Equity Option Strategies

1. “Enhance your Practice with Equity Option Strategies” Presented by: Rutgers University; in partnership with Presenters: Sean E. Heron, CFA, Rutgers University and Eric Cott, The Options Industry Council October 10, 2009

2. Options Basic

4. Commonly traded derivatives include options, futures and forwards that trade on equities, commodities, currencies and interest rates.

6. Reduce risk (Hedging)

7. Reduce transaction costs (from rebalancing).

8. Defer Taxes

10. A Put option gives the buyer the right, but not the obligation, to sell a stock at a predetermined price for a specified period of time.

13. OTC markets consist of financial institutions, corporate treasurers and investment manager trading derivatives over the phone.

14. Listed Options are traded on an exchange 7

17. Option Premium = Time Value + Intrinsic Value

18. Time Value is a combination of the expected future movement of a stock and the amount of time remaining until the option expires. The longer the timeframe and the greater the expected movement, the higher the Time Value.

19. Intrinsic Value equals price of the underlying stock minus the strike price. An options value can’t be below its intrinsic value. Source: http://www.optionseducation.org/basics/options_pricing.jsp

20. Price of a Call and Put For example, XYZ stock is trading at $26. A call with a strike price of 25 is trading at $3. Then the call has an intrinsic value of $1 (=26-25) and a time value of $2 (=premium minus intrinsic). A put with a strike of 30 is trading at $5. Then the put has an intrinsic value of $4 and a time value of $1.

22. In the money options have intrinsic and time value

24. Components of an Options Price What options are ITM, ATM or OTM? If the stock is trading at 25

25. Call Payoff Graphs Call with a strike of 25 trades at $3 buyer’s max gain (S-X) is unlimited, max loss is 3. Seller’s max gain is $3, max loss is unlimited (S-X). Break-even 28 (strike + premium)

28. Limited downside risk, with unencumbered upside potential.

29. Stock replacement.

32. Early exercise is usually only done to capture the dividend by converting to stock.OTM Let expire – lose rights Max Loss = premium paid

36. Protecting another position.

37. Delay creating a taxable event, but still reduce risk.

39. Max Gain/Loss If the stock is trading at 25, what is the max gain/loss

40. Max Gain/Loss If the stock is trading at 25, what is the max gain/loss for the owner of the option?

41. Max Gain/Loss If the stock is trading at 25, what is the max gain/loss for the writer of the option?

42. Max Gain/Loss If the stock is trading at 25, what is the max gain/loss for the writer of the option?

43. Straddle Call and Put with a strike price of 25 trades at $6 Buyer’s max gain is infinite, max loss is $6 Seller’s max gain is $6, max loss is infinite Break-even 19 and 31 (=strike +/- premium)

44. Buy (Long) Straddle Right to buy or sell the underlying at a predetermined price (25 Strike). Pays $6 for the right. Wins with the stock above 31 or below 19. Reasons for buying a straddle: Trading the underlying around the strike. Expects the stock to move a lot in either direction. Court Case Earnings Report FDA Approval Macro Events

46. Feels the markets price for expected movement is to high.Court Case Earnings Report FDA Approval Macro Events

47. Straddle Call + Put = Premium. Premium +/- Strike = Breakeven

48. Straddle Call + Put = Premium. Premium +/- Strike = Breakeven

49. Strangle Call and Put with a strike price of 22.5 and 27.5 trades at $4.50 Buyer’s max gain is infinite, max loss is $4.50 Seller’s max gain is $4.50, max loss is infinite Break-even 18 and 32 (=strike +/- premium)

50. Buy (Long) Strangle Right to buy at 27.5 or sell at 22.5 the underlying. Pays $4.50 for the right. Wins with the stock above 32 or below 18. Reasons for buying a strangle: Trading the underlying around the strike. Expects the stock to move a lot in either direction. Court Case Earnings Report FDA Approval Macro Events Buyer’s max gain is infinite, max loss is $4.50

52. Feels the markets price for expected movement is to high.Court Case Earnings Report FDA Approval Macro Events Buyer’s max gain is $4.50, max loss is unlimited

53. Call Bull Spread Bull buys the 25 call at 3 and sells the 30 call at 1, net debit $2 Buyer sells a higher strike to subsidize the purchase of the lower strike. Max gain $3 and max loss $2 Bear sell the 25 call at 3 and buys the 30 at 1, net credit $2 Seller buys the higher strike to cap the potential loss on the short lower strike. Max gain $2 and max loss $3

59. Pricing an Option Option Price = Time Value + Intrinsic Value Components of an Option’s Price (DIVUTS) Dividends Interest Rates Volatility Underlying Stock Time Strike

60. Volatility

61. Volatility An options theoretical price will fluctuate with the price of the underlying stock, but will also fluctuate with changes in implied volatility. Similar to insurance companies raising prices for risk they don’t want, options prices rise when there is no one willing to accept (write) the risk of future price fluctuations. If enough investors believe a stock will have greater volatility going forward, implied volatility and option prices will increase to entice others to write options. If option prices (implied volatility) is perceived to be to high, investors will sell or at least elect not to buy. Implied Vol. can get high if too many investors want to protect a position at the same time and no one is willing to accept the risk of future price fluctuations.

62. Volatility Option Buyers Want volatility to expand after their purchase. Volatility is the cheapest when there is a perception that the coast is clear with regards to events that may cause future price fluctuations. Option Sellers Want volatility to contract or subside after their sale. Implied Volatility tends to be highest just ahead of events that move stocks, i.e. Court Cases, Clinical Trials/FDA Approvals or Earnings Reports.

63. Volatility – Historical vs. Implied

64. Volatility – Expected vs. Implied

65. Current Environment Current Environment Stock Valuations - High or Low Implied Volatility - High or Low What strategy works well in the current environment? When to buy options When to sell options When to use spreads When to implement a collar

66. Investment Strategies with Options

67. Investment Strategies with Options Portfolio Income Strategy – Covered Call Writing Portfolio Protection Strategy – Buy Puts, Put Spreads or Implement a Collar Portfolio Recovery Strategy– Increase upside potential without increasing downside risk

68. Index Options Advantages Diversification Taxes Lower Transaction Cost Broad Hedging Disadvantages Not single stock specific May have higher tracking error to hedged position

69. Portfolio Income Strategy

71. Buy 5000 Shares at $100 (total $500,000)

72. Sell 50 one year 100 Calls at $11 (Total $55,000)

74. Portfolio Income Strategy Expiration 1 year: Potential Outcome # 2 –SPY Has Risen Sharply SPY is trading at $120 Repurchase all options at $20 per underlying share ($120,000 total) Short-term loss on options sold at $9, repurchased at $20 = loss of $45,000 Sell 375 shares of SPY at $120 per share, to raise funds to repurchase above options (capital gain = $7,500) Net realized short-term capital loses = $37,500; Taxes due = $0 (in this example we offset short-term losses against gains. Additional tax benefits may be gained by offsetting against short-term gains elsewhere in the portfolio) Value of remaining 4,625 shares of SPY = $555,000 Plus Dividends $11,250 Total Return $66,500 (66.25K/500K = 13.25%)

75. Portfolio Income Strategy Expiration in 1 year: Potential Outcome # 3 – SPY Has Risen Less Sharply SPY is trading at $110 Repurchase all options at $1 per underlying share ($5,000 total) Short-term gain on options sold at $11, repurchased at $1 = $50,000 Sell covered calls at a higher strike price with a further expiration Strike Price = $110, options will expire in a year Premium received: $10 per underlying share ($50,000 total) While corrective action was taken to prevent having stock called at $100 per share, by rolling the option strike price to $110 and the option expiration out to another year, the client has for the moment retained full stock ownership and has received net option premium of $20 per share ($11 - $1 + $10) or $100,000 total (5000*20). Realized short-term capital gain from options - $50,000 Plus Dividends $11,500 Value of the 5000 shares of SPY = $550,000 Total Return $66,500 (66.5K/500K = 13.25%)

76. Portfolio Income Strategy Expiration in 1 year: Potential Outcome # 4 – SPY is Lower SPY is trading at $86.75 (SPY down 13.25%) Calls expire worthless Client keeps the call premium received of $55,000 Premium received taxed as short-term capital gains Dividends received $11,500 Sell 5000 shares of SPY at $86.70 per share, to harvest losses. Net realized short-term capital loses on SPY = $66,250; Taxes due = $0 Total Return = $ 0

81. Disadvantages of Covered Call Writing Incomplete downside protection Expired or repurchased options may be taxed at short-term rate* It is possible for options to be exercised prior to expiration Occurs infrequently and is largely predictable Corrective trades may be implemented if an early exercise appears likely and is undesirable Options can and will be exercised if the written stock is above the option strike price at expiration Triggers sale of the underlying stock Triggers realization of capital gains or losses to repurchase the option to prevent expiration “Unqualified” covered calls that are deep in-the-money or have less than 31 days to expiration when written may cause dividends on the underlying stock to be ineligible for the new 15% dividend tax rate*

82. Portfolio Protection Strategies

83. Portfolio Protection Strategies Hedging – Strongest to Weakest Sell SPX Index Futures – Full Protection Buy SPX Index Put – Floor Downside Risk Buy SPX Index Put Spreads – Less protection at a reduced cost (High Vol. Skew is better for put spreads) Buy VIX Futures – Inverse price relationship with SPX Futures Buy VIX Calls (Sell VIX Puts) Write SPX Index calls

84. Portfolio Protection Buy SPX Index puts, if protection is cheap. Captures Upside / Limits Downside Implement a collar Caps Upside / Limits Downside Buy SPX Index put spreads, if skew is high or puts are expensive. Captures Upside / Cushions Downside Buy VIX futures when vol. is low and forward volatility term structure is flat. Negatively Correlated to SPX Write SPX Index calls when volatility is elevated. Caps Upside / Cushions Downside

85. Portfolio Protection What a difference a year can make. When implied volatility is low purchasing puts may be the best option. In Jan’07, an ATM 1yr put cost 4.5% Limited downside risk Known maximum drag on upside performance In Jan’07, a 10% OTM put cost 1.75% In Jan’08, implied volatility was too high to warrant the purchase of puts. 1yr ATM puts on the SPX cost 8% (115/1450) 1yr 10% OTM put on the SPX cost 4.3% (63/1450) 1yr ATM straddle on the SPX cost 18% (260/1450)

86. Portfolio Protection What a difference a year can make. In Jan’09, implied volatility was too high to warrant the purchase of puts. 1yr ATM puts on the SPX cost 14.5% (130/900) 1yr 10% OTM put on the SPX cost 10.5.% (95/900) 1yr ATM straddle on the SPX cost 28% (253/900) Jan’09 with the SPX trading at 900, 1 yr ATM /10% OTM put spread ATM 900 Put – 14.5% 10% OTM 810 Put – 10.5% Put Spread Cost – 4% Upside drag 4%, Downside Cushion 6%

87. Portfolio Protection Estimated Price of a 1-Year Put Option, 10% Out-of-the-Money As a Percent of the S & P 500 Index Estimated Prior to 2004

88. Portfolio Protection Protecting a well diversified portfolio with a beta of 1 (with the same div. yield). Each contract is equal to 100 times the index. $1mm portfolio, index value 1000 Portfolio is 1000 times the index. Protect the portfolio from losing more than 10% ($900,000) over the next year Strike/Index - (Put) + Div = Floor OTM 95% - 8.5% + 3.5% = 90% Floor ATM 100% - 13.5% + 3.5% = 90% Floor $1mm/ (1000*100) = 10 Contracts Buy 10 one year 5% OTM Puts at 8.5% to limit the downside loss to 10%

89. Portfolio Protection (Weakest) Write SPX Index calls when vol. is elevated. When implied volatility is high writing covered calls may be the best option. Loss in down markets reduced by premium received Limits upside potential to premium received In the beginning of 2009 1yr ATM calls on the SPX sold @ 13.5% 1yr ATM straddle on the SPX sold @ 28%

90. Portfolio Protection Implement a Collar to reduce risk when options are expensive, but downside risk is high. Implement a Collar Short call will cover the cost of the long put Risk/Return profile has a Cap/Floor Source: OIC

91. Advantages of Listed Option Collars Collars are an excellent way to delay the sale of underlying stock into future tax years while offering downside protection against catastrophes and allowing some measure of upside participation in the stock Simplicity; listed zero-cost collars require no opening of a margin account Competitive pricing and transparency of transactions for listed options Widespread availability of information; listed options prices are published on the Internet and in newspapers After collar has been executed, opportunistic trades can be made to take profits, adjust strike prices, or get out of the collar altogether we strongly recommends taking some profits on collars when they exist and maintains a full-time options trading desk to take advantage of these opportunities Adjusting positions is difficult or impossible with over-the-counter collars

92. Advantages of Listed Option Collars No minimum number of contracts necessary to execute a listed options collar (listed collars may be executed on as few as 100 shares of stock; we usually recommends trades covering at least 1,000 shares) A collared stock has not been diversified, only hedged Purchase of a put option may cause those shares of the underlying stock to be ineligible for the reduced dividend tax rate of 15%* Generally, no money is received from the collar transaction to purchase other diversified securities; it is possible to borrow partially against the collared stock

93. Disadvantages of Listed Option Collars While a collar “locks-in” a range of returns for the underlying stock, the amount of upside return locked in may prove unattractive relative to other opportunities The put option portion of a collar receives disadvantageous tax treatment; losses on the put option may not be realized prior to disposition of underlying stock The amount of put protection is constrained by the IRS* we considers it advisable to purchase protective puts that are out-of-the-money (where the strike price is lower than current stock price)* It is believed that the IRS could treat the purchase of protective puts that offer too much protection as a constructive sale of the underlying stock* Because collars are partially covered call options, the upside covered call part of a collar may be exercised early (this can be a positive outcome, and is also possible under many circumstances with over-the-counter collars, including takeovers or tender offers)

94. Portfolio Recovery Strategy Getting your money back is as easy as 1 2 3 Long Stock 1x, Long 2x ATM Calls @ 3 and Short 3x OTM Calls @2 (Leverage with known risk). Portfolio potential levered 3x to the upside, capped at OTM call strike. Portfolio risk limited to 1x the downside.

95. Speculation and Leverage Initially Purchased 100 shares @ 40 and Now Trading @ 25, Down $1500 Investment now worth $2500. B 2 25 Calls at $3 (-6) S 3 30 Calls $2 (+6) Capped at 30 Max Gain - $1500 over the 30 strike Max Loss - $2500 at zero

96. Speculation and Leverage Investment 2500. 100 shares of stock at $25 per share. B 2 25 Calls at $3 (-6) S 3 30 Calls $2 (+6) Capped at 30 Max Gain - $1500 over the 30 strike Max Loss - $2500 at zero

97. Additional Benefits of Options Reduce cost or risk Contain risk and redeploy capital. Monetize Collars Buy options to cap risk of loss Lock in profits without creating a taxable event Stock replacement to limit downside Diversification Target buy/sell price Rebalance asset allocation Reduce transaction cost

98. Sell Hold Hedge Hold Sell Portfolio Management with Options Old investment solution for managing a portfolio: New investment solution for managing a portfolio:

100. Tax deferral

101. Want to sell, but at a higher price

102. Don’t want to sell, but want less risk

103. Can’t sell

104. Raise cash (“monetize”) today, defer sale (and taxes)

106. Risk Management Products Matrix Utility of Strategy to Meet These Objectives = Yes, strong  = Yes, weak No = No

107. Start Using Options to Enhance Your Practice Trading Options In-house Trading Desk Operational Support Listed Options vs. OTC Options Anyone can trade listed options OTC contracts require internal legal review Hire Third Party Investment Manager Learn enough about options to advise clients about the many benefits of using options. Focus on clients and partner-up with a money management firm that specializing in options.

108. Benefits of a Partner Am I an asset manager or asset gatherer? Build a recurring fee-based revenue stream Gain access to institutional-quality solutions Leverage expertise through partnerships FA can find a SMA Partner for accounts as small as $100k Strategies offered by asset managers Portfolio Protection Portfolio Income Portfolio Recovery Custom strategies for concentrated equity positions

109. Looking for answers Clients: How can I recapture some of my losses without taking the risk of significant equity exposure? How can I increase the yield on my portfolio? How can you help me prevent this from happening again? Advisors: I trade options for my personal account, but I don’t have the resources to trade them for my clients. Can using options really help me grow or retain business? How can I get my clients/prospects off the sidelines? How do convince a skeptical client to use options?