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Investing 101

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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  1. Investing 101 Lesson 5 Options

  2. 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

  3. 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)

  4. 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 • …

  5. !!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!

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

  7. Review! • What is the SML? • What is CAL? • What is CAPM? • What is Beta?

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

  9. 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

  10. 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

  11. 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

  12. 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

  13. Call Option – Long max(0, ST – X) Put Option – Long max(0, X – ST) Possible Payoffs at Expiration

  14. Call Option – Long max(0, ST – X) – Ct Put Option – Long max(0, X – ST) – Pt Possible Profits of Options: Long Positions

  15. Call Option – Short Ct – max(0, ST – X) Put Option – Short Pt – max(0, X – ST) Possible Profits of Options:Short Positions

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

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

  18. Covered Call Writing:Short Call and Long Stock

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

  20. Protective Put:Long Put and Long Stock

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

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

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

  24. Put(X) + Call(X) Put(X1) + Call(X2) Straddles and Strangles

  25. 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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