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Options

Tõnno Vähk

October 12th 2005, Vilnius


Options are not for everyone!

• Have you ever traded shares?


• Do you make your own investment decisions?
• Can you act quickly in the market?
• Do you follow market more than just closing prices?
• Do you know anything about technical and fundamental
analysis?
• Do you have basic mathematical skills?
• Good stock traders are also successful in options!
• More opportunities, bigger return and smaller risk!

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What are we talking about?
• Basic option theory and terminology
• Factors affecting option price and pricing of options
• Time value
• Volatility
• Delta
• Dividends
• How to start trading?
• How to get information?
• How to measure risks?
• How to formulate strategy?
• Exercises and examples
• Inefficiencies and opportunities in the market

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Complex and risky?

• Complexity is in terminology!
• Lack of knowledge is a big threat
• Risks are easier to control and often smaller than with shares
• Options expire, shares and bonds don’t
• Knowledge, strategy and discipline are necessary!

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What is an option?
• An option is part of a class of securities called derivatives
• They derive their value from the worth of an underlying investment

The right (but not the obligation) to buy or sell securities at


a given price before a given date

o Right to buy (CALL) or right to sell (PUT)


o EXERCISE PRICE or STRIKE – given price for future transaction
o UNDERLYING – any asset or security
o MATURITY DATE, EXPIRY DATE – time when option ends
o PREMIUM - Option price

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Terminology

• 1 option = contract on 100 shares


• Option premium per one share or total
premium
• Exercise vs selling option to market
• Option style: American or European
o American options can be exercised
always during the life of the option!
o European options can be exercised only
at the Maturity Date!
• Option buyer and Option seller (writer)

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Option Price or Premium
• Share price today - 100

• Call (right to buy) with Strike price 70


• What is it worth today?
o 30 is the option price if we need to decide now

• Put (right to sell) with Strike price 110, 80


• What is it worth today?

• Call at 100, 200


• What is it worth today?

• This is the INTRINSIC VALUE of the option!

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ITM, ATM, OTM

• In the money - ITM


o STRIKE is more favourable to the option holder than market
price of the share
o Intrinsic value is positive
• At the money - ATM
o STRIKE = Market price of the share
o Intrinsic value is 0
• Out of the money - OTM
o STRIKE is less favourable to the option holder than market
price of the share
o Intrinsic value is 0

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Payoff diagram – Stock Position

pikk aktsia positsioon

50

25
Kasum

0
0 50 100 150 200
-25

-50
Hind

aktsia

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Payoff Diagram – Call Option
pikk positsioon ostuoptsioonis

50

25
Kasum

0
0 50 100 150 200
-25

-50
Hind

ostuoptsioon

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What if we don’t have to decide today?

• Share price at market 100


• Call option with Strike Price 70
• Maturity 5 days from today – what is it worth?
• But if Strike is 90, 100?
• Option has obviously additional value as share price might move!
• Intrinsic value does not change
• Time Value emerges!
• Time Value = Premium – Intrinsic Value

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Time Value

• Time Value decreases as the Time to Maturity decreases


• Time Value depends on the probability that Option is ITM when it
expires
• Time Value is largest when uncertainty is largest – with ATM options
• Time Value also depends on how much the share price moves
• The bigger the VOLATILITY the more you can win with the option
and the bigger the Time Value

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Time Value decreases as Time to Maturity decreases!

ajaväärtus

100
90
80
70
60
50
40
30
20
10
0
100 80 60 40 20 0

time value

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Time Value
60

50

40
Optsiooni p reemia

30

20

10

0
30 40 50 60 70 80 90 100 110 12 0 130 1 40 150 160
-10
Aktsia turu hind

Optsiooni pr eemia ajaväärtusega T=3 kuud


Optsiooni vä ärtu s lõpptähtpäeva l

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Theta
• Theta is the change in the price of an option for a 1-day decrease
in the time remaining to expiration
• Theta is almost always negative – time is the option buyer’s
enemy!
• Time Value drops fastest during the last 30 days and for ATM
options

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Theta Exercise
• ETL11P117.5 today Oct 12th, 1.87 kroons
• Share price 119, implied volatility 18%

• What will the premium of the option be in 3 weeks time if the


share price and volatility will not change?
• 1.11 – time value has declined by 0.76
• Nov 18th – 37 from now
• with 21 days the Time value drops about 41%

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Factors affecting Option Premium

• CALL or PUT
• SHARE PRICE
• STRIKE
• MATURITY DATE
• VOLATILITY
• INTEREST RATE
• DIVIDENDS

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Volatility

• Why is volatility so important?


o All the other inputs are fixed and given
o By trading options you are trading actually volatility
o Volatility reflects market’s opinion about the share price
movements in the future!
o Volatility determines the Time Value!

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Historical vs Implied Volatility

• Historical reflects history!


• Historical is calculated from historical share price movements
• It may not be the best indicator for future
• Still often gives us a guideline about what to expect

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Historical Volatilities
30 day historical volatility

70,0%
ETL 60,0%
TV 50,0%
MZN 40,0%
30,0%
20,0%
10,0%
0,0%
30.11.2004
22.12.2004
13.01.2005
4.02.2005
28.02.2005
23.03.2005
14.04.2005
6.05.2005
30.05.2005
21.06.2005
13.07.2005
4.08.2005
26.08.2005
19.09.2005
11.10.2005
Implied volatilities: ETL – 18%, TV – 20%, MZN – 40%

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Option Price Movement

• If there is any Time Value in the Option Price then it never


moves 1:1 to share price but always LESS!
• Option Price moves according to the PROBALITY of being In-
The-Money at Maturity!
• That probability is called DELTA
o Share Price 100
o Strike 100
o Option Premium 5
o Delta?
o Share Price 100 -> 101, how much Premium changes?

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Delta

• Delta is the change in the option value for every point change in
the stock price
• Long stock position: delta 1.0
• Short stock position: delta -1.0
• Deeply ITM PUT
o Bought: delta –1
o Sold: delta 1
• Deeply ITM CALL
o Bought: delta 1
o Sold: delta –1
• Deeply OTM Options’ DELTA = 0

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Delta Exercise

• Investor has today – Oct 12th, 30 contracts of LTL10C2.7


• Share price today 2.73, implied volatility 30%

• What is the delta of this option? Premium?


• Delta is 0.61 and premium 6.98 cents

• Share price rises to 2.75 tomorrow, what is premium then?


• 7.97 (if it rose today then 8.26), new delta 0.68
• How big is gamma??

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How do dividends affect the price of the option?

• Dividends are only for shareholders!


• Call option owner does not get dividends, he has to exercise
option before the ex-date to get dividends
• Put option holder would be stupid to exercise before the
dividends
• Option price in the market reflects its value so you can always
sell the option back instead of exercising

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Put Option

• Time to Maturity: 2 weeks


• Share Price: 100 Litas
• Strike: 150 Litas
• Dividends: 10 Litas in 1 week

• European type – what is price?


• American type – what is price?
• European=American=c.a. 60 Litas
• What if dividends are not known?

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Call Option

• Time to Maturity: 2 weeks


• Share Price: 100 Litas
• Strike: 50 Litas
• Dividends: 10 Litas in 1 week

• European type – what is price?


• American type – what is price?
• European=40 and American=50 Litas
• Right to exercise earlier becomes very
valuable!

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Dividends

• For European option holder the effective share price is always:


o Share price in the market minus dividends during the life of the
option
• Same situation is with American Put as the early exercise right is
worthless
• But American Call owner has a choice and the answer is not always
clear!

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American Call

• Time to Maturity: 3 months


• Share Price: 100 Litas
• Strike: 95 Litas
• Dividends: 3 Litas tomorrow (EX-DATE)

• What to do? To exercise today or not??


• A: exercise – value 5 Litas
• B: no exercise – value ? Litas
• ? = c(share price 97, strike 95, TTM 3 months) = 7-8 LTL?

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American Call

• Owner actually can choose the more valuable between two


options:
o American Call till dividends
o European Call till Maturity

• Pricing is complicated
o Easy method: look which is more valueable now
o Analytical formula: Roll-Geske-Whaley

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Dividend Exercise

• It is 20.04.2006, a day before options’ Friday


• MZN price is 21 Litas in the market and 21.04.2006 is EX-DATE
• Dividends are 0.4 Litas
• Investor has MZN4C20.5, MZN5C21, MZN6C20.5, MZN5P21.5
American options
• What should we do with them today?
• Hint: MZN5C20.5 trades at 0.63 Litas in the market

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How to start?

• Get basic knowledge!


• Observe market – price movements!
• Analyse underlying!
• Understand all the risks involved!
• Determine your strategy, aim and risk limits!
• Determine the investment amount according to your risk limits!

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Basics

• Terminology
• Option parameters
• Price determining factors
• Payoff diagrams
• Time Value and Theta
• Historical and Implied Volatility
• Delta and it’s dynamics

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Market and Prices

• How to find and read prices?


• LHV Investor main page
o Enter Stock Symbol and pick Options
• EBAY:
• EBAY Call Oct05- 40 XBAJH
o First 3 letters is stock symbol
o Forth is period and Call-Put
o Fifth is Strike

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Examples of Use

• Investor believes the rise of the share price in long term but
considers the risks too big – He buys 1 year ATM call (leap)
• Investor believes the rise of the share price but is afraid of short
term fall of the market due to external risks– He buys 3 month
ATM call or buys share and 3 month put
• Investor owns a share that is not traded very actively and is
stable. He thinks the rise in the next half a year will not be more
than 5-10% but he does not want to sell the stock– He sells 10%
OTM Covered Call and pledges the shares as collateral

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Examples of Use

• Investor is convinced that share that trades at 53 can not fall below
50 (e.g. BV) and he would be happy to buy at 50– He sells 3 month
Put at Strike 50 and places deposit (margin) as colleteral
• Investor foresees big jumps in share price in the near future due to
important news coming out– He buys 1-2 month Straddle or
Strangle

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Underlying

• The same factors that affect share price affect also option price
• Fundamental analysis
• Volatility
• Management
• Dividends
• Profit history
• Technical analysis especially in short term perspective

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Make risks certain!

• Share price does not move in the right direction or moves too little
• You will be short of time
• Sold option will be exercised
• Volatility moves in wrong direction
• Trading with share will be stopped
• Technological risks
• Dividends
• …

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Strategy

• To sell back earlier or hold till end?


• What this decision will be based at?
• Minimal profit/maximal loss?
• What is the return on the trade?
• Where is Break-even?
• What kind of options to buy and why?
• How much cash to invest?
• How big part of the portfolio into the trade?
• Are the specific risks acceptable?

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Risk Limits and Goals

• What kind of investor are you today and which in the future?
• Risk tolerance level
o How much capital do you have? How much can you put under
risk?
o Personal factors – age, income, debt burden…
o Investment experience
o Personal goals – yearly return, pension insurance, inflation
cover, short term profit...

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Criteria of Successful Investing

• Patience
• Perseverance
• Knowledge
• Honesty – don’t cheat yourself and accuse the others
• Planning – strategy
• Discipline – follow the rules you have set, use experience, don’t
deviate from plan!

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Threats and Recommendations

• It is easy to see opportunities but they are always accompanied


by risks
• Greed and inablitity to decide are biggest problems
• Don’t count on unrealized profit – take profit!
• Exotic combinations are good for learning but not for real trading
use
• When return is limited – is it worth the risk?
• Draw payoff diagramm – risk profile

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How to pick an option?

• What is the motive of the trade? (leverage, risk reduction…)


• Which Strike?
o Which gives the best return when the vision is right?
• How much time value?
o As little as possible when you know the movement!
• Which period?
o Little extra!
• How big leverage, how big risk?
o The bigger the leverage the greater the threat to lose money
o Find opportunities and inefficiencies in prices!

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What to do with bought option?

• What to follow?
o It is often enough to follow share price (spread, liquidity,
volatility)
• When to sell back?
o When vision has realized or situation changed!
o Limit orders good to use to minimize liquitity risk
• To exercise or sell back?
o Rather sell back!
• What to do at the end?
o Selling back or cash settlement
o If no intention to exercise then select cash settlement in
Portfolio overview

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How to benefit from options?

• Leverage
• Hedging risks
• Planning future share transaction
• Insuring profit
• Enhancing return of the portfolio

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Opportunities in Prices

• Options with small time value are cheap!


• Very short options are cheap!
• Buy on Monday/sell on Friday!
• Buy in the morning/sell in the evening!
• Market reacts slowly, volatilities change slowly, fast reaction
guarantees success
• Liquidity often better in options than in underlying
• Risk/return ratio often very good

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Options in LHV

• Tõnno Vähk – tonno.vahk@lhv.ee, 6 800 447


• Mihkel Oja – mihkel.oja@lhv.ee, 6 800 446
• Kristjan Lepik – kristjan.lepik@lhv.ee, 6 800 440

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