Option Trading 101 - Simple Bullish Strategies (Excel) transcript

hello everyone and welcome to metal the best platform around for distance learning in business finance economics and much much more my name is saba and today we're going to cover some option strategies so derivatives trading strategies that will help you to profit from your market forecasts regarding the potential direction of the stock prices and potential volatility of the market in general so obviously when you are trading options there are four potential strategies you can go with if we are talking about the simplest ones so you've got your usual calls and puts or call and put options where call options give you the opportunity but not the obligation to buy the underlying asset at the specified strike price and the specified exercise date or maturity date and put options that give you the opportunity but not the obligation to sell the underlying asset at a specified strike price at a specified maturity date here we are considering just the European options so the simplest of the vanilla option types European options unlike American options are exercisable only on the maturity date whereas American options are exercisable at every single trading day up to the maturity date so generally American options are more valuable they have higher option premier but European options are easier to simulate to value and to exercise strategies based on so up from now we're gonna deal with European options only so without further adieu let's investigate some of the simplest bullish and bearish strategies based on European options so if you believe that the stock price of a particular company so that's your underlying asset that's a stock of a particular company that's liquidly traded and options are being available to buy or sell well if you believe that the stock price of this company go up then you can choose one of the two option trading strategies you can either long call option for the stock of this company or you can short boot option for the same company so the logic is that if the share price of the company goes up then you would be able to been officially exercised the call option as you are the holder of the code the call and when the stock price is higher you'll be able to exercise your right so you'll buy the stock at the strike price that is lower than the share price that you focused to be in place when the option matures and you grasp you obtain the payoff that's the difference between the share price whatever it is at the end of your trading period and the strike price that you'll be able to buy the stock for in case of the shotput well you're writing the boot option so you are selling that so you straight away obtaining the option premium so someone else someone who you solved the option to has the right to exercise the put option but if the price goes up they won't be able to benefit from holding the boot option you have written to them so if your forecast is correct and the share price indeed goes up then they have no incentive to exercise their right and you are getting away with just getting the premium and they allow the option to lapse so that's the logic now let's simulate those two option trading strategies that are inherently bullish based on well-known company traded and London Stock Exchange relics PLC let's assume that we are currently on the 13th of January 2020 and we select an option with maturity date of the 21st of February 2020 so it's a relatively short term option trading strategy which covers slightly more than a month of the investment horizon so what can be potential forecasts that underlie this option dragon strategy well it has been announced on the 13th of January 2020 that Rolex PLC is targeting to acquire a number of smaller companies so potentially they can extract lot of value of those M&A activities so we assume that the market will reflect this increase in corporate value over this relatively short period of time and will be able to benefit from our forward-looking forecasts that the share price of relaxed ability is gonna appreciate so at this point in time 13th of January 2020 we can either long co-option in relics or we can short a put option in relics so what we need to understand is what's going to be the share price at the start of our trading period and we know that because well that's the share price in place in the market at the time and that's 1946 and half pence per share and bear in mind that London Stock Exchange is a very peculiar place as that's the only Stock Exchange in the world where the price is quoted in pence so that's not bounds that spends so it's roughly nineteen half quid per share and option prices are as well quoted in pence so don't let that confuse you as in all other major stock exchanges you'll have prices quoted in a dollars not cents euros not Euro cents but on the London Stock Exchange it's always pens not pounds so that's just a small peculiarity characteristic of this particular stock market so if we believe that the share price is gonna appreciate we can either longer cover shorter put and in case of those simple option trading strategies you need to select a strike price that's as close to the center price so the share price at the start of the trading period as possible and for the sake of liquidity it's not always the case that you'll have options at any strike price you can imagine because if you had option prices every single pants as a strike price then you would not have enough trading to for the market for the option market to be liquid for there to be enough price discovery so what's generally occurs was generally occurs on the option is that you have available strike prices at reasonably narrow ranges that are sufficient to execute all sorts of various ocean trading strategies but that are wide enough to encourage enough liquid trading in every single spot so in case of relics strike prices go in a step of 50 pence so you would have options being available for like eighteen hundred bands 1,850 pounds nineteen hundred and fifty two thousand and so on and so forth so as it it's relatively easy to understand that's the closest strike price to our center price of nineteen and a half pounds roughly it's nineteen hundred and fifty pence which is manifested here so we'll both gone a long a call option at nineteen hundred fifty pounds and shot a put option nineteen hundred fifty pounds what we also need is to understand what are the current option premium that we can either long the option for or short or right the option for so obviously you could just look at the last prices so the prices at which the last trade in these options occurred but that would not be totally realistic and it that would not truly reflect the transaction costs in place at the options market what you have to look for if you wanna your trading strategy simulation to be as realistic as possible is to look at the bid-ask spread so bid prices and ask prices and you always need to simulate long in an option so buying one at the ask price and the writing of the option so selling it or shorten it at the bid price what is the reason for it why well bid and ask prices reflect the current limit orders that have been in place and someone has issued them previously at the market so if you wanna buy the option right now you'll need to satisfy someone else's limit order for this option so you would need to buy it at the US price and if you want to sell the option immediate by issuing a market order of your own you satisfy someone else's limit order that is currently being in place in the market so that would reflect the bid price and the bid-ask spread reflects one of the dimensions of market liquidity so the higher the bid-ask spread the lower is the liquidity of the market the more illiquid is the market and the more difficult arbitrage is on that particular option market so in our example the premium for the long call so they asked price of the call option for LX PLC at the expiry date of 21st of February 2020 was currently at the 13th of January 2020 standing at 52 and a half pence per share so that's the ask price as for the bid price for the respective put option so that's the price that we'll get so the premium that we'll obtain by writing a put option at the strike price of nineteen hundred and fifty pounds is 41 and a half pence per share so that reflects the bid-ask spread obviously naturally the prices for put options at the center price are slightly lower than the premier for call options at the same strike price because of the general tendency of stock prices to go upward with time but also what those premier reflect is the volatility because the more volatile is the underline the more volatile is the stock price the more likely it is for the stock prices to move either below or above the strike price and again here let's learn some useful jargon in terms of option trading well if the strike price moves above the share price so the share price is below the strike price then it's said it's very frequently used expression that the option is in the money and if the share price moves above the strike price then the option is to be considered to be out of the money when the two are exactly equal then the option is considered to be at the money and the first ones that can be considered a very peculiar bit of job but it's useful to understand it if you are trading options in the industry without further ado let's simulate potential payoffs that will receive from either long inacol or shorting they put at those particular strike prices over those particular premium first of all the gross payoff is just the payoff that we can obtain from exercising our option or that we will lose from our counterparty to exercising the option that we have just written for them and the net payoff exiting account the premium that we either have to pay or that we receive so the gross payoff of the long haul so it depends on whether the option is in the money or out of the money so whether the strike price is above or below the current share price that will be in place at the end of our trading period so let's simulate the option payoff for plausibly wide but not too wide range of prices so what do we expect to be possible to happen at the end of our trading period on the 25th of February 2020 so we'll move at the steps of ten tens and move from 1700 all the way up to 2300 pence per share so the gross payoff would solely depend on the underlying share price so if the share price of relax PLC is lower than the strike price that we've bought the co option for then let's think is it beneficial for us to exercise our right because remember that's us who ultimately makes the decision whether to exercise our option or not we have the opportunity to buy the underlying share at nineteen hundred fifty pence per share if the current market price is lower than that we have no reason to do that we would have gotten a better deal but just buying the stock at the spot market if we decided to exercise the option though we would have bought it at 1950 and sold it for whatever it is that's less than 1950 so we would have gotten and negative gross payoff but as it's our choice ultimately whether to exercise the option or not we can just allow the option to lapse and get the gross payoff of zero so pretend that the option was not there and just move on as we did so if the share price is lower than the strike price if the call option is in the money it's not been exercised and the cross payoff is zero however as the call option moves out of the money if the underlying share price at the end of our investment period exceeds the strike price then it's easy to see that we can benefit from exercising our right we could buy the underlying stock at 950 pounds per share and sell it for whatever the share price is so for a higher value than 1,900 1,950 and our gross payoff ultimately will be the difference between the two because we can sell for whatever the share price is provided that's higher than the strike price and pay our counterparty so someone that has written the call option for us 1919 hundred and fifty and we need to work that because the strike price is the fixed component of the options contract and that's all there is for the gross pay off of the long call and we see that when the share price is 1700 so much much lower than this right price then we are not incentivized to exercise our Co option and we have the gross pay of zero but obviously we also need to account for the option premium to get from the gross pay off to the net pay off in case of the long call we are buying the option so we are getting this optionality this right and those optionality is this exclusive right to buy the underlying stock at 1950 pence per share it doesn't go for free we have to pay our country party to have this right and they have to be rewarded for taking on this hassle of satisfying our right so we need to subtract the option premium from our gross payoff and we need to lock the option premium because again the option premium is another fixed component of the option correct our print contracts have three notable characteristics so to fix them one variable the variable characteristic is obviously the underlying share price at the end of the investment period at the maturity date and the two fixed components are the strike price and the option premium that's why we don't leave the share price the underlying share price locked and we'll lock the strike price and the option premium to reflect that so we can see that obviously I'll cross pay of a zero but our net payoff is negative option premium because we have to pay that and we didn't get any payoff from exercising the option after that then we can bottom right click it all the way down and see what the payoff structure of the call option of long-haul looks like so we have limited downside if the price goes down then as the share price exceeds the strike price so as it starts exceeding 950 s the option starts moving out of the money then the call option is beneficial to exercise and our playoff starts increasing but please note that if the share price increases a little then we do not break even because the premium that we had to pay is lower than the cross payoff we have obtained from exercising the call so we start profiting from the long call only if the share price increases a lot from the strike price so we break even around 2,000 three pence per share at this region but the good thing about a long call is that our upside is potentially unlimited as the share price moves way above the strike price our payoff increases further and further so as the characteristics of a long call we have fixed downside when the price goes down and ever increasing upside when the price goes up one way of graphically incorporating that logic is to construct an option payoff chart and that's the most frequently used visual tool to illustrate the structure of your option strategies payoff so to do that we need to select the share price gross pay pay off select all three columns and insert the payoff chart the easiest and most convenient tool to visualize it in Excel is to select the scatterplot with straight lines so you need to select the bottom row the middle chart and select the scatter with straight lines and we'll see that this is the payoff structure of the long call if we want to tighten it up a little bit so consider just the range of prices that were interested in we can just right click on the excess formatted and select our minimum price so a minimum price was 1700 and our maximum price that we want to consider is 2300 and we see that now the situation is much clearer we can see that our downside is limited to 52 and a half pounds when the price moves below the strike price so when the option is in the money when the option moves out of the money our payoff ever increase is ever increasing so our upside is unlimited that's the main characteristic of the long call now let's consider another boom strategy let's consider the short put in that case we are writing the option so someone else has the right to exercise the option so someone else has the right not the obligation to sell the underlying stock to us a 1950 pence per share so we have no control over whether our country party will exercise that but given the fact how simple are the underlying incentives in the option contract we can with certainty forecast what outcomes our part is going to do depending on what the share is going to be so let's try and unravel this logic so if the share price is lower than this right price so the option is in the money thus our counterparty has an incentive to exercise their option so they can sell the underlying stock to us at many turning 50 pence per share so they want to do that because the current share price is lower on the strike price they can buy the stock at for example 1700 and sell it to us at 1950 it means that they gain the gross pay off based on the put option that we've written to them what it means for us though is that we have to buy it from them at 1950 and we are left with an overvalued stock pretty much on our hands that's worth much less than what you have paid for it so it's easy to understand from that that we are losing from our short put in terms of the numerical value of our gross payoff we need to consider the following we need to pay the strike price 1950 because we are obliged to buy it that's the offer we cannot refuse and then the best way the best way we could have dealt with that is just to sell the stop at the market price so we are gaining the market price and we are paying our counterparty the strike price and if the option moves out of the money then well we're happy because our counterparty doesn't want to sell the stock to us at 1950 because they can get a better deal from the market they can sell it at a higher price on the market so it means that the option is not exercised and we are happy because our gross pay of a zero we just got the premium without going through any hassle of exercising the right of our culture body so boot options are not exercised out of the money so the gross pay off here is zero and what about the net pay off well in case of the long call or long option strategies we are obtaining the optionality so we have to pay for the inherent risk to our counterparty because no one would write an option for free in that case we have written an option so we have taken the risk of potentially losing like as much as minus 250 in that case we are the writer of the ocean we're selling that so we are obtaining the option premium so to get from the gross pay off to the net pay off in case of short option strategies we need to add the option premium to our gross payoff and again we need to lock that because the option premium is the fixed component so again now we can select that and bottom right it all the way down and from here already we can see the structure of the payoff of the short put we have unlimited downside when the stock price goes down and we have fixed upside when the price goes up but what is peculiar in terms of the comparison between a long corner shot put is that you gain a fixed amount whatever the share price increase is in case of the long pole we needed the share price to increase a lot before we start gaining and that in case of the shotput you gain a fixed amount even if the share price stays the same what is also interesting is that when the share price starts decreasing the put option becomes exercised we start losing on growth but given the fact that we have received a high premium we are not losing on that all the way until the share price actually decreases significantly below the strike price to represented graphically we could select the share price column and select the gross pay of a net pay of columns and again put up the scatter with straight lines which is the typical graph for the option payoff structure and format the x-axis to just reflect the range of underlying share prices that we are interested in so from 17 pounds to 23 pounds we see that our upside is limited at the option premium that we receive so 41 and a half pounds per share and as the shrug stock price starts decreasing below the strike price the more put option moves in the money it becomes exercised and we start losing but we do not lose on that all the way until the share price goes somewhere around not nineteen hundred and ten pence per share so that's the logic of the shotput the other interesting thing that it would see is to compare the payoff of the long column the shotput and that would allow us to determine what are the inherent beliefs of someone who wants to execute this or that option trading strategy and their beliefs about the volatility of the market if we select the column with the share prices the column with the net payoffs of the long call and the column with a net payoffs of the shotput and get it all on the chart we can see that if the share price increases a lot the long called payoff structure is much more attractive as our upside is again unlimited but if the share price moves up a little then the short put becomes the more attractive strategy from that and from the fact that the incentives of the counterparties are relatively clear we can pinpoint that even though both of those strategies long : short put are bullish the long con strategy assumes higher market volatility than the shortcut strategy in case of the short board you expect the share price to increase but to increase to a lower degree than if you would go for a long call so that's how you can determine what are the inherent market beliefs what are the characteristics of someone's market forecasts if they are going for either long haul or short put if they're going for either of the two you can be certain that the bullish in terms of the direction but for the short put someone expects lower volatility so they're bearish in volatility and if someone goes for the long haul they are expecting high volatility so they are bullish on the volatility that's all about bullish simple option trading strategies next time we're gonna consider their bearish counterparts thank you very much and stay tuned for the next episode