1. Equity & Options Trading Game and Tutorial For SEBC May 8, 2004 Sanjiv Parekh

2. Equity and Options Trading Game and Tutorial Welcome Sloan Trading Room Task Force was established in 1997 by Prof. Andrew Lo. Trading room is used for research, trading games and simulations, and finance classes. Types of trading games include: equity, fixed income, derivatives, and foreign exchange. Information: http://mitsloan.mit.edu/trader Email Us: taskforce@mit.edu

3. Equity and Options Trading Game and Tutorial Agenda Today’s Game: 2 Stocks and 2 Options Trading Interface Trading Mechanics: Bid-Ask Accessing Private Information Two Practice Games Questions and Answers The Final Game

4. Equity and Options Trading Game and Tutorial Case Scenario Two Stocks –Firm 1 –Firm 2 Two Options –30 Call on Firm 1 –30 Put on Firm 1 Two periods: Year 1 and Year 2 0% interest rate, no cost to borrow money Stocks are non-dividend paying

5. Equity and Options Trading Game and Tutorial Private Information and Prices Different parties may have private information in the market. This information may give you an advantage in trading. Bid and Ask prices may reflect what private information other traders have If you know what the stock should be worth, take advantage of wrong prices through arbitrage

6. Equity and Options Trading Game and Tutorial Game Setup The values of the stocks at the end of the two periods depend on what state the company is in Firm 1 has 3 different possible states in each period Firm 2 has 3 different possible states in each period

7. Equity and Options Trading Game and Tutorial Realized events determine each stocks’ realized dividends Realized dividends determine each stocks’ price Events are all equally likely Traders will receive private information about which event is realized Firm 1 x Fails to win contracts y Wins some contracts z Wins all contracts Firm 2 w Fails to win contracts x Wins some contracts y Wins all contracts Stock Fundamentals

8. Equity and Options Trading Game and Tutorial Firm 1 Payoff Tree Stock values depend on events realized in Period 1 and Period 2 Starting out, probability of each event is equal

9. Equity and Options Trading Game and Tutorial Firm 1 Payoff Tree Min: 0 Max: 25 E [Price] = 11.25 Private Information: Period 1: not z, Period 2: not z Use your Private Information to calculate the new expected stock price

10. Equity and Options Trading Game and Tutorial Firm 1 Payoff Tree in Period 2 Assume Event y occurred Private Information still holds What is the expected value of Firm 1 now? Min: 0Max: 20 E [Price] = 10

11. Equity and Options Trading Game and Tutorial Options European style Call Options give you the right, but not the obligation, to buy a specified amount of an underlying security at a specified price upon expiry. European style Put Options give you the right, but not the obligation, to sell a specified amount of an underlying security at a specified price upon expiry. The specified price is known as the strike price

12. Equity and Options Trading Game and Tutorial Options in this Game European Style Call on Firm 1 with strike 30 European Style Put on Firm 1 with strike 30 Options expire at the end of Period 2 Option payouts will be realized at the end of Period 2

13. Equity and Options Trading Game and Tutorial Firm 1 Option Payoff Trees Create payout trees for options and use them to price options just like the stocks

14. Equity and Options Trading Game and Tutorial Trading Mechanics Traders who want to sell stocks at a certain price post an Ask Traders who want to buy stocks at a certain price post a Bid Only Market Makers have the ability to post Bids and Asks

15. Equity and Options Trading Game and Tutorial The Bid-Ask Spread BID 158 1/8 Market maker buys Market taker sells ASK 158 7/8 Market maker sells Market taker buys

16. Equity and Options Trading Game and Tutorial Stay Within the Spread Ask sell buy 159 160 Do not trade outside the spread Be the market maker with unsophisticated traders in the market $$$ Bid sell buy 159 160

17. Equity and Options Trading Game and Tutorial Being the Market Maker Ask 90 89* Bid 80 81* New Bid Makes the Market (Market Maker) New Ask Makes the Market (Market Maker) Bid-Ask spread goes from 10 to 8 once the new bid and the new ask make the market MARKET

18. Equity and Options Trading Game and Tutorial Being the Market Maker Ask 90 91 Bid 80 79 Bid does NOT Make the Market Ask does NOT Make the Market MARKET

19. Equity and Options Trading Game and Tutorial Terminology Going Long: buy the stock –You think the stock price will go up Going Short: sell the stock –You think the stock price will go down –Selling more units than you have, known as short selling, ends up with negative number of units. –In this game, you can short sell as much as you want –Have to cover short position at end by buying back the stock. Done automatically in the game.

20. Equity and Options Trading Game and Tutorial Trading Interface Stock Names Traders in the FTS markets determine prices Individual endowments Seconds remaining for current trading period. You can borrow or lend at a 0% interest rate Realized payouts displayed here

21. Equity and Options Trading Game and Tutorial Enter any trading name (at least 3 characters) Type in the actual names of each trader on the team Logging In DO NOT PRESS CONNECT UNTIL ASKED TO DO SO