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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 • 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 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!! • 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…. • Wait in American Sign Language ---->>
Review! • What is the SML? • What is CAL? • What is CAPM? • What is Beta?
Main Teaching Points • Short selling, Anyone remember what this is??? • Naked Calls • Naked Puts • Covered Calls • Covered Puts • Spreads
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 • 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 • 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 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
Call Option – Long max(0, ST – X) Put Option – Long max(0, X – ST) Possible Payoffs at Expiration
Call Option – Long max(0, ST – X) – Ct Put Option – Long max(0, X – ST) – Pt Possible Profits of Options: Long 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 Value at Expiration • The profit line: Payoff Covered Call Profit S x 0
Covered Call • Covered call strategy combines long stock position with short call position • What are investors betting on? • When does this strategy pay off?
Consider yourself informed! For more info on options and spreads feel free to stick around
Put(X) + Call(X) Put(X1) + Call(X2) Straddles and Strangles
Option Strategies • There are numerous other trading strategies using options • The same trading strategies can be implemented with different sets of assets