Many options-trading strategies have arisen from the advent of listed options.
Despite the appeal of these tech niques, the experts agree that such specialized trading strategies should be left to experienced investors.
Our goal is not to master these strategies, but to explain in general terms what they are and how they work.
Writing options and spreading options are two types of specialized options strategies.
Generally, investors write options because they think the price of the underlying stock will move in their favor.
It is not going to rise as much as the buyer of a call expects, nor is it going to fall as much as the buyer of a put hopes.
The writers use option writing as an investment transaction.
They get the full option premium in exchange for agreeing to live up to the terms of the option.
There are two ways in which investors can write options.
An investor simply writes a put or call and hopes the price of the underlying stock doesn't move against him or her.
Naked writing can be very profitable if it succeeds because it requires no capital up front.
The amount of return to the writer is limited to the amount of option premium received.
There is no limit to loss exposure.
The price of the underlying stock can rise or fall by just about any amount over the life of the option and, thus, can deal a real blow to the writer of a naked put or call.
These options are written against stocks the investor already owns or has a position in.
An investor could write a call against his stock or write a put against it.
The long or short position can be used by the investor.
It is a conservative way to generate attractive rates of return.
The object is to write a slightly out-of-the-money option, pocket the option premium, and hope the price of the under lying stock will move up or down to the option's strike price.
You are adding an option premium to the other usual sources of return.
The option premium adds to the return.
If the price of the stock moves against the investor, it can cushion a loss.
There is a hitch to this.
The investor can only realize a limited amount of return.
The option becomes valuable when the price of the underlying common stock exceeds the strike price.
The investor loses money on the options.
For every dollar the investor makes on the stock position, he loses an equal amount on the option position.
If the price of the underlying stock goes up, the call writer misses out on the added profits.
Let's assume you own 100 shares of PFP, Inc., an actively traded, high-yielding common stock.
The stock is currently trading at $73.50 and pays a quarterly dividend of $1 a share.
The buyer can take the stock off your hands if you write a three-month call on PFP.
You will get $250 for writing the call if the options are trading at $2.50.
You will earn dividends and capital gains on the stock, but you will also get to pocket the $250 you received when you wrote the call.
$250 was added to the quarterly return on your stock.
The profit and loss characteristics of this covered call position are summarized in Table 14.6.
The maximum profit on this transaction occurs when the market price of the stock is equal to the strike price on the call.
You don't get the added profits if the stock price keeps going up.
The holding period return of 13.6% is the result of the $1,000 profit you earn at a stock price of $80 or above.
It's not hard to see why covered call writing is popular.
A little cushion to losses is added by covered call writing.
Before you start losing money, the stock price has to drop more than $2.50, which is what you received when you sold the call.
There are many ways to combine options with other securities to achieve an investment objective.
Synthetic securities are probably more unusual than any other.
This is an example.
You want to buy a convertible bond on a company that doesn't have any outstanding convertibles, but that company doesn't have any outstanding convertibles.
Combining a straight bond with a listed call option can be used to create your own convertible.
Buying and writing options on the same stock could be used to create an option spread.
The strike price and expiration date would be different with these options.
Spreads account for a large amount of the trading activity on the listed options exchanges.
Each spread has a different investment goal in mind.
It would be done by buying a call at a strike price and writing a call at a higher strike price on the same stock.
You could buy an August call on Facebook at a strike price of $80 and simultaneously sell it at a strike price of $85.
The first option would cost you $8.40, while the option that you sell would bring in 888-492-0.
The net cost of this position is $3.50.
If the price of the underlying stock went up by a few points, the position would make a lot of money.
The price of Facebook stock would be $88 if these options expired.
The call option that you purchased would pay you $8, but you would have to pay $3 to the buyer of the option you wrote so your net cash payoff would be $5.
Other spreads are used to make money.
Others try to make money when the price of the underlying stock goes up or down.
Spreads are created to take advantage of different option prices.
The payoff from spreading is usually substantial.
If the market and the difference between option premiums move against the investor, some spreads that seem to involve almost no risk may end up with devastating results.
This is the simultaneous purchase of a put and call on the same stock.
Unlike spreads, straddles usually involve the same strike price.
The object is to make a profit from a big or small swing in the price of the underlying common stock.
If the price of the stock goes up, you can make money on the call side of the straddle, but not on the put side.
The calls are useless if the price of the stock plummets.
You're ahead of the game if you make more money on one side than on the other.
Refer to Figure 14.1 again as an example.
Imagine buying a Facebook call and put with a strike of $82.50 and an August expiration date.
The total cost of this position is $7.38.
To make money on this transaction, Facebook stock would have to fall more than $7.38 below the strike price or rise more than $7.38 above it.
Your position loses money if Facebook stock stays within that range.
You make money when the underlying stock price doesn't go up.
When you wrote the options, you got to keep most of the option premiums.
The principles that underlie the creation of straddles are the same as those for spreads.
Combining options will allow you to capture the benefits of certain types of stock price behavior.
If the underlying stock and option premiums don't behave as expected, you lose.
Only knowledgeable investors should use straddles and spreads.
How would you make money on a call option and put option?
Mention five variables that can affect the price of options, and explain how each affects prices.
There are three ways in which investors can use stock options.
Imagine being able to buy or sell the S&P 500 at a reasonable price.
Think about what you could do.
If you felt the market was about to go up, you could invest in a security that tracks the price of the S&P 500 and make money when the market goes up.
If you wanted to capture the market's performance, you wouldn't have to go through the process of selecting specific stocks.
The market could be played as a whole.
You can do this by purchasing a mutual fund or an exchange traded fund that is linked to the S&P 500, but you can also do it with stock-index options and calls.
Since 1983, index options have been popular with both individual and institutional investors.
We will take a closer look at these popular investments.
When the market M15_SMAR3988_13_GE_C14.indd 606 moves in one direction or another, the value of the index option moves accord.
Set tlement is defined as cash because there are no financial assets backing these options.
The published market index that underlies the option is 100 times the cash value.
If the S&P 500 is at 2,100, the value of an S&P 500 Index option will be $100.
The cash value of the option will be affected if the underlying index moves up or down.
Most options on individual stocks are American options and can be exercised at any time, but stock index options may be American or European options, so they may be exercisable only on the expira tion date.
More than 100 stock indexes have put and call options.
There are options on the stock market in the US, as well as options on foreign markets such as China, Mexico, and Japan.
About 10% of traded option contracts were index options, and a large percentage of these contracts were on five of the leading stock indexes.
Small-cap stocks in the United States are measured by the Russell 2000 Index.
The behavior of the 100 largest nonfinancial stocks listed on Nasdaq is tracked by the 100 largest nonfinancial stocks on the index.
The S&P 100 index is made up of 100 stocks that have actively traded stock options.
One of the most actively traded index options is the DJIA Index, which measures the blue-chip segment of the market.
The most popular instruments are options on the S&P 500.
There's more trading in the SPX options contracts than in the other options combined.
The CBOE dominates the market, accounting for more than 98% of the trades in 2015.
There are put and call options on index options.
They have issue characteristics like any other call or put.
A put lets a holder profit from a drop in the market.
The holder can profit from a market going up.
The quotation system for index options is the same as for stock options, except for the fact that the strike price is an index level.
The S&P 500 Index is traded on the CBOE.
Let's say the S&P 500 Index closed at 2058 and the August call has a strike price of 2055.
If the underlying index exceeds the strike price of the call, it will have a positive value.
The value of this call is 3.
If the call trades at 49.92, it's 46.92 points above the call's intrinsic value.
The option's time value is different.
If the S&P 500 Index went up to 2200 by late August, this option would be quoted at 2200 - 2055, which is 146.
This contract is worth $14,500 because of the multiple value of the index options.
If you had purchased this option when it was trading at $48, it would have cost you $48 and you would have made a profit of $9,508 in less than a month.
The holding period return was a whopping 90%.
The quotation system used with index options is similar to the one used with stock options: strikes and expiration dates are shown along with option prices and volumes.
The option strikes and closing values for the underlying asset are shown as index levels.
On the day of this quotation, the closing S&P 500 Index level was 2051.
Most broad-based index options use the full market value of the underlying index for purposes of options trading and valuation.
The option on the Industrial Average is based on 1% of the average, while the transportation average is based on 10%.
If the DJIA is at 11,260, the index option would be valued at 1% of that amount.
The cash value of this option is not the same as the underlying DJIA, but it is the same as 1% of the DJIA.
There is no effect on option valuation because the strike prices are based on the same 1% of the Dow.
The difference between the strike price on the option and 1% of the DJIA is what matters.
The option index would close at 112.60 if the DJIA closes at 11,260.
A call option on this index might have a strike price of 110, which would mean that the call is slightly in-the-money with an intrinsic value of 2.60.
If the option was not set to expire immediately, its market price would be higher, with the difference between the market price and the option's time value being the option's time value.
The "mini" index option is 10% of the value of the under lying index.
The Mini-NDX Index is 10% of the value of the Nasdaq 100.
The S&P 500, the Russell 2000, and the FTSE 250 are all included in the "Minis".
Although equity options can be used in spreads, straddles, or even covered calls, they are most often used for speculating or hedging.
With a relatively small amount of capital, index options can be used as a speculative investment.
Like any other put or call, index options provide attractive leverage opportunities and at the same time limit exposure to loss to the price paid for the option.
hedging vehicles and index options are equally effective.
A good deal of the trading in these securities is accounted for by hedging, which is a major use of index options.
To see how these options can be used for hedging, you have to assume that you have a diversified portfolio of different stocks.
You can protect your capital by selling all of your stocks.
If you plan to get back into the market after it drops, it could lead to a lot of unnecessary taxes.
There is a way to have your cake and eat it, too, and that is to hedge your stock port folio with a stock index put.
If the market goes down, you can use your put money to buy more stocks at the lower prices.
If the market continues to go up, you will only be out the cost of the puts.
The increased value of your stock holdings could lead to the recovery of that amount.
The same hedging principles are used for stock-index options and equity options.
The only difference is that with stock-index options, you're trying to protect a whole portfolio of stocks rather than individual stocks.
When markets are falling and the need for portfolio insurance is greatest, the cost of protecting your portfolio with index options can become very expensive, with price premiums of 20% to 30% or more.
The effectiveness of this strategy will be impacted by that.
The amount of profit you make or the protection you get depends on how closely the behavior of your stock portfolio is matched by the stock-index option you use.
It is not certain that the two will behave in the same way.
Selecting an index option that reflects the nature of the stocks in your portfolio is important.
If you hold a number of small-cap stocks, you might want to use the Russell 2000 index option as a hedging vehicle.
You can choose the DJIA index option if you hold mostly blue chips.
You can't get dollar-for-dollar portfolio protection, but you should try to get as close a match as possible.
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