 $0.00 $1.95
$30.00 July $2.75 $0.00 $2.75
$32.50 July $1.60 $0.00 $1.60

 

3.0)         Profit & Losses

 

3.1)         BUY CALLS (bullish sentiments, capped downside risk, unlimited upside potential)

Example Stock ABC (price $22.50) BUY $22.50 CALL at $1.85

Stock Price at Expiry Profit/Loss at Expiry
$15 ($1.85)
$20 ($1.85)
$22.50 ($1.85)
$24 (0.35)
$25 $0.65 ($25-$22.50-$1.85)
$30 $5.65 ($30-$22.50-$1.85)

 

a) Advantage: You can get the benefit of upside movement in stock. You are “in the money” once stock crosses $22.50. After this the upward or downward movement in stock price will match with the option price. If stock closes at $30.00 on the expiry date, you will make $30-$22.50-$1.85=$5.65 with an investment of $1.85.

b) Disadvantage: If stock does not cross $22.50 at the expiry you will lose all your investment of $1.85. No matter how much stock goes down, your loss is limited to $1.85.

c) You can always come out of transaction by selling these calls before the expiry date with profit/loss.

 

3.2)         BUY PUTS (bearish sentiments, unlimited downside potential)

Same Example: BUY $22.50 PUT at $1.35

Stock Price at Expiry Profit/Loss at Expiry
$15.00 $6.15 ($22.50-$15.00-$1.35)
$20.00 $$1.15 ($22.50-$20-$1.35)
$21.50 ($0.35) ($22.50-$21.50-$1.35)
$25.00 ($1.35)
$30.00 ($1.35)

 

a) Advantage: This is opposite of buying calls. You can get full advantage of fall in stock price below $22.50.

b) Disadvantage: If stock does not go below $22.50 at expiry date you will lose all your investment of $1.35.

c) You can always come out of transaction by selling these calls before the expiry date with profit/loss.

 

3.3)         SELL CALLS (capped profit potential, unlimited downside risk)

Same Example: Sell $22.50 CALL at $1.85

Stock Price at Expiry Profit/Loss at Expiry
$15.00 $1.85
$20.00 $1.85
$22.50 $1.85
$24.00 $0.35 ($22.50-$24.00+$1.85)
$25.00 ($0.65) ($22.50-$25.00+$1.85)

 

a) Advantage: If stock does not go over the strike price of $22.50, you keep the premium of $1.85 as profit with no investment of yours.

b) Disadvantage: if stock goes over $22.50, you will miss on upside potential of the stock as your profit will be limited to $1.85

c) Naked Call Sell: If you sell calls naked and it goes over the stock price, you either take a loss in the options or you will have to buy the stock price at the higher market price (higher than the strike price).

d) Example: If stock closes at $30 on the expiry date, you are obligated to buy stocks at $30 from the market and sell at $22.50 as shown in the table or keep them for future growth.

e) Selling covered calls: Less risky as you already own the stocks and you will sell the stocks at $22.50 even though the market is at $30.00. In addition you will keep the call premium.

f) This strategy of buying calls and selling calls works well for a lot of people. Example: you bought stock at $22.50 and sold calls for $1.85 for the same stock price of $22.50. If stock does not go over $22.50, you keep $1.85 as profit and also keep the stock for future call selling. If stock goes over $22.50, your stocks will be sold at $22.50 but you still made $1.85.

Huge Disadvantage:  If stock goes down to a lot, even though you keep the profit of $1.85 but you lose on the stock price much more than $1.85.  So selling calls works best with established good stocks but they give lower premiums than speculative stocks. The best is, if you own stocks that are already up in value, and even if you have to sell your stocks you are still ahead.

 

3.4)         SELL PUTS (bullish sentiments, capped upside potential, unlimited downside risk)

Same Example: sell $22.50 put at $1.35

Stock price at Expiry Profit/Loss at Expiry
   
$15.00 ($6.15) ($15-$22.50+$1.35)
$20.00 ($1.15) ($15-$22.50+$1.35)
$21.50 $0.35 ($22.50-$21.50 +$1.35)
$22.50 $1.35 ($22.50-$22.50 +$1.35)
$25.00 $1.35
$30.00 $1.35

 

Usually a put is sold when a stock is already down. Example: in this case if stock is down from $35.00 to $22.50 and now you are bullish on this stock, you can sell put for a strike price varying from $22.50 to lower levels. If stock does not go below $22.50, you keep the premium of $1.35. But you are obligated to buy the stock at the strike price if it goes below the strike price.


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