An Introduction to Options

Trading Success

Presented by:

James B. Bittman

Senior

Instructor, The Options Institute

(the educational arm of

The Chicago Board Options Exchange)

and Author, Options for the Stock Investor

and Trading Index Options

In order to simplify the computations, commissions have not been included in the examples used
in these materials. Commissions will impact the outcome of the stock and options transactions
and should be considered.

Options involve risks and are not suitable for everyone. Prior to buying or selling an option, a
person must receive a copy of Characteristics and Risks of Standardized Options. Copies which
may be obtained from The Chicago Board Options (1-800-OPTIONS) or from your broker. The
investor considering options should consult their tax advisor as to how taxes may affect the
outcome of contemplated options transactions. A prospectus, which discusses the role of the
Options Clearing Corporation, is also available without charge upon request addressed to the
Options Clearing Corporation; 440 S. LaSalle St., Suite 908, Chicago, Illinois 60605 or the CBOE;
LaSalle at Van Buren, Chicago, Illinois 60605.

ANY STRATEGIES DISCUSSED, INCLUDING EXAMPLES USING ACTUAL SECURITIES AND
PRICE DATA, ARE STRICTLY FOR ILLUSTRATIVE AND EDUCATION PURPOSES 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 PERFORMANCE.

Disclaimer

Investor Goals

BUY “GOOD” STOCKS AT “GOOD” PRICES

SELL STOCKS AT “GOOD” PRICES

INCREASE INCOME

REDUCE RISK

INVESTORS SEEK THE BENEFITS

OF STOCK OWNERSHIP

OPTIONS CAN BE USED

TO TARGET THESE OBJECTIVES

Learning to Use Options

Understand the Mechanics

(How options work)

Have a Strategy, a Goal, and a Plan

Define “success” in advance

Have Realistic Expectations

A contract which gives the buyer

the right (but not the obligation)

to buy some underlying

instrument at a specified price

until an expiration date.

Call Option

Strike Price:

The “specified price” in an
option contract.

Expiration Date:

The date after which an option
contract and the right it
contains ceases to exist.

Strike Price and Expiration

The call buyer or call owner is
described as having a “long
call position.”

Example:

Buy 5 XYZ Jan 2003 80 Calls at 15

Call Buyer

Stock Price Cost of Value at

at Expiration Call Expiration P/(L)

120

115

110

105

100

95

90

85

80

75

Long Call (

Buy 1 80 Call @ 15)

Long Call (

Buy 1 80 Call @ 15)

LONG CALL

+25 -

+20 -

+15 -

+10 -

+ 5 -

0 --|----|----|----||----|----|----|----||----|----|----|----||----|----|-

60

80

100

- 5 -

-10 -

-15 -

-20 -

“Buy” Now, Pay Later

An investor will accumulate the cash to

purchase stock over the next 18 months, but
wants to lock in today’s stock price.

STRATEGY: (1) BUY LEAPS CALL

(2) START SAVING

AT EXPIRATION:

If stock is above strike price, exercise call and

use savings to pay for stock.

If stock is at or below strike price, a loss

results. Reconsider the decision.

“Buy” Now, Pay Later

STRATEGY: (1) Buy LEAPS Call

(2) Start Saving

GOAL:

Buy Stock With Limited Risk

PLAN:

Exercise The Call

REALISTIC EXPECTATIONS:

The full premium paid for
the call is at risk of being lost.

Buy a Call for a “Trade”

A trader has a two-week bullish forecast for a

stock due to a pending earnings report.

STRATEGY: BUY A 60-DAY CALL

IN TWO WEEKS (OR SOONER):

If profit target is reached, sell the call and
realize the profit.

If stop-loss point is reached, sell the call and
realize the loss.

If two weeks pass and neither is reached,
sell the call.

STRATEGY: Buy a 60-day Call

GOAL:

Make a short-term profit

PLAN:

Sell the Call in two weeks (max.)

REALISTIC EXPECTATIONS:

The full premium paid for
the call is at risk of being lost.

Buy a Call for a “Trade”

The call seller or call writer is
described as having a “short call
position.”

Example:

Sell 5 QRS Sep 75 Calls at 3

Call Seller

Seeking “High” Returns

COVERED WRITING DEFINED:

BUY STOCK AND SELL CALLS
(ON A SHARE-FOR-SHARE BASIS)

Example:

Buy 500 QRS

73

Sell 5 Sep 75 Calls

3

Selling Covered Calls

Covered call writers are
obligated to sell the stock if an
assignment notice is received.

The possibility of an early
assignment must be considered.

Stock Price Long Stock Short 75 Call Combined
at Expiration Profit / (Loss) Profit / (Loss) Profit / (Loss)

80

79

78

77

76

75

74

73

72

71

Selling Covered Calls

Selling Covered Calls

COVERED CALL

+ 6 -

+ 5 -

+ 4 -

+ 3 -

+ 2 -

+ 1 -

0 --|----|----|----||----|----|----|----|----||----|----|----|----|----||----|----|-

70 75

80

- 1 -

- 2 -

- 3 -

“Static Return”

The static return calculation assumes that the stock price is
unchanged at option expiration and the call expires.

Income

Investment

Call + Dividend

Days per Year

Stock Price

Days to EXP

X

X Time Factor

“If-Called Return”

The if-called return calculation assumes that the stock price is above
the strike price at option expiration and that the call is assigned.
Note that a commission is involved when an option is assigned.

Income + Gain

Investment

(Call + Dividend) + (Strike - Stock)

Days per Year

Stock Price

Days to EXP

X Time Factor

X

A Covered Writing Plan

?

Start with cash

?

Find a stock:

5-10% expected price rise prior to expiration

?

Buy stock / sell call

?

Be willing to sell stock at strike price and be willing

to forego profits on stock above the strike price

?

At expiration: hope to end with cash

?

Have a stop-loss

?

Diversify (do more than one at a time)

?

Do it again (always be looking for more stocks)

A contract which gives the buyer
the right (but not the obligation)
to sell some underlying
instrument at a specified price
until an expiration date.

Put Option

The Put Buyer:

?

has the right to sell stock

?

at an agreed upon price (the strike)

?

until the expiration date

?

for this right, the put buyer pays a premium

Long Put

(Buy 1 50 Put @ 3)

Stock Price Cost of Value at
at Expiration Put Expiration P/(L)

63

62

61

60

59

58

57

56

55

54

Long Put

+ 5 -

+ 4 -

+ 3 -

+ 2 -

+ 1 -

0 --|----|----|----||----|----|----|----|----||----|----|----|----|----||----|----|-

55

60 65

- 1 -

- 2 -

- 3 -

- 4 -

“Free” Protection

THE COLLAR STRATEGY:

BUY PUTS AND SELL CALLS
ON A SHARE-FOR-SHARE BASIS
AGAINST OWNED STOCK

“Free” Protection

THE COLLAR STRATEGY:

Example:

Own 1,000 XYZ 100

Buy 10 Jan 95 Puts 6

Sell 10 Jan 110 Calls

6

The Collar Strategy

Stock Price Lng Stock Sht 110 Call Lng 95 Put Combined

at Expiration P / (L)

P / (L)

P / (L)

P / (L)

125

120

115

110

105

100

95

90

The Collar Strategy

+12 -

+10 -

+ 8 -

+ 6 -

+ 4 -

+ 2 -

0 --|----|----|----||----|----|----|----|----||----|----|----|----|----||----|----|-

90 100

110

- 2 -

- 4 -

- 6 -

Trading Calls and Puts

Question 1

Stock Price:

$50

? $51

Days to Exp:

90

?

90

50-Strike Call:

3 1/4

?

?

Trading Calls and Puts

Question 2

Stock Price:

$50

? $50

Days to Exp:

90

?

45

50-Strike Call:

3 1/4

?

?

Trading Calls and Puts

S t o c k

P r i c e

9 0

D a y s

7 5

D a y s

6 0

D a y s

4 5

D a y s

3 0

D a y s

1 5

D a y s

E X P

5 3

5 1 / 8

4 3 / 4

4 1 / 2

4 1 / 8

3 3 / 4

3 3 / 8

3

5 2

4 3 / 8

4 1 / 8

3 3 / 4

3 3 / 8

3

2 1 / 2

2

5 1

3 3 / 4

3 1 / 2

3 1 / 8

2 3 / 4

2 3 / 8

1 3 / 4

1

5 0

3 1 / 4

2 7 / 8

2 5 / 8

2 1 / 4

1 3 / 4

1 1 / 4

0

4 9

2 3 / 4

2 3 / 8

2 1 / 8

1 3 / 4

1 1 / 4

3 / 4

0

4 8

2 1 / 4

1 7 / 8

1 5 / 8

1 1 / 4

7 / 8

1 / 2

0

4 7

1 3 / 4

1 1 / 2

1 1 / 4

1

5 / 8

1 / 4

0

4 6

1 1 / 8

7 / 8

5 / 8

1 / 2

1 / 4

1 / 1 6

0

50 Call - Theoretical Values

Trading Calls and Puts

DELTA:

Change in option price for a one-point

change in the underlying stock price.

If the stock price changes by $1, the

option price will change by less than $1

Trading Calls and Puts

TIME DECAY is non-linear for at-the-

money options.

There is less time decay initially, and

more as expiration approaches.

Trading Calls and Puts

Realistic Expectations

Depend on 4 Questions:

1. I buy/sell the option today

2. If my forecast is correct...

3. What will the option price be?

4. Is that OK?

Trading Calls and Puts

?

The forecast must include 2 parts.

» Price of underlying

» Time period

?

Have realistic expectations

?

Always examine more than one alternative

?

Have a stop-loss point

?

Apply your method of market prediction
with discipline

The Stock Repair Strategy

Some time ago you purchased XYZ at $60. The price is now $50.
You are willing to keep holding this stock, because you think that
the price will rise to $55 in 60 days. At this point you just want
your money back. You would like to break even on this trade and
invest this capital somewhere else.

Consider the following price information and choose an option
strategy that will lower your break-even point without increasing risk
if your forecast is realized.

August 15

CALLS

PUTS

Stock #1

Strike

SEP

OCT

SEP

OCT

(@$50)

50

1 1/4

3

1

2 1/4

55

1/4

1 1/2

5 1/4

5 3/4

60 ---

5/8 10 10 3/8

Add a Ratio Call Spread to Long Stock

Own 100 shares (cost)

$60

Buy 1 50 Call

@ 3 and

Sell 2 55 Calls

@ 1 1/2 each

The Stock Repair Strategy

Stk Px Lng Stk Lng 50 Call Shrt 2 55 Calls Total
at Exp @ $60 @ 3

@ 1 1/2 ea. P/(L)

56

55

54

53

52

51

50

49

The Stock Repair Strategy

+ 3
+ 2 -
+ 1

0 --|----|----|----||----|----|----|----|----||----|----|----|----|----||----|----|-

- 1 -

50 55 60

- 2 -
- 3 -
- 4 -
- 5 -
- 6 -
- 7 -
- 8 -
- 9 -

-10 -

The Stock Repair Strategy

STRATEGY: Add Ratio Call Spread

to long stock position

GOAL:

Break Even (and cash out)

PLAN:

Hold options to Expiration

REALISTIC EXPECTATIONS:

Substantial risk from long
stock position.

The Stock Repair Strategy

OPTIONS

GIVE YOU

OPTIONS

ANSWERS

Stock Price Cost of Value at

at Expiration Call Expiration P/(L)

120

15

40

+25

115

15

35

+20

110

15

30

+15

105

15

25

+10

100

15

20

+ 5

95

15

15

0

90

15

10

(5)

85

15

5

(10)

80

15

0

(15)

75

15

0

(15)

Long Call (

Buy 1 80 Call @ 15)

Long Call (

Buy 1 80 Call @ 15)

LONG CALL

+25 -

+20 -

+15 -

+10 -

+ 5 -

0 --|----|----|----||----|----|----|----||----|----|----|----||----|----|-

60

80

100

- 5 -

-10 -

-15 -

-20 -

Stock Price Long Stock Short 75 Call Combined
at Expiration Profit / (Loss) Profit / (Loss) Profit / (Loss)

80

+7

(2)

+5

79

+6

(1)

+5

78

+5

0

+5

77

+4

+1

+5

76

+3

+2

+5

75

+2

+3

+5

74

+1

+3

+4

73

0

+3

+3

72

(1)

+3

+2

71

(2)

+3

+1

Selling Covered Calls

Selling Covered Calls

COVERED CALL

+ 6 -

+ 5 -

+ 4 -

+ 3 -

+ 2 -

+ 1 -

0 --|----|----|----||----|----|----|----|----||----|----|----|----|----||----|----|-

70 75

80

- 1 -

- 2 -

- 3 -

Long Put

(Buy 1 60 Put @ 3)

Stock Price Cost of Value at
at Expiration Put Expiration P/(L)

63

3

0

(3)

62

3

0

(3)

61

3

0

(3)

60

3

0

(3)

59

3

1

(2)

58

3

2

(1)

57

3

3

0

56

3

4

+1

55

3

5

+2

54

3

6

+3

Long Put

+ 5 -

+ 4 -

+ 3 -

+ 2 -

+ 1 -

0 --|----|----|----||----|----|----|----|----||----|----|----|----|----||----|----|-

55

60 65

- 1 -

- 2 -

- 3 -

- 4 -

The Collar Strategy

Stock Price Lng Stock Sht 110 Call Lng 95 Put Combined

at Expiration P / (L)

P / (L)

P / (L)

P / (L)

125

+25

(9)

(6)

+10

120

+20

(4)

(6)

+10

115

+15

+1

(6)

+10

110

+10

+6

(6)

+10

105

+ 5

+6

(6)

+ 5

100

0

+6

(6)

0

95

(5)

+6

(6)

(5)

90

(10)

+6

(1)

(5)

The Collar Strategy

+12 -

+10 -

+ 8 -

+ 6 -

+ 4 -

+ 2 -

0 --|----|----|----||----|----|----|----|----||----|----|----|----|----||----|----|-

90 100

110

- 2 -

- 4 -

- 6 -

Stk Px Lng Stk Lng 50 Call Shrt 2 55 Calls Total
at Exp @ $60 @ 3

@ 1 1/2 ea. P/(L)

56

( 4)

+3

+1

0

55

( 5)

+2

+3

0

54

( 6)

+1

+3

( 2)

53

( 7)

0

+3

( 4)

52

( 8)

(1)

+3

( 6)

51

( 9)

(2)

+3

( 8)

50

(10)

(3)

+3

(10)

49

(11)

(3)

+3

(11)

The Stock Repair Strategy

+ 3
+ 2 -
+ 1

0 --|----|----|----||----|----|----|----|----||----|----|----|----|----||----|----|-

- 1 -

50 55 60

- 2 -
- 3 -
- 4 -
- 5 -
- 6 -
- 7 -
- 8 -
- 9 -

-10 -

The Stock Repair Strategy