Options basics and trading strategies for FRM/CFA level 1

Options: Basics and Trading
Strategies

Session Agenda
• Part I- Introduction to Options
– What are Options?
– Intrinsic Value of Options
– Returns to Option buyers and sellers
– Put Call Parity
– Bounds and Option Values
– Determinants of Option Values
– Some special cases
3
• Trading Strategies
– Covered Call
– Protective Put
– Spread Strategies
– Combination Strategies
Part II- Options Trading Strategies

Part-I: Introduction to
Options

• Options are contracts that give its buyer the right to buy or sell a particular asset
– In future
– At a pre-decided price (i.e. exercise or strike price)
– Without any obligations
• The seller of the option collects a payment (Option Premium) from the buyer for providing the
option
• Types of options:
– Call or Put Options
• Call Option: gives option holder the right to buy the asset at an agreed price
• Put Options: gives option holder the right to sell the asset at an agreed price
– European or American Options
• European options are those that can only be exercised on expiration.
• American options may be exercised on any trading day on or before expiration
• Positions:
• Long position: An option buyer is said to be in a long position
• Short Position: An option writer (or seller) is said to be in a short position
5
What are Options?

6
Factors that affect Options value

1. Assuming the stock price and all other variables remain the same what will be the impact of an
increase in the risk-free interest rate on the price of an American put option?
A. No impact.
B. Negative.
C. Positive.
D. Cannot be determined.
Solution: B
7
Example Question

8
Intrinsic Value of Options
• Intrinsic value: is the maximum of zero and the value of the option if the option were exercised
immediately.
– At the money:
• When the price of the underlying is the same as the strike price of the option, the option is termed at the
money and exercising it carries a nil pay-off.
– In the money:
• When the price of the underlying is greater than the strike price carried by a call option, the call option is
termed in the money, as exercising it results in a positive pay off.
• When the price of the underlying is less than the strike price carried by a put option, the put option is termed in
the money, as exercising it results in a positive pay off.
– Out of the money:
• When the price of the underlying is less than the strike price carried by a call option, the call option is termed
out of the money, as exercising it will result in a nil pay off.
• When the price of the underlying is greater than the strike price carried by a put option, the put option is termed
out of the money, as exercising it will result in a nil pay off.

9
• Illustration: Pay-offs from buying a Call
– Call option is written on the stock of XYZ Corporation with a strike price of 5. Consider options on a stock
whose price is expected to range from 0 - 10 at the time of expiration.
– If share price is less than 5, then the pay off to the option buyer is nil.
– If the price is more than 5, the pay-off moves upward linearly with the share price.
0
1
2
3
4
5
6
0 2 4 6 8 10 12Call-Payoff
Stock Price
Call Value
Stock
Price
Call
Value
Put Value Strike
Price
0 0 5 5
1 0 4 5
2 0 3 5
3 0 2 5
4 0 1 5
5 0 0 5
6 1 0 5
7 2 0 5
8 3 0 5
9 4 0 5
10 5 0 5

10
• Illustration: Pay-offs from buying a Put
– Put option is written on the stock of XYZ Corporation with a strike price of 5. Consider options on a
stock whose price is expected to range from 0 - 10 at the time of expiration.
– If share price is more than 5, then the pay off to the option buyer is nil.
– If the price is less than 5, the pay-off moves linearly with the share price.
0
1
2
3
4
5
6
0 2 4 6 8 10 12Put-Payoff
Stock Price
Put Value
Stock
Price
Call
Value
Put Value Strike
Price
0 0 5 5
1 0 4 5
2 0 3 5
3 0 2 5
4 0 1 5
5 0 0 5
6 1 0 5
7 2 0 5
8 3 0 5
9 4 0 5
10 5 0 5

12
Returns to Option Sellers
• Returns to Option sellers:
– The price that the option writer gets for underwriting the contract is called premium.
– If the option is not exercised, the option writer makes profit from the premium.
– If the option is exercised, the option writer may make profit or loss depending on the spot price of the
underlying asset at the time.
• Example: A Call option writer gets premium of 1 for an option with strike price of 5.
– He makes a profit if:
• The option is not exercised when spot price is less than 5. The profit is 1 (i.e. premium);
• The option is exercised and spot price is more than 5 but less than 6.
• The profit to the call writer is less than 1.
• If the spot price is 6, the writer has no profit and no loss.
• For all spot prices more than 6, the call writer makes losses, which increase linearly with increase in spot
prices.

13
-5
-4
-3
-2
-1
0
1
2
0 2 4 6 8 10 12
Short-PutPayoff
Stock Price
Short-Put Payoffwith Premium
-5
-4
-3
-2
-1
0
1
2
0 2 4 6 8 10 12
ShortCallPayoff
Stock Price
Short-Call Payoffwith Premium
Returns to Option Sellers
Stock
Price
Option
Premium
Short-Call
Value
Put Value Strike
Price
0 1 1 -4 5
1 1 1 -3 5
2 1 1 -2 5
3 1 1 -1 5
4 1 1 0 5
5 1 1 1 5
6 1 0 1 5
7 1 -1 1 5
8 1 -2 1 5
9 1 -3 1 5
10 1 -4 1 5

14
Returns to Option Buyers
• Profit to Option buyers:
– The pay-off are distinct from the profit (or loss) to the option holder.
– To estimate the profit, the premium (price of option) is to be subtracted from the pay-off.
• Illustration: In continuation to above, further consider options which carries a premium of 1.
-2
-1
0
1
2
3
4
5
0 2 4 6 8 10 12
LongCallPayoff
Stock Price
Long-Call Payoff with Premium
-2
-1
0
1
2
3
4
5
0 2 4 6 8 10 12
Long-PutPayoff
Stock Price
Long-Put Payoffwith Premium
Stock
Price
Option
Premium
Call Value Put Value Strike
Price
0 1 -1 4 5
1 1 -1 3 5
2 1 -1 2 5
3 1 -1 1 5
4 1 -1 0 5
5 1 -1 -1 5
6 1 0 -1 5
7 1 1 -1 5
8 1 2 -1 5
9 1 3 -1 5
10 1 4 -1 5

15
Put Call parity
• Consider the Pay-off of a trader who has the following position:
– A Call Option with a Strike Price of 5 and,
– A Bond with a maturity value of 5.
Share Price at
Expiration
Call
Pay-Off Strike Price
Bond Value at
Maturity Bond + Call
0 - 5 0 5 5 5
6 1 5 5 6
7 2 5 5 7
8 3 5 5 8
9 4 5 5 9
10 5 5 5 10

16
Put Call parity
• Consider, now, the Pay-off of a trader who has :
– A Put Option with a Strike Price of 5 and,
– An equivalent unit of the underlying asset
Share Price at
Expiration
Put Pay-Off (Exercise
Price 5)
Stock
Pay-off
Stock+
Put
0 5 0 5
1 4 1 5
2 3 2 5
3 2 3 5
4 1 4 5
5-10 0 5-10 5-10

17
Put Call parity
• The Pay-offs are exactly the same
0
2
4
6
8
10
12
0 2 4 6 8 10 12
Share Price
TotalPay-off

18
Put Call parity
• Put Call parity provides an equivalence relationship between the Put and Call options of a
common underlying and carrying the same strike price:
• It can be expressed as:
– Value of call + Present value of strike price = value of put + share price.
• If value of put is not available, it can be derived as:
– Value of put = Value of call + present value of strike price - share price.
• Put-call parity relationship, assumes that the options are not exercised before expiration day, i.e. it
follows European options.
• This holds true for American options only if they are not exercised early.
• In case of dividend-paying stocks, either the amount of dividend paid should be known in advance or it
is assumed that the strike price factors the future dividend payment.
• The mathematical representation of Put Call Parity is:
= Initial stock price (S) + Put premium (P)
Put Call Parity is valid only for European options, for American Options this
relationship turns into an inequality
tt r
d
dividendsofPV
r
X
pricestrikeofPVCemium




11
)(Pr

19
Question: Put Call parity
1. According to Put Call parity for European options, purchasing a put option on ABC stock will be
equivalent to
A. Buying a call, buying ABC stock and buying a Zero Coupon bond.
B. Buying a call, selling ABC stock and buying a Zero Coupon bond.
C. Selling a call, selling ABC stock and buying a Zero Coupon bond.
D. Buying a call, selling ABC stock and selling a Zero Coupon bond
Solution: B: p + S0 = c + Ke-rT

20
Question: Put Call parity
1. Consider a 1-year European call option with a strike price of $27.50 that is currently valued at $4.10
on a $25 stock. The 1-year risk-free rate is 6%.What is the value of the corresponding put option?
A. 4.1
B. 5
C. 6
D. 25
Solution: p + S0 = c + D + Xe -rt

21
Bounds and Option Values
• The value of an option changes over its life.
• Consider the earlier illustration of the call.
– If the share price of is below 5 on the exercise date, the call will be worthless.
– If the stock price is above 5, the call will be worth 5 less than the value of the stock.
– Even before maturity of the option, its value can never remain below this lower-bound line.
– For options that still have some time to run, the heavy lower line is thus the lower-bound limit on the
market price of the option.
– The diagonal line in the plot is the upper bound limit to the option price, because the stock gives a higher
ultimate pay-off than the option.
0
1
2
3
4
5
6
0 1 2 3 4 5 6 7 8 9 10 11
CallPay-off
Share Price

22
• The value of an option changes over its life.
• Consider the earlier illustration of the call.
– If at the option’s expiration, stock price > exercise price, the option is worth the stock price minus the
exercise price.
– If the stock price < exercise price, the option is worthless. But the share owners still have a valuable
financial asset in the form of stock of ABC Corporation.
– The value of the option would lie between these two bounds throughout the option’s life.
0
1
2
3
4
5
6
0 1 2 3 4 5 6 7 8 9 10 11
CallPay-off
Share Price

23
Option Minimum Value Maximum
Value
European call (c) ct ≥ Max(0,St-(X/(1+RFR)t) St
American Call
(C)
Ct ≥ Max(0, St-(X/(1+RFR)t) St
European put (p) pt ≥Max(0,(X/(1+RFR)t)-St) X/(1+RFR)t
American put (P) Pt ≥ Max(0, (X-St)) X
Where t is the time to expiration

Part-II: Options Trading
Strategies

25
Trading Strategies
• Traders may create positions using different kinds of strategies depending on the:
– Expectations regarding the movement of the price of the underlying
– Risk appetite
– Availability of contracts

26
Covered Call
• Involves selling call options of stocks already owned or simultaneously bought
• Motivation
– Earning a return from the underlying that is already owned
– Lowering the cost of acquisition of the underlying asset
• Expectation`
– Moderate rise in the price of the underlying
• Profit Potential
– Maximum Profits when the options are exercised by the buyer
• Premium received + Strike Price – Spot Price
– If the options are not exercised the trader gets to keep the premium, thus lowering the cost of acquiring the
asset
• More conservative than buying the stock only
Stock price
at expiration
Net
profit/loss
Comparison to
simple stock
purchase
$30 (200) (300)
$32 0 (100)
$33 100 0
$35 300 200
$37 300 400
If MyCompany (MC) trades at Rs33 and Rs35 calls are priced at Rs1, then
an investor can purchase 100 shares of MC for Rs3300 and sell one (100-
share) call option for Rs100, for a net cost of only Rs3200. The Rs100
premium received for the call will cover a Rs1 decline in stock price. The
break-even point of the transaction is Rs32/share. Upside potential is
limited to $300, but this amounts to a return of almost 10%. (If the stock
price rises to Rs35 or more, the call option holder will exercise his option
and the investor's profit will be Rs35-Rs32 = Rs3). If the stock price at
expiry is below Rs35 but above Rs32, the call option will be allowed to
expire, but the investor can still profit by selling his shares. Only if the price
is below Rs32/share will the investor experience a loss.

27
Protective Put
• Involves buying put options of stocks already owned or simultaneously bought
• Motivation
– Protection against loss in the value of stocks owned
• Expectation
– Rise in the price of the underlying
• Advantage
– Trader profits from the rise in price of the underlying albeit the amount of profit is reduced by the premium
paid to purchase the put
– In case the price of the underlying goes down, the trader is still able to sell the underlying at the strike
price, thus insuring her profit

28
Spread Strategies
Bull Call Spread
• Involves purchase of Call options at a particular strike price and selling Call options for the same
underlying and carrying the same maturity but having a higher strike price.
– A vertical spread
• Motivation
– Downside protection by agreeing to a limit to the upside profits
• Expectation
– Moderate rise in the price of the underlying
– Maximum Profits when the trader is able to exercise the option purchased, i.e. the spot price is greater
than the strike price of the option written
• Difference in Strike Prices + Premium Received – Premium Paid
– Loss is limited to
• Premium Paid – Premium Received, when the options expire unexercised

29
Spread Strategies (Cont...)
• Bull Call Spread
-4
-2
0
2
4
6
8
95 100 105 110 115 120 125
Share Price

30
Bear Spread
• Involves purchase of put options at a particular strike price and the sale of the same put options at a
lower strike price.
– A vertical spread
• Motivation
– Downside protection by agreeing to a limit to the upside profits
• Expectation
– Moderate fall in the price of the underlying
– Maximum Profits when the trader is able to exercise the option purchased, i.e. the spot price is lower than
the strike price of the option written
• Difference in Strike Prices + Premium Received – Premium Paid
• Premium Paid – Premium Received, when the options expire unexercised`

31
• Bear Spread
-4
-2
0
2
4
6
8
95 100 105 110 115 120 125
Share Price
TotalProfits

32
Butterfly Spread
• Involves sale and purchase of two calls (or puts) of the same underlying carrying the same maturity. A
Long Call Butterfly can be established by selling two at the money calls with strike price say P, buying
one out of money call at price say P+X and buying another in the money call at price say P-X.
• Motivation
– To profit even when the price of the underlying is range bound and limit losses in case it moves beyond the
expected bound
• Expectation
– Not much change in the price of the underlying.
– Profits translate when the stock price remains within the bounds indicated by the purchased calls. Profits
are maximized when the price of the underlying remains unchanged
• Premium Paid – Premium Received, when the options expire unexercised

33
• Butterfly Spread
-4
-2
0
2
4
6
8
10
100 105 110 115 120 125 130
Share
Price
TotalProfits

34
Combination Strategies
• Combination Strategy: Positions taken in both the call as well as the put options of the same
underlying stocks.
Straddle
• Involves purchasing same quantity of at the money call and put options carrying the same strike price
and same maturity.
• Motivation
– To profit from wide variations in the price of the underlying, even though the direction of the movement in
price is uncertain.
• Expectation
– Large change in the price of the underlying.
– Profits translate when any one of the options can be exercised and the resultant pay-off is greater than the
premium paid for establishing the position. Profit potential is unlimited.
• Premium Paid

35
• Straddle
-2.5
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
2.5
0 2 4 6 8 10
Straddle Profits
Share
Price
TotalProfits
Combination Strategies (Cont...)

36
Strap
• Involves purchasing two at the money calls for every one at the money put purchased. Both put and
call options carry the same strike price and same maturity. More bullish version of the straddle
• Motivation
price is uncertain.
• Expectation
– Large change in the price of the underlying, price expected to increase more than decrease
premium paid for establishing the position. Profit potential is unlimited although the rise profit is steeper in
case the underlying price increases more than the call strike price.
• Premium Paid

37
• Strap
-4
-3
-2
-1
0
1
2
3
4
5
6
0 2 4 6 8 10
Strap Profits
Share
Price
TotalProfits

38
Strip
• Involves purchasing two at the money puts for every one at the money call purchased. Both put and
call options carry the same strike price and same maturity. Bearish version of the straddle
• Motivation
price is uncertain.
• Expectation
– Large change in the price of the underlying, price expected to decrease more than increase
premium paid for establishing the position. Profit potential is unlimited although the rise profit is steeper in
case the underlying price decreases more than the put strike price.
• Premium Paid

39
• Strip
-4
-3
-2
-1
0
1
2
3
4
5
6
0 2 4 6 8 10
Strip Profits
Share
Price
TotalProfits

40
Long Strangle
• Involves purchasing slightly out of money calls and puts of the same underlying carrying the same
maturity.
• Motivation
price is uncertain.
• Expectation
– Large change in the price of the underlying
premium paid for establishing the position.
• Premium Paid

41
• Long Strangle
-1.5
-1
-0.5
0
0.5
1
1.5
2
2.5
0 2 4 6 8 10
Strangle Profits
TotalProfits
Share
Price

42
• Box Spread
• Involves purchasing a Bull Call Spread and one Bear Put Spread. Box Spread yields us Risk-free rate

43
Questions
1. The S&P March 2005 index futures contract is trading at 280. The associated American 260 call
option is at 16 and the associated 260 American put option is at 3. Which of the following strategies
would you select to lock in a profit?
A. No strategy would result in a risk-free profit.
B. Buy the put, sell the call and buy the futures contract.
C. Buy and exercise the put and buy the futures contract.
D. Buy and exercise the call and sell the futures contract.
2. An investor sells a June 2008 call of ABC Limited with a strike price of USD 45 for USD 3 and buys a
June 2008 call of ABC Limited with a strike price of USD 40 for USD 5. What is the name of this
strategy and the maximum profit and loss the investor could incur?
A. Bear Spread, Maximum Loss USD 2, Maximum Profit USD 3
B. Bull Spread, Maximum Loss Unlimited, Maximum Profit USD 3
C. Bear Spread, Maximum Loss USD 2, Maximum Profit Unlimited
D. Bull Spread, Maximum Loss USD 2, Maximum Profit USD 3

Five Minute Recap
45
-4
-2
0
2
4
6
8
95 100 105 110 115 120 125
Share Price
-4
-2
0
2
4
6
8
95 100 105 110 115 120 125
Share Price
TotalProfits
Bull Call Spread
Bear Spread
-4
-2
0
2
4
6
8
10
100 105 110 115 120 125 130
Share
Price
TotalProfits
Butterfly Spread
-2.5
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
2.5
0 2 4 6 8 10
Straddle Profits
Share
Price
TotalProfits
-4
-3
-2
-1
0
1
2
3
4
5
6
0 2 4 6 8 10
Strap Profits
Share
Price
TotalProfits
-4
-3
-2
-1
0
1
2
3
4
5
6
0 2 4 6 8 10
Strip Profits
Share
Price
TotalProfits
-1.5
-1
-0.5
0
0.5
1
1.5
2
2.5
0 2 4 6 8 10
Strangle Profits
TotalProfits
Share
Price
Option Trading Strategies:
•Covered Call
•Protective Put
•Combination Strategy

Other Webinars
Here are the links for the blogs of the other recent webinars on our website to
help you with CFA/FRM preparation
Linear regression analysis (11/04/2013)
Blog: http://www.edupristine.com/blog/demystifying-linear-regression-analysis-
for-frm-level-1-exam/
Understanding Income statement (12/04/2013)
Blog: http://www.edupristine.com/blog/cfa-tutorial-understanding-income-
statement-from-cfa-perspective/
Hedging strategies using futures (13/04/2013)
Blog: http://www.edupristine.com/blog/frm-tutorial-hedging-strategies-using-
futures-for-frm-level-1-exam/
46

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