Investing 101
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Investing 101. Lesson 5 Options. Blind Monkeys Throwing Darts. 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. Blind Monkeys Throwing Darts.

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Investing 101

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Investing 101

Investing 101

Lesson 5

Options


Blind monkeys throwing darts

Blind Monkeys Throwing Darts

  • 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


Blind monkeys throwing darts1

Blind Monkeys Throwing Darts

  • 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

A Paradox

  • 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 nobody does research, then asset prices are inefficient

  • If markets are inefficient, then it is profitable to do research


Congratulations

!!Congratulations!!

  • You have made it to the last day!

  • 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!


But first

But first….

  • Wait in American Sign Language ---->>


Review

Review!

  • What is the SML?

  • What is CAL?

  • What is CAPM?

  • What is Beta?


Main teaching points

Main Teaching Points

  • Short selling, Anyone remember what this is???

  • Naked Calls

  • Naked Puts

  • Covered Calls

  • Covered Puts

  • Spreads


Derivatives

Derivatives

  • A derivative is a financial instrument whose price depends on the price of another underlying asset

  • Major derivative contracts are:

    • Futures and forward contracts

    • Call and put options

    • Swaps


Institutional characteristics of option contracts

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 put option is the right to sell an asset for a certain price at a certain time in the future


Option contracts

Option Contracts

  • 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


Option contracts1

Option Contracts

  • 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


Possible payoffs at expiration

Call Option – Long

max(0, ST – X)

Put Option – Long

max(0, X – ST)

Possible Payoffs at Expiration


Possible profits of options long positions

Call Option – Long

max(0, ST – X) – Ct

Put Option – Long

max(0, X – ST) – Pt

Possible Profits of Options: Long Positions


Possible profits of options short positions

Call Option – Short

Ct – max(0, ST – X)

Put Option – Short

Pt – max(0, X – ST)

Possible Profits of Options:Short Positions


Covered call

Covered Call

Value at

Expiration

  • The profit line:

Payoff

Covered

Call

Profit

S

x

0


Covered call1

Covered Call

  • Covered call strategy combines long stock position with short call position

  • What are investors betting on?

  • When does this strategy pay off?


Covered call writing short call and long stock

Covered Call Writing:Short Call and Long Stock


Consider yourself informed

Consider yourself informed!

For more info on options and spreads feel free to stick around


Protective put long put and long stock

Protective Put:Long Put and Long Stock


Bull spread long call x 1 short call x 2

Bull Spread:Long Call(X1) & Short Call(X2)


Bear spread short call x 1 long call x 2

Bear Spread:Short Call(X1) & Long Call(X2)


Butterfly spread call x 1 2calls x 2 call x 3

Butterfly Spread:Call(X1) – 2Calls(X2) + Call(X3)


Straddles and strangles

Put(X) + Call(X)

Put(X1) + Call(X2)

Straddles and Strangles


Option strategies

Option Strategies

  • There are numerous other trading strategies using options

  • The same trading strategies can be implemented with different sets of assets


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