introduction to options no format
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Jack Farmer
Introduction to Options
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Introduction to Options
Basic Option Positions
Intuitive Option Pricing
Option Premium
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Basic Option Positions
Intuitive Option Pricing
Option Premium
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Basic Option Positions:Long Forward
Obligated to buy
shares at an agreedprice at a futurepoint in time.
No cost upfront.
Makes money whenthe share pricerises.
Loses money when
the share price falls.
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P&L
Share Price +0
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+
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Basic Option Positions:Short Forward
Obligated to sell
shares at an agreedprice at a futurepoint in time.
No cost upfront.
Make money whenthe share price falls.
Lose money whenthe share price rises.
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P&L
Share Price +0
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+
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Basic Option Positions:Long Call
The right to buy the
share at an agreedprice at a future pointin time.
Pays a percentage ofthe share price up front
(premium). Makes money as the
share price rises abovethe strike price.
Loses premium paidwhen the share price isbelow the strike price.
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P&L
Share Price
+
0
-
+
Strike Price
Breakeven
Loss
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Basic Option Positions:Short Call
Obligated to sell shares
should the long callchoose to exercise.
Receives a percentageof the share price up
front. Loses money when the
share price rises.
P&L equal to premium
when the share pricefalls.
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P&L
Share Price
+0
+
-
Breakeven
Strike Price
Gain
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Basic Option Positions:Long Put
The right to sell the
share at an agreedprice at a future pointin time.
No obligation.
Pay premium up front. Makes money when
the share price falls.
Loses premium when
the share price rises.
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P&L
Share Price
+0
+
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Basic Option Positions:Short Put
Obligated to buy
shares should thelong put choose toexercise.
Receives premium up
front. P&L equal to
premium when theshare price rises.
Loses money whenthe share price falls.
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P&L
Share Price +0
+
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Basic Option Positions
Intuitive Option Pricing
Option Premium
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Intuitive Option Pricing:Pegboard Game
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0 0 0 0 00 0 100 200 300 40 8050 9060 10070
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Intuitive Option Pricing:Rules
Earn the money shown on the tube into which
the ball drops Drop the ball from anywhere on the board
Pay to drop the ball depending on where you
choose to drop it
How much should each drop cost?
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Which drop should cost more?
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0 0 0 0 00 0 100 200 300 40 8050 9060 10070
Up at the top in
the middle of the
game?
In the middle of the
game both vertically
and horizontally?
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Time to Vote
Up at the top in the middle
In the middle both vertically and horizontally
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Drop in Middle Halfway Down
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0 0 0 0 00 0 100 200 300 40 8050 9060 10070
In the middle of the
game both vertically
and horizontally?
Drop 1,000 balls
2 18
70
164
2 46 246
164
70
18 2
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Weighted Average Payout
Count Payout Cost Wtd Avg
2 0 0 0.00
18 0 0 0.00
70 0 0 0.00
164 0 0 0.00
246 0 0 0.00
246 10 2,460 2.46
164 20 3,280 3.28
70 30 2,100 2.10
18 40 720 0.72
2 50 100 0.10
1,000 8,660 8.66
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Price to Drop in Middle
Average payout using binomial probability is 8.66
To cover expected losses, game owner has tocollect at least that much
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Drop in Middle at Top
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0 0 0 0 00 0 100 200 300 40 8050 9060 10070
Up at the top in
the middle of the
game?
0 0 0 3 7 22
52
96
144 176 176
144
96
52
227 3 0 0 0
Drop 1,000 balls
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Weighted Average Payout
Count Payout Cost Wtd Avg
3 0 0 0.00
7 0 0 0.00
22 0 0 0.00
52 0 0 0.00
96 0 0 0.00
144 0 0 0.00
176 0 0 0.00
176 10 1,760 1.76
144 20 2,880 2.88
96 30 2,880 2.88
52 40 2,080 2.08
22 50 1,100 1.10
7 60 420 0.42
3 70 210 0.21
1,000 11,330 11.3318
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Price to Drop in Middle at Top
Average payout using binomial probability is
11.33 Why should it cost more than further down?
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Ball Drop Cost Along Middle Line
The cost of dropping a
ball rises as you move upthe middle line
Can you explain why?
Rows Cost19 11.33
17 10.82
15 10.34
13 9.86
11 9.24
9 8.66
7 7.985 7.18
3 6.25
1 5.00
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Which drop should cost more?
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0 10 20 40 6030 50 10070 11080 12090 130 170140 180150 190160
On the right at the
top?
On the right in the
middle?
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Which drop should cost more?
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0 10 20 40 6030 50 10070 11080 12090 130 170140 180150 190160
On the right in the
middle?
2 18
70
164
246 246
164
70
18 2
Drop 1,000 balls
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Weighted Average Payout
Count Payout Cost Wtd Avg
2 50 100 0.10
18 60 1,080 1.08
70 70 4,900 4.90
164 80 13,120 13.12
246 90 22,140 22.14
246 100 24,600 24.60
164 110 18,040 18.04
70 120 8,400 8.4018 130 2,340 2.34
2 140 280 0.28
1,000 95,000 95.00
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Price to Drop on Right in Middle
Average payout using binomial probability is 95
This is the average of the values in the reachablerange
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Which drop should cost more?
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0 10 20 40 6030 50 10070 11080 12090 130 170140 180150 190160
On the right at the
top?
0 0 0 3 7 22
52
96
144 176 176
144
96
52
227 3 0 0 0
Drop 1,000 balls
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Weighted Average Payout
Count Payout Cost Wtd Avg
3 30 90 0.09
7 40 280 0.28
22 50 1,100 1.10
52 60 3,120 3.12
96 70 6,720 6.72
144 80 11,520 11.52
176 90 15,840 15.84
176 100 17,600 17.60
144 110 15,840 15.84
96 120 11,520 11.52
52 130 6,760 6.76
22 140 3,080 3.08
7 150 1,050 1.05
3 160 480 0.48
1,000 95,000 95.00
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Price to Drop on Right at Top
Average payout using binomial probability is still
95 What is going on?
Please take a moment and explain this to each
other.
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Ball Drop Cost on the Right
The cost of dropping a
ball does not change asyou move up the rightside.
Can you explain why?
For the price to rise, whatwould have to be thecase?
Rows Cost19 95.00
17 95.00
15 95.00
13 95.00
11 95.00
9 95.00
7 95.005 95.00
3 95.00
1 95.00
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Asymmetrical Payouts
The key lies with the payouts of 0
If no 0s are in reach, the price to drop stays thesame
Each additional tube higher is offset by the
additional tube lower +10 on the right means -10 on the left
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hi h d h ld
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Which drop should cost more?
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0 0 0 0 00 0 00 00 00 0 00 00 100
On the left at the
top?
On the left in the
middle?
Both drops cost nothing since neither can reach any payouts.
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Analogies to Options
Premium
Strike
Time
Volatility
Cost to drop ball. Game
owner is option seller. Boundary between 0 and
positive payouts
Height of drop (number of
rows) Bounciness of game: ball,
pegs, backing
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Basic Option Positions
Intuitive Option Pricing
Option Premium
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O ti P i B & S ll
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Option Premium:Buyers & Sellers
Call buyers Long shares
Own all upside in share
Unlimited gains
Can only lose premiumalready paid
Limited losses
Call sellers Short shares
Must pay all upside in share
Unlimited losses
Can only earn premiumalready paid
Limited gains
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O ti P i G l
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Option Premium:Google
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Source: Bloomberg
StrikesCallPrices
Expiries
Share
Focus on
O ti P i G l J 08 C ll
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Option Premium:Google Jan 08 Calls
On November 2, 2007
Google shares are$706.28
Strike of $700
American style exercise
Last trade at $49.00 percall
Call costs 6.94% of shareprice (leverage).
How much higher wouldGoogles price need to risefor a call buyer to breakeven?
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Source: Bloomberg
L i b t O ti L h Li
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Learning about Options on Lehman Live
LL: Equities
Products and Services Derivatives
Listed Derivatives
Option Class Materials
Class 1 Basics.ppt Definitions
Payoff Diagrams and Examples
Moneyness
Leverage Put-Call Parity
Class 2 Basics.ppt Put-Call Parity Revisited
Introduction to Delta
Introduction to Gamma
Volatility and Vega Effect of Time to Maturity
and Theta
Effect of Interest andDividend