Investing 101Investing 101

Lesson 5Lesson 5

OptionsOptions

Blind Monkeys Throwing Blind Monkeys Throwing DartsDarts

• Malkiel suggested that it does not Malkiel suggested that it does not matter how you choose stocks in matter how you choose stocks in efficient marketsefficient markets

• You can ask some blind monkeys to You can ask some blind monkeys to throw darts on the Wall Street Journal throw darts on the Wall Street Journal to select stocksto select stocks

Blind Monkeys Throwing Blind Monkeys Throwing DartsDarts• However, rational security analysis is still However, rational security analysis is still

useful:useful:– Monkeys will probably not pick a well-Monkeys will probably not pick a well-

diversified portfolio with a desired level of riskdiversified portfolio with a desired level of risk– Monkeys do not know the tax considerations of Monkeys do not know the tax considerations of

stock choicestock choice– Monkeys do not take your specific Monkeys do not take your specific

circumstances into account (job, age, location)circumstances into account (job, age, location)

A ParadoxA Paradox

• If markets are efficient, then there are no If markets are efficient, then there are no gains from doing researchgains from doing research

• If there are no gains from doing research, If there are no gains from doing research, then nobody does researchthen nobody does research

• If nobody does research, then asset prices If nobody does research, then asset prices are inefficientare inefficient

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

• ……

!!Congratulations!!!!Congratulations!!

• You have made it to the last day!You have made it to the last day!

• You have learned about stocks, You have learned about stocks, bonds, mutual funds, economics and bonds, mutual funds, economics and portfolio building.portfolio building.

• Today you are in for a special treat, a Today you are in for a special treat, a peek into a world in which most of peek into a world in which most of the world will never hear about! the world will never hear about! OPTIONS!OPTIONS!

But first….But first….

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

Review!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 PointsMain Teaching Points

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

• Naked CallsNaked Calls

• Naked Puts Naked Puts

• Covered CallsCovered Calls

• Covered PutsCovered Puts

• SpreadsSpreads

DerivativesDerivatives

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

• Major derivative contracts are:Major derivative contracts are:– Futures and forward contractsFutures and forward contracts– Call and put optionsCall and put options– SwapsSwaps

Institutional Characteristics Institutional Characteristics of Option Contractsof Option Contracts

• A A callcall option is the right to option is the right to buybuy an an asset for a certain price at a certain asset for a certain price at a certain time in the futuretime in the future

• A A putput option is the right to option is the right to sellsell an an asset for a certain price at a certain asset for a certain price at a certain time in the futuretime in the future

Option ContractsOption Contracts

• An European option can only be An European option can only be exercised on the expiration dateexercised on the expiration date

• An American option can be exercised An American option can be exercised on any day prior to and including the on any day prior to and including the expiration dateexpiration date

Option ContractsOption Contracts

• Long position: The option buyer or Long position: The option buyer or holder pays a premium and receives holder pays a premium and receives the the rightright to buy or sell an asset to buy or sell an asset

• Short position: The option seller or Short position: The option seller or writer receives a premium and has writer receives a premium and has the the obligationobligation to deliver or purchase to deliver or purchase an asset whenever the option buyer an asset whenever the option buyer chooseschooses

Possible Payoffs at Possible Payoffs at ExpirationExpiration• Call Option – LongCall Option – Long

max(0, max(0, SST T – – XX))• Put Option – LongPut Option – Long

max(0, max(0, X X – – SSTT))

-10

0

10

20

30

0 10 20 30 40 50

Future Stock Price

Pay

off

25

25

-10

0

10

20

30

0 10 20 30 40 50

Future Stock Price

Pay

off

25

25

Possible Profits of Options: Possible Profits of Options: Long PositionsLong Positions• Call Option – LongCall Option – Long

max(0, max(0, SST T – – XX) – ) – CCtt • Put Option – LongPut Option – Long

max(0, max(0, X X – – SSTT) – ) – PPtt

-10

0

10

20

30

0 10 20 30 40 50

Future Stock Price

Pa

yoff

-3.60

21.40

-10

0

10

20

30

0 10 20 30 40 50

Future Stock Price

Pa

yoff

-0.65

24.35

Possible Profits of Options:Possible Profits of Options:Short PositionsShort Positions

• Call Option – Call Option – ShortShort

CCtt – max(0, – max(0, SST T – – XX))

• Put Option – ShortPut Option – Short

PPtt – max(0, – max(0, X X – – SSTT))

-30

-20

-10

0

10

0 10 20 30 40 50

Future Stock Price

Pa

yoff

3.60

-21.40

-30

-20

-10

0

10

0 10 20 30 40 50

Future Stock Price

Pa

yoff

0.65

-24.35

Covered CallCovered Call

• The profit line:The profit line:

S

Payoff

x

Value at Expiration

0

Profit

CoveredCall

Covered CallCovered Call

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

• 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:Covered Call Writing:Short Call and Long StockShort Call and Long Stock

-60

0

Future Stock Price

Pro

fit

Stock

Stock-Call

-Call

X0

Consider yourself informed!Consider yourself informed!

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

Protective Put:Protective Put:Long Put and Long StockLong Put and Long Stock

-60

0

Future Stock Price

Pro

fit

Stock

Put

Stock+Put

X

0

Bull Spread:Bull Spread:Long Call(XLong Call(X11) & Short ) & Short Call(XCall(X22))

-49.99

0.01

0

Future Stock Price

Pro

fit

Call(X1)

-Call(X2)

Bull Spread

X1 X2

0

Bear Spread:Bear Spread:Short Call(XShort Call(X11) & Long ) & Long Call(XCall(X22))

-50

0

Future Stock Price

Pro

fit

-Call(X1)Call(X2)

Bear Spread

X1 X2

0

Butterfly Spread:Butterfly Spread:Call(XCall(X11) – 2Calls(X) – 2Calls(X22) + ) + Call(XCall(X33))

-50

0

Future Stock Price

Pro

fit

Call(X1)

-2 Call(X2)

Butterfly Spread

Call(X3)

0

Straddles and StranglesStraddles and Strangles

• Put(X) + Call(X)Put(X) + Call(X) • Put(XPut(X11) + Call(X) + Call(X22))

-30

0

Future Stock Price

Pro

fit

Put

Call

Straddle

0

-30

0

Future Stock Price

Pro

fit

Put (X1)Call(X2)

Strangle

0

Option StrategiesOption Strategies

• There are numerous other trading There are numerous other trading strategies using optionsstrategies using options

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