; Traded options booklet v4
Documents
Resources
Learning Center
Upload
Plans & pricing Sign in
Sign Out
Your Federal Quarterly Tax Payments are due April 15th Get Help Now >>

Traded options booklet v4

VIEWS: 7 PAGES: 8

  • pg 1
									           CALL SPREAD

           Options can be combined, with or without stock, in a                               you can lose. At expiry, if the stock is trading at 240p
           seemingly endless number of combinations. This                                     or below, then both options will expire worthless and
           flexibility of options allows a trader to establish a                              the holder will have lost his outlay of 7p (£70). If, at
           particular and precise market view, or to establish                                expiry, ABC plc are trading at 260p then the 240p call
           different profit and loss parameters.                                              will be worth 20p and the 260 call will be worthless.
                                                                                              This gives the maximum profit of 13p (20p – 7p) or
           By purchasing a call and writing (selling) a call with a                           £130 per contract. At any point above 260p the 240p
           higher exercise price and the same expiry month you                                and 260p calls both move penny for penny and
           establish a position that is consistent with a mildly                              therefore the profit remains at 13p. The breakeven
           bullish view. The purchased call allows you to profit                              point for this strategy is 247p pence (240p + the 7p
           from an increase in the share price, but the written                               paid for the strategy). Above 247p is profit until the
           call establishes an upper limit for potential profit.                              maximum profit of 13p is reached at a stock price of
           Once the shares reach the strike price of the written                              260p. Between 240p and 247p the trader will recoup
           call you no longer benefit from any further price rises.                           some, but not all, of his initial outlay.

           The advantage of this trade is that the written call                               The above is an example of how options can be
           lowers your outlay, and therefore less capital is at                               combined. There are many other possible
           risk, the breakeven point is also lower compared to a                              combinations, the discussion of which is beyond the
           straight call purchase. The disadvantage is that the                               scope of this booklet.
           written call lowers your potential profit, and time
           value erosion affects the strategy in the same way                                 The Traded Option desk of Charles Stanley will be
           that it affects a long call.                                                       more than happy to provide assistance to anyone
                                                                                              seeking more details on the information contained
           Example: ABC plc shares are trading at 234p. You buy                               within this booklet, or any other aspect of option
           the 240 call for 14p and sell the 260 call for 7p. Your                            trading.
           outlay for this position is 7p, and this is the most that




           Offices: Bath Bedford Beverley Birmingham Bournemouth Brighton & Hove Cambridge Dorchester Eastbourne Edinburgh Exeter Guildford Ipswich Isle of Wight Leeds
           Liverpool London Manchester Milton Keynes Newbury Norwich Nottingham Oxford Plymouth Reading Southampton Southend-on-Sea Truro Tunbridge Wells Watford Wimborne
           Member of the London Stock Exchange. Authorised and regulated by the Financial Services Authority
May 2009




           Member of the London International Financial Futures and Options Exchange. Member of the International Capital Market Association.
           Charles Stanley & Co Limited is registered in England No. 1903304. Registered Office: 25 Luke Street, London EC2A 4AR Tel: 020 7739 8200
                                                                                                Charles Stanley & Co. Limited
                                                                                             25 Luke Street London EC2A 4AR
                                                                                                           Tel: 020 7739 8200
                                                                                                          Fax: 020 7739 7798
                                                                                                    DX 123150 BROADGATE-1
                                                                                                   www.charles-stanley.co.uk



A BRIEF GUIDE TO
TRADED OPTIONS

What is an option…? It is a contract that confers the right, but not the obligation, to
buy or sell an asset at a given price on or before a given date.
By purchasing the appropriate options it is possible         An At-the-money option is an option whose
to profit from anticipated price movements, either           exercise price is the same as, or closest to, the
upward or downward, with limited risk, or to achieve         current market price of the underlying share.
protection against adverse price movements whilst            For example, if the share price is 260p, an option
retaining the opportunity to benefit from favourable         with an exercise price of 260p would be precisely
price movements. Other applications (a few of which          at-the-money. As the stock moved to 261p, the
we will look at later), involving the writing (selling) of   260p exercise price would still be considered ‘at-
options can provide additional portfolio revenue as          the-money’. As the underlying changes however,
well as a partial hedge.                                     the option considered to be ‘at-the-money’ will
                                                             change.
One of the important advantages of exchange traded
options is that they are standardised contracts,             An Out-of-the-money option is an option that has no
generally representing 1,000 shares.                         intrinsic value. In other words a call option whose
You should become familiar with the particulars of           exercise price is above the current underlying share
these contracts such as the unit of trading, expiry          price or a put option whose exercise price is below
months, exercise and settlement.                             the current underlying
                                                             share price.
A call option is an option that conveys to the option
buyer the right, but not the obligation,                     Intrinsic value is the amount, if any, by which an
to purchase 1,000 shares at a fixed price per share at       option is currently ‘in the money’. An option that is not
any time during the life of the option.                      ‘in the money’ has no intrinsic value.

A put option is an option that conveys to the option         Time value is the amount, if any, by which an option’s
buyer the right, but not the obligation, to sell 1,000       premium exceeds its intrinsic value. If an option is not
shares at a fixed price per share at any time during         ‘in the money’ its premium consists entirely of time
the life of the option.                                      value.

The exercise price is the fixed price per share at           The premium is the term given to the sum of money
which a call option conveys the right to purchase the        that an option buyer pays for the right to acquire the
underlying shares and at which a put option conveys          option, and that an option seller (writer) receives for
the right to sell the underlying shares. It is often         incurring the obligation the option entails. The
referred to as the option strike price.                      premium for a particular option at a particular
                                                             moment in time is the sum of its intrinsic value and
For example: A call option with an exercise price of         time value. Option premiums are expressed in pence
260p conveys the right to purchase 1,000 shares at a         per share. The total cost of an option contract is
price of 260p per share.                                     therefore 1,000 times the premium. For example: one
                                                             contract with a premium of 18p would cost £180
The expiry date is the last date on which an option          (1000 x 18p).
holder can exercise the right conveyed by the option.
After that date, the option ceases to exist.                 An option writer is someone whose opening
                                                             transaction is a sale. Unlike the option buyer, who
An In–the-money option is an option that has                 acquires a specific right, the writer of an option
intrinsic value. In other words, a call option whose         incurs a specific liability (the obligation to make or
exercise price is below the current underlying share         take delivery of the underlying shares if the holder
price or a put option whose exercise price is above          chooses to exercise the option).
the current underlying price.
BASIC STRATEGIES

Each basic option strategy has its own unique risk        Market View                       Strategy
and reward characteristics that need to be                Strongly bullish                  Buy call options
thoroughly understood. Option buying strategies, for      Strongly bearish                  Buy put options
example, can offer potentially unlimited profit
                                                          Neutral to slightly bearish       Write call options
potential with limited risk. Option writing strategies,
on the other hand, have limited profit potential and      Neutral to slightly bullish       Write put options
can have potentially unlimited risk.                      Bullish                           Buy call spread
                                                          Bearish                           Buy put spread

BUYING CALL OPTIONS

The principal reason for buying call options (long        This means that at expiry the price of an option will
calls) is to profit from an expected increase in the      consist solely of intrinsic value, if any.
price of the underlying shares during the life of the
option or to establish a maximum cost for shares to       Example: ABC plc shares are trading at 376p.
be purchased at a future time. If the share price         The May 390 calls are priced at 14p. You buy a call
increases, profit can be realised either by selling the   because you anticipate a substantial upward
options (a closing sale) or by exercising the options     movement in the stock; this will cost £140
and acquiring (calling) the underlying shares at the      (1000 x 14p) plus costs. If the share price at expiry is
exercise price.                                           420p, then the 390 call is worth 30p (420p-390p).
                                                          Your profit is therefore £160 (£300-£140) less
Buying call options has the advantage of limited risk.    expenses. This represents a return of 114% (before
This is because the most that a buyer can lose is the     costs), and illustrates the gearing effect of options, as
premium paid plus his costs. However, should you          during the same period the stock has risen from 376p
change your view, or the stock doesn’t rise as            to 420p which is an 11.7% increase.
anticipated it may be possible to recover some of
your outlay by selling the option (closing sale) before   If, at expiry, the stock price is 390p, or below, then the
expiry day.                                               option will expire worthless and the holder will have
                                                          lost the premium paid plus expenses.
Buying call options also has the advantage that there
is no upper limit to a call holder’s opportunity to       It should be noted that the breakeven point in this
profit from an increase in the underlying share price.    example is 404p (390p + 14p), and the holder will
                                                          realise a profit, before expenses, at any point above
A disadvantage of buying call options is the erosion of   this.
time value that occurs during the life of an option.




2
BUYING PUT OPTIONS

The principal reason for buying put options              A disadvantage of buying put options is the erosion
(long puts) is to profit from an expected fall in the    of time value that occurs during the life of an
price of the underlying shares during the life of the    option. This means that at expiry the price of an
option or to establish a minimum sale price for          option will consist solely of intrinsic value, if any.
shares to be sold at a future time. If the share price
falls, profit can be realised either by selling the      Example: ABC plc shares are trading at 400p.
options (a closing sale) or by exercising the options    The May 390 puts are priced at 14p. You buy a put
and selling (putting) the underlying shares at the       because you anticipate a substantial downward
exercise price.                                          movement in the stock; this will cost £140 (1000 x
                                                         14p) plus costs. If the share price at expiry is 360p,
Buying put options has the advantage of limited          then the 390 put is worth 30p (390p-360p). Your
risk. This is because the most that a buyer can lose     profit is therefore £160
is the premium paid plus his costs. However, should      (£300-£140) less expenses. This represents a return
you change your view, or the stock doesn’t fall as       of 114% (before costs), and illustrates the gearing
anticipated it may be possible to recover some of        effect of options.
your outlay by selling the option (closing sale)
before expiry day.                                       If, at expiry, the stock price is 390p, or above, then
                                                         the option will expire worthless and the holder will
Buying put options also has the advantage that the       have lost the premium paid plus expenses.
put holder has the opportunity to profit from a
decrease in the underlying share price down to a         It should be noted that the breakeven point in this
share price of zero.                                     example is 376p (390p – 14p), and the holder will
                                                         realise a profit, before expenses, at any share price
                                                         below this.




                                                                                                                  3
SELLING CALL OPTIONS

Selling (writing) call options without ownership of the    deposit is re-calculated at the close of business each
underlying shares is known as ‘naked’ or ‘uncovered’       day to reflect that day’s price movements. It is
call writing. The writing of naked calls has limited       essential for clients to have a clear understanding of
profit potential (the option premium received), with       the amount of margin required, the acceptable forms
unlimited risk and carries the obligation to deliver or    of margin, and what the requirements are for making
sell the underlying shares to the option buyer at the      additional margin deposits should they become
strike price, on or before expiry.                         necessary.

The risk with a naked call is that if your market view     Example: A trader expects the price of ABC plc to
proves to be wrong and the call is exercised, you are      remain at the current price of 254p. He sells a May
obliged to deliver shares at the exercise price, no        260 call for 14p, and therefore receives £140 before
matter what the current price of the stock is. The loss    costs. Whatever the stock price at expiry the writer
incurred in acquiring shares at the current (higher)       always keeps the premium received, but that is also
share price in order to make delivery at the lower         the full extent of his profit.
exercise price may be considerably greater than the
premium received for writing the option.                   If, at expiry, the stock price is below 260p, then the
                                                           option will expire worthless (not exercised) and the
Whilst it may be possible to close a short call position   writer will have made his maximum profit of £140.
prior to exercise or expiry by purchasing an identical
option, this too can be costly if the underlying share     If, at expiry, the stock is above 260p then the option
price and option premium have risen considerably.          will be exercised and the writer will have to buy the
                                                           underlying shares at the current market price in order
Whereas buyers of options pay the full cost up front       to deliver stock to the option holder (the exerciser of
and have no further financial obligation (unless and       the option). If the stock price is above 274p (the
until they exercise the option and take or make            breakeven point 260p+14p) then the writer will be
delivery of the underlying shares), option writers         paying out more than he received for selling the
must deposit, and at all times maintain, sufficient        option.
funds with the broker through whom they are dealing
to assure contract performance. These funds are
known as margin and the amount required to be on




4
SELLING PUT OPTIONS

Selling (writing) put options has a similar risk and       Example: ABC plc is trading at 282p, and you expect
reward profile as selling calls. The writing of naked      the stock to remain static or maybe trade slightly
puts has limited profit potential (the option              higher. You decide to sell the May 270 put for 16
premium received), high but limited risk and carries       pence. This gives you £160 (1000 x 16) before
the obligation to buy the underlying shares from the       charges.
option holder at the strike price, on or before expiry.
If the shares which are put on the writer were to be       If, at expiry, the stock price is above 270p, then the
sold at a lower market price,                              option will expire worthless (not exercised) and the
the resulting loss could be greater than the               writer will have made his maximum profit of £160.
premium received by the writer. The maximum loss
is realised when the underlying stock is worthless,        If, at expiry, the stock is below 270p then the option
and the writer of the option is forced                     will be exercised and the writer will have to buy the
to buy the stock at the strike price.                      underlying shares at the strike price of 270p. If the
                                                           stock price is below 254p (the breakeven point
The risk with a naked put is that if your market view      270p-16p) then the loss when shares must be
proves to be wrong and the put is exercised, you are       purchased at the option strike price (270p) will
obliged to purchase shares at the exercise price, no       exceed the premium received (16p).
matter what the current price of the stock is. Whilst
it may be possible to close a short put position prior
to exercise or expiry by purchasing an identical
option, this too can be costly if the option premium
has risen considerably.

Therefore, writing puts is a strategy most likely to
be worth considering when your market view is
neutral to slightly bullish. Put writers, just like call
writers, are subject to margin requirements and a
sufficient level of cover must be maintained at all
times to meet these requirements.




                                                                                                                    5
COVERED CALL WRITING

In return for the premium received from the buyer of       amounts to an annualised return of 28% on the
an option, the writer of a call option accepts the         effective stock price of 268p. This compares to a
obligation to deliver the underlying shares at the         return of 0% if you had simply bought the stock.
exercise price if the option is exercised. Writing calls
against stock that is already held, or being               If the stock actually rises above 280p then the stock
purchased, is commonly called ‘covered call writing’.      will be called (the option holder will exercise his
Covered call writing has a distinctly different risk       option) from the writer. In this case the writer will
reward profile compared to writers of naked calls.         have made 30p on his outlay of 250p in 3 months.
                                                           This equates to an annualised return of 48%. It
Unlike the writer of naked calls, who must buy shares      should be noted that the option will be exercised at
at the current market price to meet their obligation,      expiry at any share price above 280p. If the stock
the covered call writer already owns the shares that       were to rise above the breakeven level of 298p (280p
are required for delivery. The premium received from       + 18p) then the writer will be worse off compared to
covered call writing can be considered as a way to         the person that had simply bought shares.
reduce the cost of shares being purchased; or
additional portfolio income. Whichever way you look        Whilst the illustration above assumes that call
at it, covered call writing offers the chance to           options are written concurrently with the purchase of
enhance portfolio performance.                             shares, call options are frequently written against
                                                           existing share holdings. This has the purpose of
Example: Let us assume that you are interested in          generating additional income within the portfolio.
buying shares in ABC plc which are currently trading
at 268p for their long term growth prospects, but you      Once again, just as above, the trade-off is limited
expect the share price to remain fairly static in the      profit potential versus increased option premium. It is
near term, or to rise moderately.                          important to realise that no additional profit is
                                                           earned if the share price at expiry has risen above the
The premium for the 280 call which has 3 months            strike price.
until expiry is 18p. By purchasing the shares at 268p
and selling the 280 calls at 18p, you have effectively
paid 250p for your shares. If, at expiry, the stock is
still trading at 268p, your option premium of 18p




6
PUT OPTIONS FOR PROTECTION

Buying put options on shares that you hold or are        Example: You own some shares in ABC plc that you
buying provides what is, in effect, price insurance.     bought for 200p. They have now risen to 258p. There
The cost of this insurance is the premium paid for the   is a choice of put options available, which provide
options. If, for example, you own some shares that       different amounts of protection, for varying amounts
have risen significantly since purchase you may now      of premium. The 260 put costs 16p and will give an
be concerned that they may have become overvalued.       effective selling price of 244p (260p – 16p) for a cost
However, selling them to lock in gains would mean        of £160 (1000 x 16). The 250 put costs 12.5 p and will
missing out on the chance to profit if the stock         give an effective selling price of 237.5p, and costs
continued to rise. By buying puts you have               £125. The 240 put costs 8p and for a cost of £80
established a minimum selling price for your shares,     provides an exit price for your stock of 232p. There
and if the stock continues to rise you are able to       are also similar strike prices available for longer
profit from the increase. As with any insurance the      periods of time, and these work in exactly the same
more protection you choose, whether that is a higher     way, they just cost more. This guarantees a lower
exit price or longer period of time, the more the        effective sale price (strike price – premium paid), but
protection will cost.                                    you are protected for a longer period of time.




                                                                                                               7

								
To top