Introduction to Options

Andrew Wilkinson

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 Disclosure of Risk
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.

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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 dont 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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 Volatility

Historic volatility measures the annualized standard deviation in price of

underlying
Implied volatility attempts to predict perceived price movement in the future
Its 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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 Volatility
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
with 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

Lets 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
Lets 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 wed 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 $1,037.50
By using a bull call spread our loss was
pinned to just 30 points or $375 at the start
Maximum profit in this case would be
distance between the upper and lower
strikes (88-86=200) LESS net premium or
200-30 =170
That would occur at upper strike price of
88.0
Maximum loss is our cost of $375, which
occurs at any level beneath lower strike
price of 86.0

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 Bear Put Spread

Used when underlying is expected to fall

Buy a put with a strike below the current
underlying price
Sell a put with an even lower strike price
and the same underlying and expiration
date
The trade is established as a debit
The net cost is the maximum loss
Maximum gain is at the lower strike price
= difference in strikes premium paid
Below the lower strike the gain from the
long higher strike is exactly offset by
losses from the lower strike

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 Bear Spread Example

A trader believes the price of May crude

oil might fall from current $62.04
Buy 1 May 60.0 put @ 2.08
Sell 1 May 57.0 put @ 1.08
Net cost of May 60/57 bear put spread
100 points
Maximum loss is 100 points * $10=
$1,000 at values of 60 and above
Maximum profit is strike spread (60-
57=3) minus cost of spread = 3-1 or 200
points or $2,000
Occurs at values from 57 and lower
Breakeven occurs at 59 (after the long
put value exceeds trade cost)

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 Closing Thoughts

Plan your trades

Create a visual image to assist you
Think premium profiling
Consider alternative strategies and what-if scenarios
Questions?

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