Options Boot Camp Part 2
About Sunset Partners Our Presenters Today Robert Hamer, Principal Chief Investment Strategist & Portfolio Manager Experience Trader Chicago Board Options Exchange: 1983-1998 Senior Vice President Merrill Lynch, Morgan Stanley 1998-2007 Education J.D., California Western School of Law Mitch Hamer, Investment Analyst Junior Portfolio Manager, Client Communications, Investment Research Experience Trading & Research, Sunset Partners Management Consultant, Various Firms Education M.S. Communication, Northwestern University B.S. Psychology, University of Illinois - Urbana 1
Welcome to Option Boot Camp Part 2 The Call Option Welcome to Option Boot Camp Intro to Call Options Today we will go over the basics of call options By the end of the session, you may have more questions than answers Learning options is like learning a foreign language Take notes, ask questions, review notes, review the videos Housekeeping Any questions feel free to ask on the Q&A or Chat Box Q&A Session Time permitting, we will stay on a few extra minutes to answer questions Q&A Video Over the weekend, Mitch & Bob will address all questions from the webinar & e-mails into a video that we will post on our website Our goal is to raise your level of market intelligence enabling you to take a more active role in overseeing your financial future. 2
Defined & Key Components Def: An option contract that gives the holder the right to buy the underlying security at a specified price for a certain, fixed period of time. One contract is equivalent to 100 shares of stock. Key Components Underlying Security Strike Price Expiration Period Price of Option Quantity Who trades call options? Those looking to speculate Stock substitution Generating income/yield on a portfolio 3
Option Chain 4
Option Chain The Calls Underlying Security Expiration Period Strike Price Cost of Option 5
Option Chain Underlying Security Expiration Period Strike Price Cost of Option 6
Option Chain Underlying Security Expiration Period Strike Price Cost of Option 7
Option Chain Underlying Security Expiration Period Strike Price Cost of Option 8
Option Chain Underlying Security Expiration Period Strike Price Cost of Option 9
Let s go over an example! Form a hypothesis Because AAPL reported unbelievable earnings they are trading cheap relative to other players in their sector, Apple Pay, Apple Watch, and further sales of iphone 6 will cause AAPL to trade 130. With this information in mind, how can we use a call option? This sets up a conversation on Buying vs. Selling Calls. Next slide. 10
Buying & Selling Calls Remember the definition of a call option. Def: An option contract that gives the holder the right to buy the underlying security at a specified price for a certain, fixed period of time. In order to buy the contract, there has to be a seller of the contract. Call Buyer Call holder, or buyer, is spending money. Upon buying a call, you have the right to own shares of stock at a specified strike price on or before a specified expiration period. When you buy a call option, if the underlying security goes up, the value of your call option goes up. If the underlying security goes down, the value of your call option goes down. Risk: As a call buyer, you cannot lose more than your debit. Contrast that to owning a stock the stock can go to ZERO. Call Seller Call seller is receiving money, known as a credit, for giving the call buyer an opportunity to purchase shares at a strike price. If you sell the call, you have the obligation to sell/deliver shares at a specified strike price on or before a specified expiration period. Risk: As a seller of calls, you have unlimited risk (exposure). A stock theoretically can go to infinity. More on this later. 11
Buying & Selling Calls Confused yet? You should be. Take detailed notes and let s proceed. Write down your questions and send them to info@sunsetpartnerscapital.com or type them in the chat box in the WebEx. We will address ALL questions. 12
Let s go over an example! Form a hypothesis Because AAPL reported unbelievable earnings they are trading cheap relative to other players in their sector, Apple Pay, Apple Watch, and further sales of iphone 6 will cause AAPL to trade 130. With this information in mind, how can we use a call option? This sets up a conversation on Buying vs. Selling Calls. Because we speculate AAPL will appreciate in price, we want to buy calls. Setting up the trade using the four components Underlying Security: AAPL Expiration Period: TBD, keeping in mind the July 2015 period Strike Price: I m not sure Cost of Option: Depends on strike price, right? Yes. 13
Strike Price As we ve mentioned, when setting up an option trade, you need to have a strike price. How do I choose the strike? In the Money At the Money Out of the Money 14
Strike Price As we ve mentioned, when setting up an option trade, you need to have a strike price. How do I choose the strike? At the Money The option strike that is closest to the current trading price of the underlying security With AAPL trading at 117.01, this one is pretty easy. At the money strike: 117 15
Strike Price As we ve mentioned, when setting up an option trade, you need to have a strike price. How do I choose the strike? In the Money If a call option is in the money, the current trading price of the stock is greater than the strike price. The 110 Strike would be considered deep in the money, while the 115 strike would be considered in the money 16
Strike Price As we ve mentioned, when setting up an option trade, you need to have a strike price. How do I choose the strike? Out of the Money If a call option is out of the money, the current trading price of the stock is less than the strike price. 17
Which Strike to Choose? Recall, your hypothesis is speculating AAPL trades 130. In The Money At the Money Out of the Money Strike 100-116 117 118 + Cost of Option Most Expensive Expensive Least Expensive Delta (Price of Option Relative to Stock) Greater than 50 50 Less than 50 Probability High Probability Moderate Probability Low Probability Assumption: You want to use the long/purchased call option to make the most money, with spending/risking as little money as possible, controlling a large amount of stock, despite the low probability of an out of the money option. Let s move on. 18
Which Expiration Period to Choose Let s look at the out-of-themoney strikes. 120 Strike FEB JUL JAN 16 DTE* 23 170 352 Ask Price $1.91 $7.20 $11.30 Clear relationship between amount of time & price Intrinsic vs. Extrinsic *DTE = Days To Expiration 19
Intrinsic vs. Extrinsic Stepping away from the example for a minute Intrinsic Value: An option that is in the money has intrinsic value equal to [TRADING PRICE STRIKE] Extrinsic Value encompasses several factors that prop up the price of an option before expiration: Time Value Volatility Dividends Closing Price of $117.00 Feb 15 $115 Strike Price of Option Intrinsic Value Extrinsic Value 23 DTE $4.40 $2.00 $2.40 On Expiration $2.00 $2.00 $0.00 20
Let s Make the Trade July 15 120 Strike $7.20/contract Because you re new, purchase 1 contract, equivalent to 100 shares. $7.20 / contract = $720 debit Long Option vs. Buying Stock Buying Power Reduction: Long Call: $720 Cost of buying call contract Long Stock: $117*100 = $11,700 Profit/Loss Differential Price* Long Call Long Stock 85 -$720 $-3200 100 -$720 -$1700 120 -$720 $300 130 $380 $1300 140 $1380 $2300 *Closing Price @ Expiration 21
Congratulations, you own a Call Option in AAPL! We ve made the trade, now what? Do I have to hold the option until expiration? Absolutely not! Suppose the following scenario occurs: Stock quickly moves up to 123 on activist shareholder Icahn comments about adding to position on strength. What is my option worth at 123 two weeks after initial purchase? Option is now In the Money, & tracking the stock more closely. We will discuss this in Option Boot Camp Part IV The Greeks. Suppose the option has appreciated $3.00 in this move from purchase price of $7.20 to $10.20. Ask yourself, have you achieved your profit objective? $3.00 / $7.20 = 45% Return Suppose you want to hold the option until expiration AAPL has to close above 127.20 to profit on the trade. Breakeven = Strike Price + Debit 22
It s been a long evening. Let s wrap it up. Here s what we ve introduced today: What is a call option? Underlying Security, Strike Price, Expiration Period, Credit/Debit Components of an Option Call Buying vs. Call Selling We focused on Call Buying today, and will get into more detail on Call Selling later in boot camp. In the Money vs. Out of the Money vs. At the Money Extrinsic vs. Intrinsic Value Closing Remarks 23
Upcoming Sessions https://sunsetpartnerscapital.webex.com Feb 2 nd, 2015: Intro to the Put Option Feb 5 th, 2015: Intro to the Greeks Delta, Theta, Gamma, Rho, Vega, etc. Later in February Building on introductory call options Building on introductory put options Introduction to options strategies spreads, butterflies, condors, covered writes, etc. 24