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    Introduction to Options

    Andrew WilkinsonAndrew Wilkinson

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    Options involve risk and are not suitable for all investors. For more information, read the “Characteristics and Risks of Standardized Options” before investing in options. For a copy call 203 618-5800 or click here. There is no guarantee of execution. Orders will be routed to US options exchanges.

    Interactive Brokers LLC is a member of NYSE, NASD, SIPC

    In order to simplify the computations, commissions, fees, margin interest and taxes have not been included in the examples used in these materials. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences.

    Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities. Past performance is not a guarantee of future results.

    Most strategies involving futures and/or options spreads require a margin account.

    Supporting documentation for any claims and statistical information will be provided upon request.

    Disclosure of Risk

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    Bulls & Bears…

    First, understanding the descriptive graph A word on volatility and options pricing Then look at some directional trades for bullish or bearish outlooks Next, some direction-neutral trades when the trader wants prices to stagnate or explode

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    What does the graph show me?

    X-axis depicts price of underlying ($) Y-axis measures profit and loss Combines price variation with cost & P/L of trade Allows trader to immediately visualize:

    Trade cost Maximum loss Maximum profit Breakeven points

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    What does the graph show me?

    Buying any option costs a ‘premium’ (debit) Maximum loss can be shown visually as a horizontal line parallel to (and below) the X-axis Selling an option creates a credit

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    Points to Remember

    These basic strategies don’t change Skill is knowing when to apply them Each strategy needs a buyer and a seller Rule of thumb:

    Long strategies will show an initial cost BELOW the zero line (DEBIT) Short strategies will show an initial ‘gain’ ABOVE the zero line (CREDIT)

    Calculating the breakevens and P/L max-mins flows from there What IS different is the HEIGHT of the debit or credit in each market or even between equities Primary reason is VOLATILITY

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    Historic volatility measures the annualized standard deviation in price of underlying Implied volatility attempts to predict perceived price movement in the future It’s a KEY determinant of option price Share prices sit across a spectrum ranging from low risk to high risk The amount of risk determines the volatility

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    Nasdaq composite versus Dow industrials iShares Technology ETF (IYW)

    Historic volatility = 18.4 Implied volatility = 20.1

    iShares Industrials ETF (IYJ) Historic volatility = 13.7 Implied volatility = 13.6

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    Long Call Examples

    Just to reiterate earlier point about risk and volatility, take two similar priced stocks from the risk spectrum to see how it impacts option pricing Next slide discusses intrinsic and extrinsic values of a call option Simply stated INTRINSIC is that portion of an option that is “in-the-money” Extrinsic value is the price of the possibility that the option will become intrinsic during its life

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    Qualcomm calls cost 30 percent more than Home Depot

    Qualcomm Inc. (QCOM) $39.60 Historic volatility = 30.6 Implied volatility = 32.7 April 37.5 call = 3.30 Intrinsic value = 39.60 – 37.50 = 2.10 Extrinsic = 3.30 – 2.10 = 1.20

    Home Depot Inc. (HD) $38.60 Historic volatility = 13.1 Implied volatility = 21.2 April 37.5 call is 2.00 Intrinsic value = 38.60 – 37.50 = 1.10 Extrinsic = 2.00 – 1.10 = 0.90

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    Long Call

    Buying a call implies a bullish view Maximum loss is cost of call option Breakeven is strike price plus premium paid Beyond here the maximum profit is unlimited with chart having 45° bias The more underlying price increases the greater the profit –shares could rise infinitely

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    Long Call Example Qualcomm Shares trading at $39.60 April 40.0 call quoted at 1.80 One month to expiration Call option nearly is at-the-money Premium is totally extrinsic (40.0 - 39.60) Maximum loss is premium of 1.80 no matter where shares settle (beneath strike) Breakeven is strike price PLUS premium = 40.0+1.80 = 41.80 Above here profit increases in line with share price If by expiration shares rise to $45.20, profit is 45.20 – 41.80 = 3.40 per contract

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    Long Put

    Buying a put implies a bearish view Maximum loss is cost of put option Breakeven is strike price minus premium Beyond here the maximum profit is unlimited with chart having 45° bias The more underlying price declines the greater the profit – shares could fall to zero

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    Long Put Example

    Home Depot Shs trading at $38.60 April 40.0 put quoted at 1.90 One month to expiration Put option is in-the-money Premium has 1.40 points intrinsic value (40.0 - 38.60) Maximum loss is premium of 1.90 if shares settle above strike Breakeven is strike price MINUS premium = 40.0 -1.90 = 38.10 Beneath here profit increases in line with share price If by expiration shares fall to $34.90, profit is 38.10 – 34.90 = 3.20 per contract

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    Covered Call

    Buy 100 shares and sell a call option with a higher strike price If shares rise the trader is making money When share price reaches strike price the call option starts to rise penny by penny in line with the shares and offsets the share price gain If shares fall, the falling equity value is offset in part by the call premium Shares could fall to zero

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    Covered Call Example

    Most options contracts = 100 shares of stock Buy 100 shares of Apple at $87.95 Sell 1 April 95.0 call option at 1.40 points

    Shares cost $8,795 Option generates $ 140 Net cost $8,655

    Breakeven is share price MINUS premium = $86.55 (in other words cost basis is reduced) Maximum profit is AT or above strike price Above the strike price the positions offset one another so profit is capped Beneath $86.55 the value declines in line in line with the stock pricewith the stock price

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    Protective Put

    Buy 100 shares and buy a put with a slightly HIGHER strike price If shares continue to rise, the trader sees his or her equity grow – minus the cost of the put If shares fall the put will offset by each penny the loss of value of the decline below the breakeven point While shares could fall to zero, the put rises commensurately

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    Protective Put Example

    Most options contracts = 100 shares of stock Buy 100 shares of Oracle at $16.60 Buy 1 April 17.0 put option at 0.80 points

    Shares cost $1,660 Option cost $ 80 Net cost $1,740

    Breakeven is share price PLUS premium = $17.40 (in other words cost basis is increased) Maximum profit is unlimited and occurs as shares increase above $17.40 The put option protects trader against share price decline below strike price minus cost or 17.0 – 0.80 = 16.20 Beneath $16.20 the put value increases in line with the stock price decline

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    Bull Call Spread

    Used when shares are expected to rise Buy a call with a strike above the current underlying price Trade established as a debit Sell a call with an even higher strike price with the same underlying and expiration date The net cost is the maximum loss Maximum gain is capped at the higher strike price = difference in strikes – premium paid Above higher strike the gain from the long lower strike is exactly offset by losses from the higher strike

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    Currency Futures – Bull Calls

    Let’s move to currency futures How does one capture the potential unwinding of the “carry-trade?” A call spread is a less risky solution but limits the upside to the trade Let’s look at how call options were priced before the recent surge in the yen Feb 14, June yen futures trading at 84.16

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    June Japanese Yen Future

    March 5 – June contract closed at 87.49

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    Bull Calls Example

    Action: Feb 14. June future closed @ 84.16 Buy 1 June 86.0 call @ 0.60 points Sell 1 June 88.00 call @ 0.30 points Long 1 June 86/88 bull call spread @ 0.30 Result: March 5. June future closed @ 87.49 Sell 1 June 86.0 call @ 2.29 points Buy 1 June 88.0 call @1.31 points Closed June 86/88 bull call spread @ 0.98 Profit is 0.98-0.30 * $12.50 = $850

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    June Bull Call - Metrics

    Had we had the foresight to play this trade via the underlying we’d have bought outright – long June yen future @ 84.16 The profit had we sold at 87.49 would have been 333 * $12.5 = $4.162.50 Maximum drawdown two days into the trade was 83 pips when June fell to 83.33 Loss would have been

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