FPA Conference Presentation in Anaheim, Ca 10-11-2009

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 CouncilOctober 10, 2009

2. Options Basic

3. What is a DerivativeSomething that derives its value from an underlying instrument.

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

5. Calls and Puts are a form of equity derivatives.Why Use Options? Speculate on price movements.

6. Reduce risk (Hedging)

7. Reduce transaction costs (from rebalancing).

8. Defer Taxes

9. Avoid market constraints, such as short selling.Calls and PutsA Call option gives the buyer the right, but not the obligation, to purchase a set amount of stock (usually 100 shares) at a predetermined price (Strike Price) at any time before the options expiration date (American) or at expiration only (European).

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.

11. The seller (writer) of the option is obligated, if assigned to sell (call) or buy (put) the stock at the predetermined strike price.Calls and PutsLong or Short a contract Long – Own – Right to buy or sell the underlyingShort – Write – Obligated to buy or sellLong or Short the Underlying Longs want the stock to riseShorts want the stock to fall6

12. Calls and PutsAmericanvs.European Exercise/AssignmentAmerican Options can be exercised at anytimeEuropean Options can only be exercised at expiration Over-the-Counter (OTC) Options vs. Listed Options

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

15. Call and Put PricesExxon Mobil (Ticker – XOM) @ 64Jan’10 Calls and Puts Closing prices on March 6, 2009

16. Call and Put PricesThe price of an option is called the Option Premium.

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 PutFor 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.

21. The MoneyXYZ stock trading at 25

22. In the money options have intrinsic and time value

23. ATM and OTM have only time valueComponents of an Options PriceWhat options are ITM, ATM or OTM? If the stock is trading at 25

24. Components of an Options PriceWhat 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)

26. Call Buyer (Long) Payoff Graphs Right to buy the underlying at 25.Pays $3 for the right.Wins with the stock above 28.Effective purchase price 28Options holders don’t have all the rights of shareholders.No rights to dividends

27. No voting rightsReasons for buying:Bullish on the market or stock.

28. Limited downside risk, with unencumbered upside potential.

29. Stock replacement.

30. Leverage.Call Buyer (Long) Payoff GraphsClosing or exiting the position.ITM Sell the contractTake the profit or limit the loss

31. Before the close of trading on the option’s expiration date.Exercise the callAt expiration and pay cash to purchase 100 shares at the strike price.

32. Early exercise is usually only done to capture the dividend by converting to stock.OTMLet expire – lose rightsMax Loss = premium paid

33. Call Seller (Short) Payoff Graphs Obligated to sell the underlying at 25.Receives $3 premium for accepting the obligation.Risk is unlimited on naked callsSeller must be financially and psychologically able to sell the underlying at 25, regardless of how high the stock is currently trading.Effective sale price if assigned is 28 (25+3).Reasons for selling:Covered Calls – willing to lose the stock at a predetermined price.

34. Naked Calls – Believes the stock will remain below 28 and full premium will be captured.Put Payoff GraphsPut with a strike price of 30 trades at $5Buyer’s max gain is 25 (=30-5), max loss is $5Seller’s max gain is $5, max loss is 25 (=30-5)Break-even 25 (=strike minus premium)

35. Put Buyer (Long) Payoff GraphsRight to sell the underlying at a predetermined price (30 Strike).Pays $5 for the right.Wins with the stock below 25.Reasons for buying puts:Neg. view on the market or a stock.

36. Protecting another position.

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

38. Investor would otherwise avoid investing in equity without some downside risk protection.Put Seller (Short) Payoff GraphsObligated to buy the underlying at 30.Receives $5 premium for accepting the obligation.Seller must be financially and psychologically able to purchase the underlying. (Margin is usually ½ the strike price).Effective purchase price if assigned is 25 (30-5).Reasons for selling:Willing to own the underlying at a lower entry point.Expects the stock to trade in a tight range (25-35), hopefully above 30 at expiration.

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

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

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

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

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

44. Buy (Long) StraddleRight 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 CaseEarnings ReportFDA ApprovalMacro Events

45. Selling (Short) StraddleObligated to buy or sell the underlying at a predetermined price (25 Strike).Receives $6 for the risk.Wins with the stock between 19 and 31 at expiration.Reasons for selling a straddle:Expect the stock to be range bound.

46. Feels the markets price for expected movement is to high.Court CaseEarnings ReportFDA ApprovalMacro Events

47. StraddleCall + Put = Premium. Premium +/- Strike = Breakeven

48. StraddleCall + Put = Premium. Premium +/- Strike = Breakeven

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

50. Buy (Long) StrangleRight 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 CaseEarnings ReportFDA ApprovalMacro EventsBuyer’s max gain is infinite, max loss is $4.50

51. Sell (short) StrangleObligated to buy at 22.5or sell at 27.5 Receives $4.50 for the risk.Wins with the stock between 18 and 32 at expiration.Reasons for selling a strangle:Expect the stock to be range bound.

52. Feels the markets price for expected movement is to high.Court CaseEarnings ReportFDA ApprovalMacro EventsBuyer’s max gain is $4.50, max loss is unlimited

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

54. Put Bear SpreadBear buys the 25 put at 3 and sells the 20 put at 2, net debit $1.Buyer sells the lower put strike to subsidize the purchases of the higher strike.

55. Max gain $4 and max loss $1.Bull sell the 25 put at 3 and buys the 20 at 2, net credit $1.Seller caps loss with the purchases of the put with a lower strike.

56. Max gain $1 and max loss $4.Exercise and Assignments90% of options expire worthless. False.Most option positions are closed.Automatic Exercise for ITM options at expiration.OCC notifies the clearing firms, the clearing firm assigns the options to their clients who are short that particular option.Why are American Options exercised early?Deep ITM Calls may be exercised early to capture the dividend the day before the x-div date.Deep ITM Puts may be exercised early if the Put is trading at parity to capture the remaining interest.

57. Options Industry Council Eric S. Cott, Director, Financial Advisor Educationwww.optionseducation.org

58. Help Desk 1-888-OptionsPricing an Option

59. Pricing an OptionOption Price = Time Value + Intrinsic ValueComponents of an Option’s Price (DIVUTS)DividendsInterest RatesVolatilityUnderlying StockTimeStrike

60. Volatility

61. VolatilityAn 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 BuyersWant 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 SellersWant 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 EnvironmentCurrent EnvironmentStock Valuations - High or LowImplied Volatility - High or LowWhat strategy works well in the current environment?When to buy optionsWhen to sell optionsWhen to use spreadsWhen to implement a collar

66. Investment Strategies with Options

67. Investment Strategies with OptionsPortfolio Income Strategy – Covered Call WritingPortfolio Protection Strategy – Buy Puts, Put Spreads or Implement a CollarPortfolio Recovery Strategy– Increase upside potential without increasing downside risk

68. Index OptionsAdvantagesDiversificationTaxesLower Transaction CostBroad Hedging DisadvantagesNot single stock specificMay have higher tracking error to hedged position

69. Portfolio Income Strategy

70. Portfolio Income StrategyInitial Investment $500,000

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

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

73. Received dividends equal to $2.25 per yearPortfolio Income StrategyExpiration 1 year: Potential Outcome # 1 – SPY is UnchangedSPY is trading at $100Calls expire worthlessClient keeps the call premium received of $55,000Premium received taxed as short-term capital gainsTaxed at 35% - After tax return of $35,750Dividends received $11,500 Total Return -$66,250 $66,250/500,000 = 13.25%

74. Portfolio Income StrategyExpiration 1 year: Potential Outcome # 2 –SPY Has Risen SharplySPY is trading at $120Repurchase 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 = $555,000Plus Dividends $11,250 Total Return $66,500 (66.25K/500K = 13.25%)

75. Portfolio Income StrategyExpiration in 1 year: Potential Outcome # 3 – SPY Has Risen Less SharplySPY is trading at $110Repurchase 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 expirationStrike Price = $110, options will expire in a yearPremium 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 - $50,000Plus Dividends $11,500 Value of the 5000 shares of SPY = $550,000Total Return $66,500 (66.5K/500K = 13.25%)

76. Portfolio Income StrategyExpiration in 1 year: Potential Outcome # 4 – SPY is LowerSPY is trading at $86.75 (SPY down 13.25%)Calls expire worthlessClient keeps the call premium received of $55,000Premium received taxed as short-term capital gainsDividends 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 = $0Total Return = $ 0

77. Portfolio Income StrategyS&P Buy-Write Composite (Simple Holding Period Returns)Performance Since Inception 12/31/03 – 8/31/09 SPY Buy-Write Composite +11.23% Est. Stand Dev. 11.9%

78. S&P 500 Total Return -7.65% Est. Stand Dev. 14.9%Down Market Performance 8/31/08– 2/28/09SPY Buy-Write Composite -34.3%

79. S&P 500 Total Return -41.8% Rapid Rising Market Performance 2/28/09 – 6/30/09SPY Buy Write Composite 21.1%

80. S&P 500 Total Return 26.1% Advantages of Covered Call WritingPotential for additional return from option premiumsWriting out-of-the-money options offers possibility of selling stock at higher pricesCapital gains tax on option is not realized at time of sale*Capital gains tax on stock is not realized unless option is called*Possible to delay realization of capital gains into a further tax year by writing covered calls*Example: In December, the investor might be more likely to write covered calls expiring in the next tax year than to sell stockContinue to receive dividends unless stock is calledCovered call premium provides partial downside protection for stockSomewhat favorable tax treatment of qualified covered call premiums*If stock is called, covered call premiums received may adopt underlying nature of stock, long or short-term*It may be possible to write a 60-day option and receive long-term capital gains treatment*Simplicity; covered calls do not require a margin account

81. Disadvantages of Covered Call WritingIncomplete downside protectionExpired or repurchased options may be taxed at short-term rate*It is possible for options to be exercised prior to expirationOccurs infrequently and is largely predictableCorrective 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 expirationTriggers sale of the underlying stockTriggers 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 StrategiesHedging – Strongest to WeakestSell SPX Index Futures – Full ProtectionBuy SPX Index Put – Floor Downside RiskBuy 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 FuturesBuy VIX Calls (Sell VIX Puts)Write SPX Index calls

84. Portfolio ProtectionBuy SPX Index puts, if protection is cheap.Captures Upside / Limits DownsideImplement a collar Caps Upside / Limits DownsideBuy 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 SPXWrite SPX Index calls when volatility is elevated.Caps Upside / Cushions Downside

85. Portfolio ProtectionWhat 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 riskKnown maximum drag on upside performanceIn 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 ProtectionWhat 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 ProtectionEstimated Price of a 1-Year Put Option, 10% Out-of-the-MoneyAs a Percent of the S & P 500 IndexEstimated Prior to 2004

88. Portfolio ProtectionProtecting 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 1000Portfolio is 1000 times the index.Protect the portfolio from losing more than 10% ($900,000) over the next yearStrike/Index - (Put) + Div = FloorOTM 95% - 8.5% + 3.5% = 90% FloorATM 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 receivedIn the beginning of 20091yr ATM calls on the SPX sold @ 13.5%1yr ATM straddle on the SPX sold @ 28%

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

91. Advantages of Listed Option CollarsCollars 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 stockSimplicity; listed zero-cost collars require no opening of a margin accountCompetitive pricing and transparency of transactions for listed optionsWidespread availability of information; listed options prices are published on the Internet and in newspapersAfter collar has been executed, opportunistic trades can be made to take profits, adjust strike prices, or get out of the collar altogetherwe strongly recommends taking some profits on collars when they exist and maintains a full-time options trading desk to take advantage of these opportunitiesAdjusting positions is difficult or impossible with over-the-counter collars

92. Advantages of Listed Option CollarsNo 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 hedgedPurchase 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 CollarsWhile 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 opportunitiesThe put option portion of a collar receives disadvantageous tax treatment; losses on the put option may not be realized prior to disposition of underlying stockThe 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 StrategyGetting your money back is as easy as 1 2 3Long 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 LeverageInitially Purchased 100 shares @ 40 and Now Trading @ 25, Down $1500Investment now worth $2500.B 2 25 Calls at $3 (-6)S 3 30 Calls $2 (+6)Capped at 30Max Gain - $1500 over the 30 strikeMax Loss - $2500 at zero

96. Speculation and LeverageInvestment 2500.100 shares of stock at $25 per share.B 2 25 Calls at $3 (-6)S 3 30 Calls $2 (+6)Capped at 30Max Gain - $1500 over the 30 strikeMax Loss - $2500 at zero

97. Additional Benefits of OptionsReduce cost or riskContain risk and redeploy capital.Monetize CollarsBuy options to cap risk of lossLock in profits without creating a taxable eventStock replacement to limit downsideDiversificationTarget buy/sell priceRebalance asset allocationReduce transaction cost

98. SellHoldHedgeHoldSellPortfolio Management with OptionsOld investment solution for managing a portfolio:New investment solution for managing a portfolio:

99. Why Hedge?True risk management, absolute returns

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)

105. Incremental return (e.g. covered calls)When NOT to Hedge?When selling is betterWhen hedging is too expensive (including fees)When time period is too longWhen time period is too shortWhen hedge is not understood by clientRelative return considerations

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

107. Start Using Options to Enhance Your PracticeTrading Options In-houseTrading DeskOperational SupportListed Options vs. OTC OptionsAnyone can trade listed optionsOTC contracts require internal legal reviewHire Third Party Investment ManagerLearn 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 solutionsLeverage expertise through partnershipsFA can find a SMA Partner for accounts as small as $100kStrategies offered by asset managersPortfolio ProtectionPortfolio IncomePortfolio RecoveryCustom strategies for concentrated equity positions

109. Looking for answersClients: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?

FPA Conference Presentation in Anaheim, Ca 10-11-2009

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FPA Conference Presentation in Anaheim, Ca 10-11-2009