FINANCIAL ENGINEERING CLUB TRADING 101

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1 FINANCIAL ENGINEERING CLUB TRADING 101

2 WHAT IS TRADING TRADING/INVESTING is the act of putting capital to use, by either buying or selling securities, for the purpose of gaining profits. Buy low, sell high

3 VEHICLES TO TRADE Stocks Options Futures Currency/Forex ETFs Mutual Funds

4 VEHICLES TO TRADE Stocks Options Futures Currency/Forex ETFs Mutual Funds STOCK (equities) is a type of security that signifies ownership in a corporation and represents a claim on part of the corporation s assets and earnings. New York Stock Exchange (NYSE)

5 VEHICLES TO TRADE Stocks Options Futures Currency/Forex ETFs Mutual Funds OPTIONS is a financial derivative that represents a contract sold by one party (writer) to another party (holder). Chicago Board Options Exchange (CBOE)

6 VEHICLES TO TRADE Stocks Options Futures Currency/Forex ETFs Mutual Funds FUTURES is a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price.

7 VEHICLES TO TRADE Stocks Options Futures Currency/Forex ETFs FOREX (FX) is the market in which currencies are traded. Currency Schedule: 24 hours a day Opens at 5pm EST Sun. Closes at 4pm EST Fri. Mutual Funds

8 VEHICLES TO TRADE Stocks Options Futures Currency/Forex ETFs EXCHANGE-TRADED FUND (ETF) is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. Mutual Funds

9 VEHICLES TO TRADE Stocks Options Futures Currency/Forex ETFs Mutual Funds MUTUAL FUNDS is an investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets.

10 INTEREST THEORY Time value of money Interest rate (r) : expressed as a percentage of the principle Example: Present value = $100 Annual discrete interest rate = 0.05 Time period = 10 years Future value after 10 years ( ) = $163.89

11 ARBITRAGE The possibility of a risk-free profit after transaction costs, by taking advantage of a price difference Example: Futures pricing with no arbitrage r = continuously compounded interested rate F = futures price S = current market price F = S e rt

12 WHERE IS THE MARKET? You don t need to work at a large firm to trade All you need is a computer and internet connection ThinkOrSwim (TOS) by TDAmeritrade

13 PAPER TRADING Want to test a trade without risking money? Real market hours Real market prices Real broker commissions Test, Learn, Improve

14 INTRO TO OPTIONS There are 2 types of options: Calls Puts

15 INTRO TO OPTIONS Buying a Call option gives you the right to BUY stock at a set price for a certain amount of time. Buying a Put option gives you the right to SELL stock at a set price for a certain amount of time.

16 OPTION PROPERTIES Underlying Strike Price Expiration Date Bid/Ask Each contract controls 100 shares of stock

17 BUYING CALLS If I buy a Call option in AAPL with a strike price of $50, then I have the right to buy 100 shares of AAPL at $50 anytime from now until the option s expiration date.

18 EXERCISING CALLS If AAPL stock is above $50 (for example $75), I could exercise the Call option for a profit. This means I could buy 100 AAPL shares at the Call s strike price of $50 and then sell them at the market price of $75 for a profit of 100*($75 $50)=$2500

19 BUYING PUTS If I buy a Put option in AAPL with a strike price of $50, then I have the right to sell 100 shares of AAPL at $50 anytime from now until the option s expiration date.

20 EXERCISING PUTS If AAPL stock is below $50 (for example $25), I could exercise the Put option for a profit. This means I could sell 100 AAPL shares at the Put s strike price of $50 and then buy them back at the market price of $25 for a profit of 100*($50 $25)=$2500

21 Options allow you to buy/sell stock at prices which the stock is not currently trading at.

22 NOTES When we buy Calls, we want the market to go up because we make money when the stock price is above our Call s strike price. (Bullish) When we buy Puts, we want the market to go down because we make money when the stock price is below our Put s strike price. (Bearish)

23 FREE MONEY?

24 Why don t I just buy a Call below the market or a Put above the market and immediately exercise it for an instant profit?

25 OPTIONS COST MONEY You must pay a debit in order to get the privileges of an option. In trading, where there is profit, there is risk. The problem with simply buying an option and immediately exercising it is that there is cost to buying an option that outweighs this possible profit.

26 SO, HOW DO I MAKE MONEY? A position s break-even point is the price that the stock must be beyond at expiration in order for the position to be profitable. When buying a Call, the break-even point is: Strike Price + Premium Paid When buying a Put, the break-even point is: Strike Price Premium Paid

27 CALL PROFIT $18 CURVE This curve details your profit at expiration as a function of the stock price. Your max loss of buying a Call is the premium that you paid for the option. Your max profit is infinite. $12 $6 $0 You make money when the stock price goes above (Strike + Premium Paid) -$

28 BUYING A CALL PROFITS IN 1/3 SCENARIOS Stock Goes UP If the stock moves up and beyond our break-evens, trade is profitable Stock Stays FLAT Lose the premium paid Stock Goes DOWN Lose the premium paid

29 BUYING A PUT PROFITS IN 1/3 SCENARIOS Stock Goes UP Lose the premium paid Stock Stays FLAT Lose the premium paid Stock Goes DOWN If the stock moves down and below our break-evens, trade is profitable

30 BUYING OPTIONS SUMMARY When buying an option, we pay a premium for the rights of the option The max loss of buying options is the premium paid for the option The max profit of buying options is theoretically unlimited Buying options profits in only 1/3 scenarios

31 Price of Call if stock closes at $ at expiration Strike $ $ $ $ $ $ $ $ $ CALLS AT EXPIRATION If a Call s strike is below the stock price, the value of the Call at expiration, will be: (Stock Price Strike) If a Call s strike is above the stock price, the value of the Call at expiration, will be $0.00

32 PUTS AT EXPIRATION Strike Price of Put if stock closes at $ at expiration 80 $ $0.00 If a Put s strike is above the stock price, the value of the Put at expiration, will be: (Strike Stock Price) If a Put s strike is below the stock price, the value of the Put at expiration, will be $ $ $ $ $ $ $ $19.00

33 Calls Strike Puts OPTION CHAIN $ $0.00 $ $0.00 Calls sit on left side Puts sit on right side Strike increases from from top to bottom This chain is for options at expiration where the stock closed at $101 $ $0.00 $ $0.00 $ $0.00 $ $4.00 $ $9.00 $ $14.00 $ $19.00

34 Calls Strike Puts OPTION CHAIN $ $0.00 $ $0.00 $ $0.00 Calls below the stock price and Puts above the stock price are called In The Money (ITM) $ $0.00 $ $0.00 $ $4.00 $ $9.00 $ $14.00 $ $19.00

35 Calls Strike Puts OPTION CHAIN $ $0.00 $ $0.00 $ $0.00 Calls above the stock price and Puts below the stock price are called Out of The Money (OTM) $ $0.00 $ $0.00 $ $4.00 $ $9.00 $ $14.00 $ $19.00

36 Calls Strike Puts OPTION CHAIN $ $0.00 $ $0.00 Strikes right around the stock price are called At The Money (ATM) In this case, the 100 and 105 strike prices for both Calls and Puts $ $0.00 $ $0.00 $ $0.00 $ $4.00 $ $9.00 $ $14.00 $ $19.00

37 Calls Strike Puts OPTION CHAIN (DETAILS) $ $1.96 $ $2.23 If there is time left until expiration, OTM options will have a price This is because they have a probability of expiring ITM There s a chance these options will become profitable $ $2.52 $ $2.86 $ $3.24 $ $6.15 $ $10.56 $ $15.49 $ $20.49

38 Calls Strike Puts OPTION CHAIN (DETAILS) $ $1.96 $ $2.23 $ $2.52 This option chain was taken from SPY on 9/3/14 after the close with 44 Days Till Expiration (DTE) $ $2.86 $ $3.24 $ $6.15 $ $10.56 $ $15.49 $ $20.49

39 Calls Puts OPTION CHAIN (DETAILS) Bid Ask Bid Ask Each option, like any product has a Bid/Ask spread. Bid: Highest price a buyer is willing to buy Ask: Lowest price a seller is willing to sell

40 THE OTHER SIDE SELLING OPTIONS

41 SELLING CALLS If I sell a Call option in AAPL with a strike price of $50, I take in a net credit equal to the price of the option. Three things could happen from here

42 SELLING A CALL PROFITS IN 2/3 SCENARIOS Stock Goes UP If the stock moves up and beyond our break-evens, the trade has unlimited loss potential Stock Stays FLAT Collect the premium as profit Stock Goes DOWN Collect the premium as profit

43 SHORT CALL $6 PROFIT CURVE $0 Your max profit is the credit you received for selling the option -$6 Your max loss is infinite You make money when the stock price stays below (Strike + Credit Received) -$12 -$

44 SO, HOW DO I MAKE MONEY? When selling a Call, the break-even point is: Strike Price + Credit Received When selling a Put, the break-even point is: Strike Price Credit Received

45 EXERCISE & ASSIGNMENT When buying options, we have the right to exercise those options whenever we wish (once they go ITM) However there s a party on the other end of this action as well, the person that sold the option to the buyer If I sell an option that goes ITM (where we don t want short options to be), there s the risk of assignment

46 EXERCISE & ASSIGNMENT The buyer of a Call option has the right to buy 100 shares of stock at the strike price The seller of that Call option has the obligation to sell 100 shares of stock at the strike price if the buyer chooses to exercise his option

47 EXERCISE & ASSIGNMENT The buyer of a Put option has the right to sell 100 shares of stock at the strike price The seller of that Put option has the obligation to buy 100 shares of stock at the strike price if the buyer chooses to exercise his option

48 ASSIGNMENT Say I sell a Call option with a strike price of $50 If AAPL stock is above $50 (for example $75), I could be assigned the Call option for a loss This means I would have the obligation to sell 100 AAPL shares at the Call s strike price of $50 and then buy them at the market price of $75 for a loss of 100*($50 $75)=($2500) Similar mirror story for the Put side

49 STRATEGIES Buying a Call Unlimited profit potential Limited loss potential Selling a Call Limited profit potential Unlimited loss potential Buying a Put Unlimited profit potential Limited loss potential Selling a Put Limited profit potential Unlimited loss potential

50 STRATEGIES Bullish Bearish Buy Buy Call Buy Put Sell Sell Put Sell Call

51 BUY OR SELL? Buying options is like betting on what direction the stock will move, by how much it will move, and the time it will take for that move to take place Selling options is like betting where the stock won t move to and for how far into the future it won t move there

52 BUY OR SELL? Buying options profits in 1/3 scenarios Selling options profits in 2/3 scenarios

53 THANK YOU

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