Investing 101 Lesson 5 Options

Blind Monkeys Throwing Darts Malkiel suggested that it does not matter how you choose stocks in efficient markets Malkiel suggested that it does not matter how you choose stocks in efficient markets You can ask some blind monkeys to throw darts on the Wall Street Journal to select stocks You can ask some blind monkeys to throw darts on the Wall Street Journal to select stocks

Blind Monkeys Throwing Darts However, rational security analysis is still useful: However, rational security analysis is still useful: –Monkeys will probably not pick a well-diversified portfolio with a desired level of risk –Monkeys do not know the tax considerations of stock choice –Monkeys do not take your specific circumstances into account (job, age, location)

A Paradox If markets are efficient, then there are no gains from doing research If markets are efficient, then there are no gains from doing research If there are no gains from doing research, then nobody does research If there are no gains from doing research, then nobody does research If nobody does research, then asset prices are inefficient If nobody does research, then asset prices are inefficient If markets are inefficient, then it is profitable to do research If markets are inefficient, then it is profitable to do research …

!!Congratulations!! You have made it to the last day! You have made it to the last day! You have learned about stocks, bonds, mutual funds, economics and portfolio building. You have learned about stocks, bonds, mutual funds, economics and portfolio building. Today you are in for a special treat, a peek into a world in which most of the world will never hear about! OPTIONS! Today you are in for a special treat, a peek into a world in which most of the world will never hear about! OPTIONS!

But first…. Wait in American Sign Language ----  >> Wait in American Sign Language ----  >>

Review! What is the SML? What is the SML? What is CAL? What is CAL? What is CAPM? What is CAPM? What is Beta? What is Beta?

Main Teaching Points Short selling, Anyone remember what this is??? Short selling, Anyone remember what this is??? Naked Calls Naked Calls Naked Puts Naked Puts Covered Calls Covered Calls Covered Puts Covered Puts Spreads Spreads

Derivatives A derivative is a financial instrument whose price depends on the price of another underlying asset A derivative is a financial instrument whose price depends on the price of another underlying asset Major derivative contracts are: Major derivative contracts are: –Futures and forward contracts –Call and put options –Swaps

Institutional Characteristics of Option Contracts A call option is the right to buy an asset for a certain price at a certain time in the future A call option is the right to buy an asset for a certain price at a certain time in the future A put option is the right to sell an asset for a certain price at a certain time in the future A put option is the right to sell an asset for a certain price at a certain time in the future

Option Contracts An European option can only be exercised on the expiration date An European option can only be exercised on the expiration date An American option can be exercised on any day prior to and including the expiration date An American option can be exercised on any day prior to and including the expiration date

Option Contracts Long position: The option buyer or holder pays a premium and receives the right to buy or sell an asset Long position: The option buyer or holder pays a premium and receives the right to buy or sell an asset Short position: The option seller or writer receives a premium and has the obligation to deliver or purchase an asset whenever the option buyer chooses Short position: The option seller or writer receives a premium and has the obligation to deliver or purchase an asset whenever the option buyer chooses

Possible Payoffs at Expiration Call Option – Long Call Option – Long max(0, S T – X) Put Option – Long Put Option – Long max(0, X – S T )

Possible Profits of Options: Long Positions Call Option – Long Call Option – Long max(0, S T – X) – C t Put Option – Long Put Option – Long max(0, X – S T ) – P t

Possible Profits of Options: Short Positions Call Option – Short Call Option – Short C t – max(0, S T – X) C t – max(0, S T – X) Put Option – Short Put Option – Short P t – max(0, X – S T ) P t – max(0, X – S T )

Covered Call The profit line: The profit line: S Payoff x Value at Expiration 0 Profit Covered Call

Covered Call Covered call strategy combines long stock position with short call position Covered call strategy combines long stock position with short call position What are investors betting on? What are investors betting on? When does this strategy pay off? When does this strategy pay off?

Covered Call Writing: Short Call and Long Stock

Consider yourself informed! For more info on options and spreads feel free to stick around

Protective Put: Long Put and Long Stock

Bull Spread: Long Call(X 1 ) & Short Call(X 2 )

Bear Spread: Short Call(X 1 ) & Long Call(X 2 )

Butterfly Spread: Call(X 1 ) – 2Calls(X 2 ) + Call(X 3 )

Straddles and Strangles Put(X) + Call(X) Put(X) + Call(X) Put(X 1 ) + Call(X 2 ) Put(X 1 ) + Call(X 2 )

Option Strategies There are numerous other trading strategies using options There are numerous other trading strategies using options The same trading strategies can be implemented with different sets of assets The same trading strategies can be implemented with different sets of assets