Due date: Beginning of class 7
C.1 You have been given US $200,000 to invest in a portfolio of options. You enter the market on the last trading day before class 7. Prices are available on the internet, Bloomberg or the WSJ (see Data Sources listed in Appendix A). If you go over the US $200,000 then you can borrow up to US $50,000 at 7% (annualized). If you are under, then invest in a money market account at 5% (annualized). You must buy at least US $150,000 worth of options. If there are big differences, you will have to downsize/upsize your trades. You must close your portfolio no later than the trading day before the assignment is due.
Your $200,000 should be used either to purchase call or put options You may write covered calls up to a $100,000 premium received and placed in escrow for you (a money market account 5% annually). You may not write naked puts or write naked calls. You may spread options. This involves buying and selling options on the same stock. See Appendix A for information on retrieving option prices. See Appendix B for information on constructing option symbols.
Writing (i.e., selling) a naked call or put simply means that you have sold one of these options and therefore face substantial risk. For example, assume you write one call option on company X with a strike price one US dollar above the current stock price of US $50. Therefore, the exercise price of the call is $51. You receive the 100 times the quoted option price as a premium. Each option contract is written on 100 shares of the underlying stock. If the stock doubles in price to US $100 and the call option is exercised, you lose US $49*100 = US $4,900 minus the premium paid for the option. A covered option means that in addition to writing a put or call option you also buy (in the case of a call) or sell (in the case of a put) the underlying security. If you write a covered call option and the stock price doubles, then your gain on the underlying security offsets the your liability when the option is exercised. Note that you still bear risk in our example employing a call option. If the underlying stock price falls you could lose more money on the underlying security than you received in premium when writing the option. Similar logic applies to writing a covered put option.
To keep the problem somewhat realistic, to make sure that all people play both markets and to make sure no one goes broke, you are limited in your option purchases to a minimum expenditure of $100,000 on options.
You must build a spread sheet to keep track of your portfolio. I recommend that you keep your portfolio relatively simple -- if you buy 25 different options the accounting will be quite difficult.
If it turns out that your options do not trade on the liquidation date, you can calculate the price using the Black-Scholes model (See Option Dynamics for a Java version of the model), using the estimate of implied volatility from the last day the option traded. You are not allowed to take an unreasonable position -- e.g. spreading more options than underlying stock available. If you want to make a big trade, then you must check how much stock is outstanding (on bloomberg, [symbol] DES [go]) and you are restricted to no more than 10% of that, for your options position. I also reserve the right to revise unreasonably large trades downwards.
To initiate a trade, use the following TRADE FORM