1

Options Fundamentals
Covered Calls
June 14, 2016
Benefits & Tradeoffs
Joe Burgoyne, The Options Industry Council
Steve Claussen, OptionsHouse
Joe Burgoyne
Director, Options Industry Council

www.OptionsEducation.org
 2 The Options Industry Council

Options involve risks and are not suitable for everyone. Prior to buying or selling options,
an investor must receive a copy of Characteristics and Risks of Standardized Options.
Individuals should not enter into options transactions until they have read and understood
the risk disclosure document, Characteristics and Risks of Standardized Options,
available by calling 1-888-OPTIONS or by visiting OptionsEducation.org.” Copies may be
obtained by contacting your broker or The Options Industry Council at One North Wacker
Drive, Chicago, IL 60606.

In order to simplify the computations, commissions, fees, margin interest and taxes have
not been included in the examples used in these materials. These costs will impact the
outcome of all stock and options transactions and must be considered prior to entering
into any transactions. Investors should consult their tax advisor about any potential tax
consequences.

Any strategies discussed, including examples using actual securities and price data, are
strictly for illustrative and educational purposes only and are not to be construed as an
endorsement, recommendation, or solicitation to buy or sell securities. Past performance
is not a guarantee of future results.
 3 Who We Are

About OIC
The Options Industry Council (OIC) is an industry cooperative funded by OCC, the world’s
largest equity derivatives clearing organization and sole central clearinghouse for U.S. listed
options, and the U.S. options exchanges. OIC’s mission is to provide free and unbiased
education to investors and financial advisors about the benefits and risks of exchange-traded
equity options. Managed by OCC, OIC delivers its education through the Options Education
Program, a structured platform offering live seminars, self-directed online courses, mobile
tools, podcasts, webinars and live help. OIC’s resources can be accessed online at
www.OptionsEducation.org or via mobile app for iOS.

About OCC
OCC is the world’s largest equity derivatives clearing organization and the foundation for
secure markets. Founded in 1973, OCC operates under the jurisdiction of both the U.S.
Securities and Exchange Commission (SEC) as a Registered Clearing Agency and the U.S.
Commodity Futures Trading Commission (CFTC) as a Derivatives Clearing Organization. OCC
now provides central counterparty (CCP) clearing and settlement services to 17 exchanges
and trading platforms for options, financial futures, security futures and securities lending
transactions. More information about OCC is available at www.theocc.com.
4 Who We Are
5

A World Without Options

6 What Are My Investment Choices

In a world without options, stock investors have

limited choices.

Long Stock Short Stock Treasury Bill

7 Options Are Financial Tools

• Options make it possible to target a variety of

investment objectives:
− reduce risk
− increase income
− improving the risk-reward of investments
− lowering the cost basis of long stock
− portfolio diversification
− leverage
− unique tradeoffs
8 Options and Risk-Reward

• Many option positions & strategies have

finite and measurable maximum risk and
maximum reward potential
• Some positions can have unlimited risk or
unlimited reward potential
• It’s important to understand the potential
outcomes of each position & strategy you
employ
 Annual Options Volume
9 (1973-2015)

OCC Annual Contract Volume by Product Type (1973-2015)

5.0

4.5

4.0
Cleared Contracts, Billions

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0

Non-Equity Equity
10

Option Fundamentals:
Core Concepts
11 Presentation Outline

• Core Concepts
− Call & Puts
− Contract Terms
− Rights & Obligations
− Expiration/Exercise & Assignment
− Option Premium
− ITM-ATM-OTM
− Pricing Factors
− Your Questions
12 Core Concepts

• Especiallywhen starting out, the fundamental

concepts and terminology can be confusing
but not necessarily complicated

• Be patient, learn the concepts

 An “Option” to Trade a Stock
13 and Other Assets

• Options cannot exist without an “underlying”

asset
• Options “derive” their value from that asset
• Options can be listed on many asset classes
− stocks
− Exchange-Traded Funds (ETFs)
− indexes
− currencies
− interest rates
− futures
− and more
14 What Are Options

• Options are contracts that give

− the buyer the right to buy or sell an underlying
asset
− the seller an obligation to buy or sell an underlying
asset at a specified price, on or before a given date
in the future
15 Types of Options

• There are two “types” of options:

− calls
− puts
• For equity options, the underlying asset to be
purchased or sold:
− 100 shares of underlying stock or
− 100 shares of an ETF (Exchange Traded Fund)
16 Equity Call Options

• An equity call buyer:

− has the right to buy 100 shares of underlying stock
− is “long” the call contract
• An equity call seller:
− has the obligation to sell 100 shares of underlying stock
− is “short” the call contract
− is also called the “writer”
17 Equity Put Options

• An equity put buyer:

− has the right to sell underlying stock
− is “long” the put contract
• An equity put seller:
− has the obligation to buy underlying stock
− is “short” the put contract
− is also called the “writer”
18 Rights vs. Obligations

Option contracts give…

Call Put

• 100 shares of
Long Right Right
(buyer) to buy to sell the underlying
• at the strike price
Short Obligation Obligation
• any time before
(seller) to sell to buy expiration
19 Contract Terms

• Equity option contracts have terms:

− underlying stock – contract specific
− unit of trade – usually 100 shares
− strike or exercise price – contract specific
− expiration month – contract specific

• Unlike shares of stock, equity options expire

20 Option Example & Terms

XYZ January 50 Call at $2.20

• XYZ = underlying stock
− 100 XYZ shares change hands if exercised
• January = expiration month
− expiration day = third Friday
in January
• 50 = strike (exercise) price
− price per share if exercised = $50.00
21 Option Example & Terms

XYZ January 50 Call at $2.20

• Call = option type
• $2.20 = quoted premium
− total premium paid by buyer to seller =
$2.20 x 100 shares = $220.00
− excluding commissions
22 Long Call

Limited risk with unlimited profit potential

Profit Unlimited
Profit Potential

0
Limited Strike Price of stock
Risk at expiration

Loss
23 Short Call

Limited profit potential with unlimited risk

Profit

Limited Profit
Potential
0
Strike Price of stock
at expiration

Loss Unlimited
Risk
24 Long Put

Limited risk with substantial profit potential

Profit
Substantial
Profit Potential

0
Limited Strike Price of stock
Risk at expiration

Loss
25 Short Put

Limited profit potential with substantial risk

Profit

Limited Profit
Potential
0
Strike Price of stock
at expiration

Substantial
Loss Risk
26 Expiration

• All options have an expiration date

• The expiration date can vary among underlying

asset classes
− standard equity and ETF options: typically expire
on the 3rd Friday of the stated month*
− weekly option expirations expire every Friday

* On and after February 15, 2015, the expiration date will be the
3rd Friday of the expiration month for standard options.
27 Option Expiration

June
• Expiration day for expiring Sun Mon Tue Wed Thu Fri Sat
standard equity options is X X X X X X X
the third Friday of the X X X X X X X

expiration month X X X X X X X
X X X X X X X

• Expiration Friday X X

− (if Friday is holiday then Thursday) Expiration

Friday
− last day expiring equity options
trade
− last day option may be exercised
by contract buyer
28 Expirations on the OH platform
 Exercise, Assignment and
29 Settlement

• Exercise: A long option holder chooses to invoke his

rights
− call holder owns the right to buy the stock at the strike
price
− put holder owns the right to sell the stock at the strike price
• Assignment: The option writer fulfills the obligation set in
motion by the option holder
− call writer has the obligation to potentially sell stock at the
strike price
− put writer has the obligation to potentially buy stock at the
strike price
• Upon exercise or assignment, the option gets “settled”
(becomes stock) and ceases to exist
30 Option Premium

• An option buyer pays premium (price)

− non-refundable
• An option seller receives premium (price)
− keeps, whether assigned or not
• Premium quoted on a per share basis
− total paid/received = quoted price x 100 shares
− example: $3.00 quoted x 100 = $300.00 total
− excluding commissions
31

Option Premium:
In the Money
At the Money
Out of the Money
32 Intrinsic Value vs. Time Value

Option Premium:
Intrinsic Value (if any) + Time Value
• Intrinsic value
− in-the-money amount
• Time value
− any premium in excess of intrinsic value
− decays with time as expiration approaches (“time decay”)
• At expiration option worth only intrinsic value
− no time remaining
 Calls: In-the-money,
33 At-the-money, Out-of-the-money

Jan 150 call

• Call is in-the-money (ITM) Feb 150 call

Apr 150 call
ITM
− stock price above strike price Jan 155 call
Feb 155 call

• Call is at-the-money (ATM) Apr 155 call

Jan 160 call
− stock price same as strike price Feb 160 call ATM
Apr 160 call

• Call is out-of-the-money Jan 165 call

Feb 165 call
(OTM) Stock
Apr 165 call
Jan 170 call
OTM
− stock price below strike price Price
$160.00
Feb 170 call
Apr 170 call
 Puts: In-the-money,
34 At-the-money, Out-of-the-money

Jan 150 put

• Put is out-of-the-money Feb 150 put
Apr 150 put
OTM
(OTM) Jan 155 put
Feb 155 put
− stock price above strike price Apr 155 put
Jan 160 put
• Put is at-the-money (ATM) Feb 160 put
Apr 160 put
ATM

− stock price same as strike price Jan 165 put

Feb 165 put
• Put is in-the-money (ITM) Stock
Apr 165 put
Jan 170 put
ITM
− stock price below strike price Price
$160.00
Feb 170 put
Apr 170 put
35 The Ins and Outs Quiz

Stock Price Option In, At, Out

$55.00 60.00 Call Out

$77.00 75.00 Call In
$63.00 65.00 Put In
$51.00 50.00 Put Out
$22.55 22.50 Call In
36 Strike Prices on the platform
37 Intrinsic Value vs. Time Value

• In-the-money calls and Time

Value?
puts
− have intrinsic value Intrinsic
Value
− may have time value Total
Premium
• At-the-money calls and puts
− no intrinsic value
Time
− all time value Value

• Out-of-the-money calls and

Total
puts Premium

− no intrinsic value
− all time value
38 Premium Value Quiz

Stock Option Intrinsic Time

Option In, At, Out
Price Price Value Value
$78.00 70.00 Call $10.50 In-the-money $8.00 $2.50
$58.50 60.00 Put $3.75 In-the-money $1.50 $2.25
$84.00 85.00 Call $2.25 Out-of-the-money 0 $2.25
$22.50 22.50 Call $1.50 At-the-money 0 $1.50
39

Option Pricing
40 Car Insurance

Driver A Driver B
(safe driver) (reckless driver)

$15,000.00 Car Price $15,000.00

$500.00 Deductible $500.00
6 months Time 6 months
5% Interest Rate 5%

$450.00 Premium $650.00

Which driver would you rather insure?

41 Stock Insurance

Stock A Stock B
(stable) (volatile)

$48.00 Stock Price $48.00

$45.00 Strike Price $45.00
3 months Time 3 months
5% Interest Rate 5%

$300.00 Premium $575.00

42 Stock Insurance

Automobile Stock
Car Price Stock Price
Deductible Strike Price
Time Time
Interest Rate Cost of
Driver Risk Money
Volatility
43 Option Pricing

Option Pricing Model

• Input
− stock price
− strike price
− volatility
− time until expiration
− cost of money (interest rates less dividends)
• Output
− call and put premiums (theoretical values)
− the “Greeks”
44 Pricing Factors or The “Greeks”

• Theoretical change in option price with change in other

factors (primarily pricing factors)
• Delta
− option price vs. changing stock price
• Gamma
− option delta vs. changing stock price
• Theta
− option price vs. changing time until expiration
• Vega
− option price vs. changing volatility
• Rho
− option price vs. changing interest rate
45 Option Pricing

• Option pricing models can be a useful tool in

establishing a trading plan
• Option pricing models do not make your
investment decisions
• Option prices are subject to many unforeseen
variables
− in addition to pricing factors there is unpredictable
supply and demand
46 Option Delta

• Delta:
− the expected change in an option’s price (up or down)
for each 1-point move in underlying stock price
• Deep in-the-money options
− high deltas approaching 100% (or 1)
• At-the-money options
− deltas around 50% (or .50)
• Far out-of-the-money options
− low deltas approaching 0% (or 0)
47 Option Delta

• CONSIDER: Stock = $ 50.00

50 call = $ 3.00
• WHAT IF: Stock $50.00 → $ 51.00
50 call $3.00 → $3.50
?
Stock $51.00 → $ 52.00
50 call $3.50 → $4.10
?
• Assume all other factors are fixed:
− time = 60 days
− volatility = 28%
− interest rates = 4%
− dividend = 0
48 Delta

• Deep ITM options have high deltas

approaching 100 and may act as stock
substitutes
• ATM options have deltas closer to 50
• OTM options have deltas approaching 0
• Options rarely move as much as the
underlying stock
• Calls have positive deltas
• Puts have negative deltas
49 Effect of Time

• CONSIDER: Days to expiration

= 60
50 call = $ 3.00
• WHAT IF: Days to expiration 60 → 30
50 call $3.00 → $2.00
?
• Assume all other factors are fixed:
− stock = $50.00
− volatility = 28%
− interest rates = 4%
− dividend = 0
50 Time Decay

• Option premium erodes with the passage of

time
− only time value affected – not intrinsic value
− erosion accelerates as expiration approaches
Call Value

3 2 1

Time To Expiration (Months)

51 Theta

• Time decay (theta) is at its greatest near the

end of the life of an option
− Short-term option decay is greater than long-
term option decay
• Time decay hurts option holders
• Time decay helps option writers
• Time decay is greatest for ATM options; near
0 for deep ITM and far OTM options
52 Option Chain

• Where to find option price quotes online

− brokerage firm, exchange or quote provider Web sites
− www.OptionsEducation.org
− free quotes usually delayed
• Often found in an option chain format

Portion of option chain from IVolatility.com

Accessible via www.OptionsEducation.org
For illustrative purposes only
53 OptionsHouse Option Chain
 54 OptionsHouse Option Chain

Intrinsic Extrinsic
Greeks
Values

Source: OptionsHouse
Implied
For illustrative purposes only Volatilities
55 Option Pricing Summary

• Investors should have a plan that includes realistic

expectations of the goals they hope to achieve
− understand option pricing factors
− use option pricing model to explore best and worst case
scenarios in advance of entering the marketplace
− set your expectations accordingly

• Ultimately, who determines option trading prices?

− the marketplace
− best bid and ask prices among all market participants
− i.e., among option professionals and investors like you
− not an exchange
56 Get To Know These Concepts

• Calls & Puts

• Contract Terms
• Rights & Obligations
• Expiration/Exercise & Assignment
• Option Premium
• ITM-ATM-OTM
• Pricing Factors
57 Next Webinar

Option Theory to Application

Adding Income Generation to your Portfolio

Thursday June 16th 4:30pm ET

 The Options Education
58 Program
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59 For More Information

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