The Option Pit Method Option Pit Beginning Boot

The Option Pit Method Option Pit Beginning Boot Camp The Option Pit Method For trading options Option Pit

Option Boot Camp- The Option Pit Method - The Option Pit method uses - Position Structure - Efficient use of Capital - Risk Management - Structure positions that have “edge” but keep the risk reward profile reasonable

The Option Pit Method “The volatility is in the toilet. ” - Mark Sebastian numerous times on Bloomberg News “If you think education is expensive, try ignorance. ” ― Derek Bok, former Harvard President

Boot Camp - What you will learn • Calls, puts, stock and execution • Options with Stock • Intro to volatility and positions • Intro to spreads

Option Boot Camp 1 - What you will learn • What is a Stock? • characteristics • What are Calls? • Risk/reward and assignment • What are Puts? • Risk/Reward and assignment • Risk Reward Basics • Putting it together

Risk and reward is sprinkled thorough out the basic boot camp Tying concepts together are very important I will highlight the flagged concepts Risk, reward, loss and gain will help investors make relative judgements on option and stock trading. As we go through the course try to understand what will make the “best” risk reward setup for a given market condition or idea As in why stock over calls or why puts over short stock?

Stock Basics Stocks are ownership stakes of a public company trade on the secondary market (exchanges) • Number of shares outstanding (float) x share price = market cap • There are primary market shares but mostly not available to the public • There are different classes of stock (voting rights mostly) • Stock options trade on exchange listed issues

Payout • How much do you make owning a stock?

Payout • That is defined by the "tick" and number of shares you own. What is a “tick”? How much a position makes on the minimum move times the position size. Uptick and downtick Change on the day Size Bid x ask

Payout- Dividends • Stocks also pay a dividend (some do) usually once a quarter. • Most returns posted by mutual funds include dividend "reinvestment“ – 50% of the S&P 500 returns were from dividends take the dividend and buy more stock (Warren Buffett method seems to work) Call ownership does not pay dividends

Payout- Round lots • 100 shares is what we call a round lot. Remember this for later. A. 10 on 100 shares is $10 • Profit or loss- tick (. 01) or price change (Chg on day from previous close) x the number of shares will generate a profit (or a loss) • AAPL is trading 94. 69 on 100 shares down 2. 69 on Feb 24 th – The $2. 69 price change x 100 is -$269 before commissions

Payout- Cap Gains and Dividends Capital Gains – watch it go up! Dividend Reinvestment- cash flow stream that buys more stock – Option Investing is not too different from this – There is option price appreciation and option income (more or less) from option sales • We will take each separately in the course

Risks with ownership Stocks can go down- stocks drop due to • Market conditions (SPX drops, ugly global issues, etc. ) • Name or Company Specific issues (company is broken or disappointing somehow) • Sector in decline (oil, housing, tech, etc)

Risks with Ownership • Levels of Stock Declines – Stocks can go to down- equity value declines severely but is not bankrupt • Stocks can go down but only go to 0 so you cannot lose more than the investment (key risk point) • What is the arc of a move? – Stocks can get delisted – equity goes away to 0

Stock vs. Bond Risk Reward • Bonds are mostly income with some capital gain (low premium risk) • More bond holder rights (senior) – distressed bond hedge funds buy these looking for a big bang in capital appreciation (more on this in the volatility section in Boot Camp 3) • Less bond holder rights (subordinate) • Treasuries (full faith and credit of Uncle Sam) perceived as no risk

LTCM Implosion Is Instructive. • Remember according to LTCM, the risks they were taking were next to impossible to lose money on • REALLY? • If they could have held on, LTCM would have eventually made money – The key is risk management!

Convertible bond basics • Bond with an embedded "call" that can convert to stock Why did I put this in? Know what you are investing in! • Know the contract specifications, call dates, delivery, etc • Caveat Emptor!

Long and Short • This is what we call a direction bias for a security • Is the stock, index, commodity, bond going to go up in price or down in price • This is also known as the direction of the underlying security as any option will respond to the price action of this security – Long wants the underlying to go up in price – Short wants the underlying to down in price

What is long and short stock Long stock is ownership and has rights » The direction bias is up chart » Tick for tick win or loss » Loss is theo 0 Short is borrowing and has obligations » The direction bias is down » Tick for tick win or loss » Loss is Theo unlimited (there is more risk in shorting a stock than owning, remember this when we talk about puts)

How does short stock work? – It must be “located” and borrowed (borrow rate) from an owner » This implies that it can be taken away (short squeeze) » It happens with enough frequency that it can upset option markets » Short stock has an implied risk of being taken away in addition to the direction bias (two risks not 1) • We cover more dynamics in Silver

What is the borrowing rate There is a cost associated with borrowing stocks for retail traders (it is a hassle for the broker dealer but they charge the trader for the hassle) – If the cost gets too high the issue could be “bought in” and the shorts are forced to cover or buy back their shorts » If too many have to do it at once you get a short squeeze • Recent is WTW

WTW

Equity Calls • The call holder has the right to buy 100 shares (round lot) of stock for a given price over a certain period of time. • The tick on a call is 100 x number of contracts. – So a. 01 move on 10 contracts is. 01 x 100 x 10 or $10 • We buy a call to open and we sell a call to close for a long call position (quote line) – It has a strike price, delivery, time to expiration and option premium

Call Payout • the long call wants the underlying to go up and will pay out some fraction of the move. – Moneyness- different strikes have different payouts (ITM, ATM, OTM) » What you gain in leverage you give up in tick by tick movement – The call tick is somewhat less than the underlying tick on a straight move up. The leverage is quite different. • Profit- a long call will profit if the underlying moves up fast enough over a given period of time –note there are two parts » Direction » Time

AAPL Calls itm atm otm

Risk associated with call ownership – – The underlying does not move up fast enough The underlying moves down Out of time » Once expiration comes there is no time left and the game is over • Call vs stock payout – Risk reward payout for a round lot of 100 shares and 1 call contracts – We can walk through this!

Moneyness Profit Comparison AAPL Feb 95 call @. 86 AAPL Feb 90 call @ 4. 85 Note the P/L difference to $100

Value proposition – The risk in the long call versus the margin reduction over stock is the main reason to own a call over stock » Example on $1000 » The trick is making sure there is enough time to work it out » Setting loss limits early since the leverage should work in an up move • Small losses are key

Puts • The put holder has the right to sell 100 shares (round lot) of stock for a given price over a certain period of time. • We buy a put to open and sell the put to close for a long put (quote line) – It has a strike price, delivery, time to expiration and option premium

Payout • the long puts wants the underlying to go down and will pay out some fraction of the move . – Money ness- different strikes have different payouts (ITM, ATM, OTM) » What you gain in leverage you give up in tick by tick movement – The put tick is somewhat less than the underlying tick on a straight move down. The leverage is quite different. • Profit- a long put will profit if the underlying moves down fast enough over a given period of time – note there are two parts » Direction » Time

Risk Associated with Put Ownership – – The underlying does not move down fast enough The underlying moves up Out of time » Once expiration comes there is no time left and the game is over • put vs stock payout – Risk reward payout for a round lot of 100 shares and 1 put contract

Put Moneyness Profit Comparison AAPL Feb 95 put @ 1. 26 AAPL Feb 100 put @ 5. 26

Value proposition – Risk reward payout for a round lot of 100 shares and 1 put contract – The premium risk in the long put versus the margin reduction/ short squeeze potential over short stock is the main reason to own a put over short stock » Example on $1000 » The trick is making sure there is enough time to work it out » Setting loss limits early since the leverage should work in an up move • Small losses are key

Delivery – Delivery of the underlying comes in the form of a security or cash » It is not a reason to panic » Exercise is from ownership (long the contract) » Assignment is from obligation (short the contract) but your risk is actually reduced but margin increases » Know what you are getting • Most equity options deliver stock, most index option deliver cash but check here: http: //www. cboe. com/products/

Delivery- Result – If you have to take the stock, long or short, you need the money (margin). Note the margin of taking the stock is always more than just the call or put. The option has risk to the strike price, stock risk is much greater up or down » Exercise is more risk » Assignment is less risk • When does one take delivery – One takes deliver on expiration for European exercise – One can take delivery any time during the term for American Exercise » There are mathematical rules here

When is something assigned – Generally assignment happens in American Exercise options when the delivery value is more than the option value. There are several parts: » Cost of carry, dividends and the put value of the strike – Interest rates XRT (think of the cost by your broker for margin) » This is known as cost of carry (strike x rate x time to expiration/360) and this is one side of the equation – Dividends » Remember this is the cash flow stream • Long calls don’t pay a dividend • Long puts don’t owe a dividend » The rule is simple, if the dividend is worth more than the put on the strike the call will be assigned 99% of the time.

Dividend Assignment Example • You are assigned a short put if the cost of carry is greater than the value of the call on the strike • You are assigned a short call if the dividend is greater than the value of the put on the strike • UNP Feb 26 W 79 calls @ 1. 03 with stock trading 80. 09 the div is. 55

Expiration and Assignment – There are expirations every week and the contract bought or sold tells you when the expiration is. This is when settlement and delivery happen. • Options settle on the closing price for the contract and all delivery is based on the that price. – When to take assignment/risk it » Short options can be assigned after Fridays close. If the option is close to the strike it can be assigned and the assignment is random. » Never for this class is the answer so close the short options that drop below. 10.

Short Calls and puts • How to make money – You want the underlying to move in the right direction or nowhere at all during the term of the option – You can only make what you sell the option for- loosely equivalent to a dividend stream (remember the risk in a dividend paying stock is the cost of the underlying which is a lot) • Short calls want the underlying to go down in price • Short puts want the underlying to go up in price – The risk reward profile is extreme for short options • We will spend the rest of the time in Boot Camp reducing it

Short Call and Put Comparison Short AAPL Feb 95 call Short AAPL Feb 95 puts

Working out the risk reward • Short Call- selling 95 call $2000 in margin to make $76 around 4% for 2 days • The ultimate goal is minimize the margin and increase the yield potential • Short Put-selling a 96 put $9600 in margin to make $66 in 2 day or less than 1%

Finding Options in the Market • Do the hard side first – Getting filled when the market is dropping. » Long direction underlying is easy to fill » Short direction underlying is hard to fill (HARD SIDE) • Reading markets – Size and width – deeper the better as it is a trading zone • Fill expectation • What is a Theorhetical Value and how does it help fill expectation?

Practical Applications

Notes

Quiz • What is the risk reward difference between a long call and a short put. • What is delivery? • When is a short call assigned? • Do we risk short options close to the money on expiration?