Fundamentals of Options

Part I
March 3, 2013
Tim Weithers, Co-Director of Education, Chicago Trading Company
Jim Bittman, Senior Instructor, The Options Institute at CBOE
29
th
Annual Risk Management Conference
CBOE OPTIONS INSTITUTE 2
Disclaimer
Options involve risks and are not suitable for all investors. Prior to buying or selling options, an
investor must receive a copy of Characteristics and Risks of Standardized Options. Copies may be
obtained by contacting your broker, by calling 1-888-OPTIONS, or at www.theocc.com.
In order to simplify the computations, commissions, fees, margin interest and taxes have not been
included in the examples used in this presentation. These costs will impact the outcome of all stock
and options transactions and must be considered prior to entering into any transactions. Multiple leg
strategies involve multiple commission charges. Investors should consult their tax advisor about any
potential tax consequences.
The information in this presentation, including any strategies discussed, is strictly for illustrative and
educational purposes only and is not to be construed as an endorsement, recommendation, or
solicitation to buy or sell securities.
Supporting documentation for any claims, comparisons, statistics, or other technical data, will be
supplied upon request. Past performance is not a guarantee of future results. CBOE and Chicago
Board Options Exchange are registered trademarks and SPX, The Options Institute and Weeklys are
service marks of Chicago Board Options Exchange, Incorporated (CBOE). S&P and S&P 500 are
registered trademarks of Standard & Poor's Financial Services, LLC and have been licensed for use
by CBOE.
Copyright 2013 CBOE. All rights reserved.
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Session Outline
Why Options? Why Bother?
Brief Review of Basics
Understanding Strategies and Objectives
Performance of Benchmark Indexes
Introduction to Option Price Behavior
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Why Options? Why Bother?
Without options,
there are three strategy choices.
Short Stock T-Bill Long Stock
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Options Give You Options!
Ratio Call Spread Call Volatility Spread Split-strike Synthetic Put Volatility Spread
Long Straddle Short Straddle Long Strangle Short Strangle
Long Call Short Call Long Put Short Put
Options offer many strategy choices.
CBOE OPTIONS INSTITUTE 6
Possible Portfolio Objectives
Generate income
Limit risk
Reduce variability of returns
Lower the cost of protection
Creative portfolio protection
Tactical market entry and exit
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Possible Uses of Options
Passive Strategies
(rules based and consistent)
Actively Managed Strategies
(subjective and opportunistic)
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WHAT ARE OPTIONS?
Options are _________
Option buyers get ______
Option sellers get __________
WHAT ARE FUTURES?
Futures are _________
Futures buyers get ______
Futures sellers get __________
contracts
rights
obligations
Options Basics
contracts
obligations
obligations
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Contract Terms
Buyers of calls get the __________
Sellers of calls get the _______________
Buyers of puts get the __________
Sellers of puts get the _______________
right to buy
obligation to buy
right to sell
obligation to sell
Why buy the right?
Why assume the obligation?
Why not just buy/sell the stock?
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The action (also Sell)
Creates a new position
(Close to eliminate an existing position)
# of contracts
Underlying stock (100 shares) or index
Expiration month (3
rd
Friday)
Strike price or exercise price
Option type (also Put)
Price per share ($670 per contract)
Buy to Open 1 XYZ Dec 55 Call @ 6.70
Buy
Open

1
XYZ
Dec
55
Call
6.70
Options Require More Decisions
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What are most options users doing?

What is a strategy?
Basic Option Strategies
Objectives:
Options are typically not used in a vacuum.
Generating Returns -- Profit Driven
Managing Risk -- Risk Averse
Containing Costs -- Premium Resistant


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Premise: Long Stock (or Portfolio)
This is good.
This is not good.
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LONG PUT
Bearish
Protect a stock/portfolio

SHORT PUT
Collect premium
(income)
Establish a buy price
LONG CALL
Bullish
Buy stock and limit risk

SHORT CALL
Collect premium
(income)
Establish a selling price
Basic Strategies at Expiration
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#1 Protective Put

#2 Covered Call (or Buy-Write or Overwrite)

#3 Collar


Variations
Common Option Strategies
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Given a long underlying position:
Protective Put
advantage: absolute downside
protection below
the exercise price
disadvantage: reduces potential
profit by the amount
of the premium
X
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X
What is a Protective Put?
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Protective Put
Profit potential - Yes
Eliminates downside risk - Yes
At what cost?
Does make sense if used tactically.
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advantage: premium received
partially offsets
downside loss
disadvantage: upside profit
potential is
now limited
X
Given a long underlying position:
Covered Call
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What is a Covered Call ?
X
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Covered Call
Profit potential Yes (but limited beyond a point)
Eliminates downside risk Not really
At what cost? You actually take in money
(an income or yield enhancement strategy)
The most popular option strategy in equities
Typically used over and over and over again:
strategically
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buy a
Protective Put
sell a
Covered Call
Given a long underlying position:
Collar
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What is a Collar ?
Put Strike
Call Strike
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Collar
Profit potential Yes (but limited)
Downside protection Yes (below strike of put)
Premium payment necessary Maybe
Also, can be employed strategically
(though the strike prices may change)
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What if you wanted better protection?
Old
Put
Strike
Old
Call
Strike
New
Put
Strike
New
Call
Strike
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Variations: Protective Put Spread
exercise
price
exercise
price
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Variations: Unbalanced Collar
Put Strike
Call Strike
Buy puts on 100%
Sell calls on 70%
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Option Investment Strategies Summary

What exposures do you want?
What exposures would you like to mitigate?
What is your market view?
Where is the market going?
Where is the market not going?
When will the move happen?
Always remember: insurance is expensive
when the house is on fire.

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Benchmark Indexes
Three Passive Strategies
Writing covered calls on an index portfolio
Write at-the-money index calls
(BXM Index)
Write 2% out-of-the-money index calls
(BXY Index)
Writing cash-secured index puts
(PUT Index)
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Writing Covered Calls
X
Call Expires
Keep Premium
Call I-T-M
Limited Profit
Own an S&P 500 Portfolio
Sell S&P 500 Index Call Options
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Writing Cash-Secured Puts
X
Put I-T-M
Effectively Long
Put Expires
Limited Profit
Have cash (or cash-like investments)
Sell S&P 500 Index Put Options
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Indexes Since Mid-1988
www.cboe.com/benchmarks Past performance is not a guarantee of future results
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Benchmark Indexes
www.cboe.com/benchmarks Past performance is not a guarantee of future results
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Excerpt from Jan. 2012 paper by Asset Consulting Group
An Analysis of Index Option Writing for Liquid Enhanced Risk-Adjusted Returns
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Collaring a Portfolio (CLL Index)
X
Put I-T-M
Limited Loss
Call I-T-M
Limited Profit
Have cash (or cash-like investments)
Sell S&P 500 Index Put Options
X
Options
Expire
Long
Portfolio
CBOE OPTIONS INSTITUTE 35
10
20
30
40
50
1000
1100
1200
1300
1400
1500
SPX
VIX
CBOE Volatility Index (VIX) vs SPX
S&P 500
VIX Index
CBOE OPTIONS INSTITUTE 36
Creative Insurance
Buy calls on VIX
Allocate 1% of portfolio over 12 months to
purchase O-O-M VIX calls based on rules.
The rules dictate the amount of calls
purchased based on the level of volatility.
VXTH is an index of this approach created
by CBOE.

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Excerpted from paper by Asset Consulting Group -
Key Tools for Hedging and Tail Risk Management
(February 2012)
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VXTH with VIX Call Weighting
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
0.00
20.00
40.00
60.00
80.00
100.00
120.00
140.00
160.00
180.00
3
/
3
1
/
2
0
0
6
7
/
1
1
/
2
0
0
6
1
0
/
1
7
/
2
0
0
6
1
/
2
9
/
2
0
0
7
5
/
8
/
2
0
0
7
8
/
1
5
/
2
0
0
7
1
1
/
2
1
/
2
0
0
7
3
/
4
/
2
0
0
8
6
/
1
1
/
2
0
0
8
9
/
1
8
/
2
0
0
8
1
2
/
2
6
/
2
0
0
8
4
/
7
/
2
0
0
9
7
/
1
6
/
2
0
0
9
1
0
/
2
2
/
2
0
0
9
2
/
2
/
2
0
1
0
5
/
1
2
/
2
0
1
0
8
/
1
9
/
2
0
1
0
1
1
/
2
6
/
2
0
1
0
3
/
8
/
2
0
1
1
6
/
1
5
/
2
0
1
1
9
/
2
2
/
2
0
1
1
1
2
/
3
0
/
2
0
1
1
4
/
1
1
/
2
0
1
2
7
/
1
9
/
2
0
1
2
1
0
/
2
5
/
2
0
1
2
2
/
7
/
2
0
1
3
Source: CBOE and Bloomberg
VXTH and S&P 500 Total Return Indexes
(Through February 14, 2013, Scaled to 100 on 3/31/06)
VIX Call Weight S&P 500 (TR) VXTH Index
CBOE OPTIONS INSTITUTE 39
Excerpted from paper by Asset Consulting Group -
Key Tools for Hedging and Tail Risk Management
(February 2012)
CBOE OPTIONS INSTITUTE 40
New Topic: Option Pricing
Prior to expiration, an options price can
be estimated from six inputs:
Price of the underlying (stock price)
Exercise price of the option
Time to expiration
Current interest rates
Dividends paid during options life
Expected volatility of the underlying
over the life of the option
These are
known
This is
unknown
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Impact of Underlying Price
Today Today
Stock Price 50.00 51.00
Days to Exp. 60 60
50 Call 2.50 ??
55 Call 0.80 ??
Concept:

3.00
Option prices change less in
dollars than stock prices.
Delta
1.05
+ 2%

+20%
+31%
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60 Days 40 Days 20 Days EXP
Stock Price 50 50 50 50
Days to Exp. 60 40 20 0
50 Call 2.50 2.00 1.40 0
20% 30% 100%
55 Call 0.80 0.50 0.15 0
38% 70% 100%
Concept:
Impact of Time
Different options decay
at different rates
Theta
CBOE OPTIONS INSTITUTE 43
spot
price
time
What is volatility?
CBOE OPTIONS INSTITUTE 44
Three meanings of Volatility
Historical volatility is the standard deviation of
returns over a prior time period (e.g. the last 30
days, 50 days, etc.).
Implied volatility is the volatility in the market
price of an option (e.g. if used in an option-
pricing formula, it will produce the market price
of an option.).
Realized volatility is the volatility experienced
by the underlying asset during options life.
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Why Volatility is Important
Small changes in volatility can have a noticeable
impact on an options price.
Implied volatility can react very quickly to new
information, which causes option prices to adjust.
Typically, implied volatility rises when stock prices
are falling, and falls when stock prices are rising,
i.e., volatility and changes in underlying price are
negatively correlated.
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0
25
50
75
100
125
150
175
200
225
250
275
300
325
350
375
-10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10% 12%
n
u
m
b
e
r

o
f

o
c
c
u
r
r
e
n
c
e
s

daily price change (nearest 1/4 percent)
SPX Daily Price Changes: January 2003 - February 2013
number of days: 2546
biggest up move: +11.58% (13 October 2008)
biggest down move: -9.03% (15 October 2008)
mean: +.0300%
standard deviation: 1.31%
volatility: 20.77%
skewness: -.0544
kurtosis: +10.4475
CBOE OPTIONS INSTITUTE 47
100
120 call
90 days to
expiration
.25 each day
+

1.50 each day
+

10.00 each day
+

value =.05
value =.75
value = 8.00
option value
80 put
CBOE OPTIONS INSTITUTE 48
What We Expect
Stock Price
Strike Price
Time
Interest Rates
Dividends
Volatility
65 Call Price
65

33



3.50
62
65
35 days
3.0%
0.0%
42%
2.10
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What Sometimes Happens
A decrease in volatility can offset your expected gain!
Stock Price
Strike Price
Time
Interest Rates
Dividends
Volatility
65 Call Price
62
65
35 days
3.0%
0.0%
42%
2.10
65

33


32%
2.10
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Option Pricing Concepts
Options prices change differently than stock prices.
Delta concept: options prices change less in dollars
than stock prices.
Theta concept: the time value of options decreases
over time, and different options decay at different
rates.
Volatility: (1) volatility can have a big impact on
options prices, (2) volatility changes, and (3) there
are different ways of thinking about volatility:
historical, implied, realized.
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Using Options Requires..
Understanding the trade-offs
Realistic expectations about option prices
Matching strategies to objectives
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Options Are Not a Zero-Sum Game
Investors have different objectives.
Some want insurance.
Some want income.
Some want leverage.
Options offer all investors more
strategy alternatives.
Options Give You Options!
CBOE
400 South LaSalle Street
Chicago, Illinois 60605
www.cboe.com
Tim Weithers
tim.weithers@chicagotrading.com
312-863-8034
Jim Bittman
bittman@cboe.com
312-786-7491