1 International Securities Exchange. 2 Steve Meizinger Director of Education ISE Steve Meizinger ISEoptions.com [email protected].

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International Securities Exchange

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Steve MeizingerDirector of Education

ISESteve Meizinger

ISEoptions.com

[email protected]

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Spread Opportunities Using ISE Sector Indexes(RUF)

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For the sake of simplicity, the examples that follow do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of a given strategy. An investor should review transaction costs, margin requirements and tax considerations with a broker and tax advisor before entering into any options strategy.

Options involve risk and are not suitable for everyone. Prior to buying or selling an option, a person must receive a copy of CHARACTERISTICS AND RISKS OF STANDARDIZED OPTIONS. Copies have been provided for you today and may be obtained from your broker, one of the exchanges or The Options Clearing Corporation. A prospectus, which discusses the role of The Options Clearing Corporation, is also available, without charge, upon request at 1-888-OPTIONS or www.888options.com.

Any strategies discussed, including examples using actual securitiesprice data, are strictly for illustrative and educational purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities.

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www.iseoptions.com

• Free volatility data on all ISE listed options

• Updates on ISE broad market index products

• Updates on ISE sector options

• [email protected]

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Rights and Obligations

• Options are contracts• Option buyers get rights

Call buyers get the right to buy

Put buyers get the right to sell• Option sellers get obligations

A short call is an obligation to sell

A short put is an obligation to buy

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Options have value for two reasons

• The cost of money - The risk-free rate that money can be invested less any dividends that are paid

• Volatility - The movement of stocks is measured by the standard deviation

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Option Greeks: A refresher

• Delta• Theta• Gamma• Vega• Rho

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Delta

• How much an option price changes relative to the underlying price changing $1.0

Deep in Money - Have intrinsic value and have higher deltas

At the Money - Have no intrinsic value and have deltas that are approximately 50%

Out of the Money - Have no intrinsic value and have lower deltas

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Different underlying prices and maturities affect delta

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Theta

• The amount an option depreciates as measured on a daily basis

• Also called time decay

• Options are generally worth more given more time until expiration

• Time decay is not linear, much greater impact with few days left until expiration relative to many days left until expiration

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Call option value

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Theta graphically

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Gamma

• Gamma is an estimate of how much the delta of an option changes when the price of the stock moves $1.00

• Gamma is “potential” delta

• Gamma is inversely related to theta, the more gamma an option has the more time decay or theta an option has

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Vega

• An estimate of how much the theoretical value of an option changes when volatility changes 1.00%

• Higher volatility translates to higher option prices

• If an underlying has a 16 volatility its expected daily range is .16/square root of trading days (approximately 16) = 1%

• 40 volatility/16 =.025* underlying (RUF $26.48) = $0.66 is the one standard deviation expected range for RUF assuming 40 volatility and an index value of $26.48

• The higher the volatility the greater the expected range

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Rho

• Rho is an estimate of how much the theoretical value of an option changes when interest rates move 1.00%

• Least used of all the “Option Greeks”

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Options are dynamic

• Using options, investors can choose price forecasts, time forecasts or volatility forecasts or a combination of all three

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Spreads

• The term “spread” is loosely used term that can describe any multiple-leg part strategy

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Why trade spreads?

• Spread strategies offer investors and traders unique sets of trade-offs

• Spread strategies offer lower risk with reduced upside/downside depending on the strategy selected

• For a particular market forecast, a spread strategy may offer a better risk/reward ratio or higher profit potential

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Spreads assist in hedging

• Spreads can help mitigate risk

Volatility risk (Vega)

Time decay risk (Theta)

Underlying price risk (Delta)

• Spreads create an efficient way of creating long or short delta exposure

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Bull call spread

• Bull call spreads involves the purchase of one call and the sale of another call with a higher strike price. Both options have the same underlying and the same expiration date

• Bull call spreads are known as debit spreads, they are one type of vertical spread

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Index options

• Index options enable investors to gain exposure to the market as a whole or to specific segments of the market with one trading decision and frequently with one transaction. To obtain the same level of diversification using individual stock issues or individual equity option classes, numerous decisions and transactions would be required. Employing index options can defray both the

costs and complexities of doing so.

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ISEoptions.com

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ISE Homebuilders (RUF)

• The ISE Homebuilders Index includes residential construction companies and prefabricated house manufacturers

• The largest weightings in the index are: Lennar Corp, Pulte Homes, Centex Corp, D.R. Horton, KB Home, Toll Brothers and NVR Inc

Please visit www.iseoptions.com for further information regarding ISE indexes

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ISE Homebuilding index (RUF)

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RUF volatility has been increasing

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Spread Strike selection

• Deciding which strikes to spread depends on your forecast and the market’s forecast

ITM, ATM, OTM• Depends on your view of:

time passage (theta)implied volatility (vega)

• Another consideration: Is the option that you sell worth selling? If the bid if is too low, it may not worth selling

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Bullish call spread using RUF

• With RUF trading at 26.48

(Index forecast: (Up 4% by expiration, 38 days)

Buy 1 RUF Sept 25c at $2.35

Sell 1 RUF Sept 27.5c at $0.95

Net debit $1.40

• The 25-27.5 RUF Call spread is purchased for $1.40, or $140, plus commissions

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RUF Bull Call spread at expiration: cost (1.40)

RUF index RUF Sep 25c RUF Sep 27.5c

RUF Sep 25/27.5 call spread

22.5 ($2.35) $0.95 ($1.40)

25 ($2.35) $0.95 ($1.40)

26.48 ($0.87) $0.95 $0.08

27.5 $0.15 $0.95 $1.15

30 $2.65 ($1.55) $1.15

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RUF Bull Call diagram

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RUF Index

• Indexes are cash settled, there is no need to worry about closing out the spread for fear of residual positions after expiration

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Another look: choosing between strategies

• RUF is 26.48• Your forecast: You believe the index will be rise

approximately 4% to 27.5 at the option’s expiration• Possible strategies

Buy RUF Sep 25c @$2.35

Sell RUF Sep 27.5c @$0.95

Buy the 25/27.5c spread @$1.40

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Estimating Results

Today At Expiration Profit/(loss)

RUF Index $26.48 $27.50 Not applicable

Sept 25 call $2.35 $2.50 $0.15

Sept 27.5 call $0.95 0 ($0.95)

Sept 25/27.5 call spread

$1.40 $2.5 $1.10

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Another view: Bearish

• Bearish debit put spread involves the purchase of one put and the sale of another put with a lower strike price. Both options have the same underlying and the same expiration date

• Bear put spreads are also a type of a vertical spread

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RUF Put Spread

• RUF is quoted at $26.48

Buy RUF Sept 27.5p @$1.90 Sell RUF Sept 25p @$.75

Net debit $1.15

• The 27.5/25 RUF put spread is purchased for a $1.15 debit or $115 not including commissions

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RUF Bear Put Spread at expiration: cost (1.15)

RUF Index Sept 27.5p Sept 25p RUF Sept 27.5/25p

22.5 $3.10 ($1.75) $1.35

25 $.60 $0. 75 $1.35

26.48 ($0.88) $0.75 ($0.13)

27.5 ($1.90) $0.75 ($1.15)

30 ($1.90) $0.75 ($1.15)

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RUF Bear Put Spread

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Need more time for your RUF forecast?

• RUF is 26.48• Your forecast: You believe the index will rise

approximately 13%, although it will take 4 months for that to occur

• Buy RUF Dec 25c @ $3.50Sell RUF Dec 30c @ $1.30

Net debit $2.20

• The Dec 25-30c RUF Call spread is purchased for $2.20, or $220, plus commissions

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More time for our forecast to true

RUF Dec 25-30 call spread debit $2.2

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Options give you alternatives

Today At Expiration Profit/(loss)

RUF Index $26.48 $30.00 Not applicable

Dec 25 call $3.50 $5.00 $1.50

Dec 30 call $1.30 0 ($1.30)

25/30 call spread

$2.20 $2.80 $2.80

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More time needed for a bearish forecast

• RUF is 26.48• Your forecast: You believe the index will decline

approximately 5%, although it will take 4 months for that to occur

• Buy RUF Dec 30p @ $4.50Sell RUF Dec 25p @ $1.60

Net debit $2.90

• The Dec 25-30 RUF put spread is purchased for $2.90, or $290, plus commissions

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More time for a bearish forecast

RUF Dec 30-25 put spread debit $2.9

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RUF Bear Put Spread at expiration: cost (2.9)

RUF Index Sept 30p Sept 25p RUF Sept 27.5/25p

22.5 3.00 (.90) 2.10

25 .50 1.60 2.10

26.48 (.98) 1.60 (.08)

27.5 (2.00) 1.60 (.40)

30 (4.5) 1.60 (2.90)

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Risk/Return

• Risk and return are inherently linked

• Each investor must weigh their own investment goals and their own risk tolerances

• Selecting time frame and strike prices is based on your forecast and your risk tolerances and your financial goals

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Summary

• Spread strategies offer lower risk with reduced upside/downside depending on the strategy selected

• For a particular market forecast, a spread strategy may offer a better risk/reward ratio or higher profit potential

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Caution

• Just remember the market does not care what price you paid for your spread

• All option strategies work, but they do not work all the time

• Trade within yourself based on your own investment goals and your own risk tolerances

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www.iseoptions.com

• Free volatility data on all ISE-listed options

• Updates on ISE broad market index products

• Updates on ISE sector index options

• New webinar options topics each month

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International Securities Exchange