To become a good Options investor, understanding the basic fundamentals and its pricing is key. In this session, we will discuss fundamentals of Options. This is an opportunity for beginners to ask the most basic questions on the working of CALL/PUT options and we will also put on trades (on a demo account).
We will discuss risks of buying and writing Options.
We can then talk about basic strategies involving single CALL/PUT contracts. We will see why writing PUTS can be so rewarding; so much so that Warren Buffet prefers selling PUT options.
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Meetup 2-options-single legstrategies
1. Basics & Single leg Options Strategies
EXPLORING FUNDAMENTALS
Amit Shanker
contactamipro@gmail.com
2. Disclaimer
Various sections of the "Brainstorm Options Investing in London" Meetup Group web-site (and
subsequent discussions in our real-life Meetups) will naturally incorporate topics such as Stocks,
Options, investing and many other related areas. Our intention is to provide a platform to share
information between our members for educational purposes only, however at no time is this
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3. Introduction
• Can you describe Stock Options in your own words?
• How much percent would you be willing pay to
secure your portfolio from downside risk?
• Do you hedge your investments? If yes, can you give
an example?
4. Formulating a winning trade
Discipline:
• Maintain separate accounts for your trading activity and treat it as your business
• Be very clear with the Risk in every trade. Ideally, each trade should never risk more than 5% of your capital
• Make sure you are not skewed or over diversifying your portfolio
Identifying opportunities:
• What is the rationale behind the trade? Is it an impulsive trade or you are convinced with the opportunity
• Do you have a clearly defined Entry and Exit criteria
Recovering from unexpected move:
• Do you have a ‘Plan B’ if the market moves against you?
Bad habits
• Averaging a position that’s gone against you (usually should not be your ‘Plan B’)
5. Concept of Forward Contracts
THE PROBLEM
• The market values of wheat and
other crops fluctuate constantly
as supply and demand for them vary,
with occasional large moves in either
direction.
• Based on current prices and forecast
levels at harvest time, the farmer
might decide that planting wheat is a
good idea one season, but the price of
wheat might change over time.
• Once the farmer plants wheat, he is
committed to it for an entire growing
season. If the actual price of wheat
rises greatly between planting and
harvest, the farmer stands to make a
lot of unexpected money, but if the
actual price drops by harvest time, he
is going to lose the invested money.
THE SOLUTION
Forward contracts are mutual
agreements to deliver a certain
amount of a commodity at a certain
date for a specified price and each
contract is unique to the buyer and
seller.
• For this example, the farmer can sell
a number of forward contracts
equivalent to the amount of wheat he
expects to harvest and essentially lock
in the current price of wheat.
• Once the forward contracts expire,
the farmer will harvest the wheat and
deliver it to the buyer at the price
agreed to in the forward contract.
6. Risks with Forward Contract
• if the farmer has a low yield year and he
harvests less than the amount specified in
the forward contracts, he must purchase the
bushels elsewhere in order to fill the
contract.
• This becomes even more of a problem when
the lower yields effect the entire wheat
industry and the price of wheat increases due
to supply and demand pressures.
• Also, while the farmer hedged all of the risks
of a price decrease away by locking in the
price with a forward contract, he also gives
up the right to the benefits of a price increase
7. Options in context of Stocks
Options are essentially made up of three things:
• Option Type
◦ Call
◦ Put
• Strike Price
• Exercise Price
• Expiration Date
8. Important Terms
Instruments Instrument
Attributes
Economy Option Types Option Attributes
Stocks Volatility Interest Rate CALL ITM
Futures Dividend Inflation PUT ATM
Options Growth Political News European Style OTM
Warrants American Style Intrinsic Value
Premium
Strike Price
Underlying
Expiration Date
Spot Price
9. CALL Options
A call option is an option contract in which the
holder (buyer) has the right (but not the
obligation) to buy a specified quantity of a
security at a specified price (strike price)
within a fixed period of time (until
its expiration).
For the writer (seller) of a call option, it
represents an obligation to sell the underlying
security at the strike price if the option
is exercised. The call option writer is paid
a premium for taking on the risk associated
with the obligation.
10. PUT Options
A put option is an option contract in which the
holder (buyer) has the right (but not the
obligation) to sell a specified quantity of a
security at a specified price (strike price)
within a fixed period of time (until
its expiration).
For the writer (seller) of a put option, it
represents an obligation to buy the underlying
security at the strike price if the option
is exercised. The put option writer is paid
a premium for taking on the risk associated
with the obligation.
11. Example 1: Long CALL
Rationale
Buying long CALL is a directional trade and you are expecting the market to move up further
Analysis
• How do you decide the strike price?
• How do you decide the Expiration Date?
• What’s the maximum profit/loss possible on the position?
• What is the Entry/Exit criteria?
• How much am I expecting the market to move for me to make a decent profit?
Best Case
The stock climbs above (strike price + premium paid)
Worst Scenario
On expiration date, if market closes below ‘strike price’, you lose premium paid to buy the option
12. Example 2: Long PUT
Rationale
Buying long PUT is a directional trade and you are expecting the market to fall from here on. PUT is usually
purchased as an insurance (hedge) for your long term portfolio
Analysis
• How do you decide the strike price?
• How do you decide the Expiration Date?
• What’s the maximum profit/loss possible on the position?
• What is the Entry/Exit criteria?
• How much am I expecting the market to move for me to make a decent profit?
Best Case
The stock drops below (strike price + premium paid). If you owned the underlying, the profit from PUT option will
compensate the loss made on the underlying. You will still lose the amount paid as premium to by the PUT option.
Worst Scenario
On expiration date, if market closes above 'strike price’, you lose premium paid to buy the option. If you owned the
underlying and the stock moves above strike price, you can possibly make a profit (and even go on to recover the
premium paid to be the option)
13. Example 3: Sell PUT
Rationale
Writing a PUT option can be part of an effective strategy when you plan to buy stocks. You can buy stocks at a
discounted price!
Analysis
• How do you decide the strike price?
• How do you decide the Expiration Date?
• What’s the maximum profit/loss possible on the position?
• What is the Entry/Exit criteria?
• How much am I expecting the market to move for me to make a decent profit?
Best Case
The stock closes above strike price. You will pocket the premium amount.
Worst Scenario
WARNING: Writing an naked option is a risky trade. There is a potential for unlimited loss. On expiration date, if
market closes below ‘strike price’, you will lose the difference between Spot price and Strike price.