Option Trading 101 - Simple Bearish Strategies (Excel) transcript

hello everyone and welcome to Neville the best platform around for distance learning in business finance economics and much much more my name is Sarah and today we are continuing examining simple option trading strategies last time we discussed what to do if you are bullish given a particular stock price what to do what options to trade if you believe that the stock price will go up we discussed long hauls relatively short put strategy and how they correspond to different beliefs about market volatility what to do though if you believe that the share prices will go down to do that let's consider a very famous case study regarding well-known British oil company tallow oil that has been going through some rough times so they have been underperforming in terms of the profit announcements the CEO has quitted and it's pretty much easy to focus that the share price is going to be at a downward spiral from now on so let's consider that we are again on the 13th of January 2020 we basically are just the sport when the CEO quitted and we have options available to us to trade at maturity date of the 25th to February 2020 again and we can expect the share price to further plunge below the current level so in case of this particular company we can utilize two of the bearish option trading strategies so if you are bearish regarding the your market forecast about the particular company's stock price you can either go for a long put or a short call let's examine first the incentives of an options trader whether they go for long put or a short call obviously if you loan a put option it is not exercised out of the money because well you could have sold for a better deal or the market but if the price falls below the strike price you can profit as much as the share price have been decreasing so if you have the opportunity to sell at the strike price and the share price moves below that your payoff will be determined by how much the price has decreased below the strike price and in case of the short call well in case of the short call you are basically betting on the stock price to decrease as you are obtaining the premium and you would have to exercise your counterparties right to buy the stock from you at the strike price if the price goes up but if it stays the same or goes down then the option would not be exercised you can't party will allow it to lapse and you will just get away with getting the premium and not providing anything for the option contract at all so that's the two strategies you can easily go with when you are bearish when you believe that the stock price will go down so first let's examine the starting share prices so the center price of tallow oil and options that are available for trading with regards to long puts and short calls in case of those other two simple option trading strategies you are also aiming at selecting your strike price to be as close to the center price so to the share price at the start of your trading period as possible so at the start of the trading period the stock price of telecoil was sixty two point three pence per share and options for a towel oil are available for trading at increments of five pounds so you would be talking about 55 60 65 70 and so on and so forth so it's easy to determine that the closest strike price to the center price is 60 cents per share because well sixty two point three is a little bit close to 69 is 265 so let's stick with that and investigate what are the premium of a long boot option at sixty and short call at sixty so again if you are running an option you need to consider the ask price that's the price you can buy the option for immediately by and launching a market order and for the short call you need to consider a bid price for the call at this particular strike price as that the price you'll be able to sell the call option immediately given the current limit orders the time place of the market so the premium of the long put at six depends Bashar is sixpence the premium of the short called at the same strike price is five and a half pence per share so let's consider again white yet not too wide range of potential share prices so let's go from ten pence per share all the way to how many twenty pence per share so being slightly symmetric and moving it 1 pence per share at a time so let's consider the gross pay off of the long put so if the share price is lower than the strike price well the put option is in the money and we already know that put options are exercised in the money because we have the incentive to exercise the option that we're holding we could buy the stock at the current market price which is lower than the strike price and then exercise our right to saw that six depends per share the strike price to our counterparty and benefit from the difference in those two prices so a gross payoff will be just the difference between the price that we are selling the stock at and the price that we can buy it for so the difference between the strike price that's what we receive and the current market price that's what we paid and if the option moves out of the money well put options are not exercised at the money because even if we held the stock we could have sold it for a better deal on the market rather than exercising our option for 60 pence per share so a gross payoff is 0 what about the net payoff well regarding the net payoff in case of long put we have bought an option so we had to pay someone in particular the counterparty the writer of the option that we are holding for that optionality so we need to subtract the option premium from Alvarez pay off to get to the net pay off and then we can whatever I click it all the way down and see what the payoff structure of the long put is so we can see that if the stock price goes down we have ever-increasing upside if the stock price goes up we have a limited downside that's determined only by the option premium we have to pay so again that's very similar to a loan call I'll be it just symmetrical error around the strike price we have unlimited upside when the price goes down limited downside when the price goes up and we can see that if the share price moves down but only by a little we start gaining in draws but we still lose in that because our gross payoff that we get from the difference in share prices is lower than the option premium that we had to pay now let's illustrate this payoff structure using our favorite options pay of charts so again what tomorrow middle I can scatter with straight lines again we can follow the axis to reflect only in the range of stock prices we care about and see that obviously and we can see that indeed the option payoff of the long put has an unlimited upside when the price goes down and limited downside what the price goes up and that's that basically reflect our beliefs about the stock price movements we do believe that the stock price will come down because again it's a better strategy in here insane but we also to believe that it will go down by a lot because well if it goes down by little we're still losing because we had to purchase the option at the ask price at the option premium of six pence per share so you are only gain in that if the stock prices drop by more than six pence per share so that's why the long put is the bearish high volatility strategy so you are bearish on the direction of surprise movements but you are bullish on volatility you expecting higher volatility now let's consider the payoff structure for short call so for the short call we need to investigate what happens if the option is in the money so what happens if the share price is lower than the strike price well then call options are not exercised and well-coached not exercised in the money that's clear but let's consider what the incentives are of someone we have written the option to well they can they could have bought tallow oil from us at 60 pence per share but do they really want to well if the share price falls below 60 pence per share they even if they wanted they could have bought it for a better deal on the market so they don't want to exercise it and the pay of that that would have gotten from exercising the option would be negative because they could have bought it at 460 from us and then they would have to sell it for a lower price on the market so it makes no sense for them to exercise the option so we are actually happy about it because we extracted the option premium from them and we didn't have to provide anything to satisfy their right to buy it from us at 60 pence per share so growth payoff is 0 what happens is the co option moves out of the money lab well coefficients are exercised out of the money our counterparty has the incentive they're interested in buying the stock from us at 60 and then selling it for a higher price that's currently been in place at the market what means for us though is that well imagine our country party approaches us and says well you have to I have the right to buy olive oil at six depends from you and if you haven't got the stock price somewhere with you you'll have to buy it from the market so you have to pay the market price and receive six depends so receiving six depends and you are paying the market price which higher than the strike price so against that on gross you are losing if your short call that you are written is exercised and that's all there is for the gross pay off of the short call so obviously we can see that if the share price is lower than the strike price then the short call is not exercised and you get the gross pay from zero but actually the only reason why we would have written a call is to obtain the premium so to get from the gross pay up to the net pay off in case of the short call we need to add the premium of the short call to our gross pay off and then we can bottom right click it all the way down and see what is the payoff structure of the short call so we have a fixed upside when the price goes down and unlimited downside when the price goes up so again this is a very very notable feature of option trading if you long an option you have a fixed downside an unlimited upside when you're short an option you have a fixed up set in a limited downside that's why writing options is inherently more risky because you can lose as much money as would be determined by the movements of the share price but how are those two strategies different well if the share price moves down but by only a little so for example it drops down to 59 in case of output we still lose 5 pence on net simply because we had to pay 6 pence per share option premium but in case of the short call we are immediately gaining the short call premium and we don't have to worry about anything else so if we plot the gross and net payoff of the short call we can visualize exactly the same project of fixed upside and unlimited downside but what is more interesting is to visualize and compare the payoffs of those two options in terms of that payoffs and compare them and that would help us to visualize what are the volatility beliefs of traders that engage in those strategies so we can see here that if the share price moves down but but a little then a short call is much more attractive than the wrong foot but if the price decreases further down then the long hood becomes a much more attractive option due to and unrestricted upside and that's all there is for simple option trading strategies in the next videos we would be discussing option spreads so portfolios of options you could turns out long were shot multiple options at the same time at various strike prices and that's how you can modify your payoff structure to make it more consistent with your forecast and with your overall beliefs about where the market will go and for now stay tuned