Alan Cring Productions in association with Emergent Light Studio presents
the Illinois State Collegiate Compendium, academic lectures in business and economics.
This is business finance, FIL 341 for autumn semester 2024.
Today, financial options. See, you have to sound real formal, dignified in fact.
Actually, I learned that from Apple iTunes. I think I was the first or one of the first education podcasters
they ever took in Apple years ago. And boy, they let me know everything has to be professional.
The music, the serious voice and all that kind of stuff. And I'll be darned if they didn't pick me up.
And they've kept me ever since. God knows why. But anyway, I'll talk more and I'll show you on Monday
how these podcasts and RSS work. But let me get... Now, we're going to look at the numbers first.
But a little bit of caution. Financial options is really... It can be really mathematical.
And I'm talking at the PhD level of mathematics. It's that serious.
You're using some pretty high powered... A form of calculus called stochastic calculus.
And at the undergrad level, we have a course, FIL 347. So if this excites you, you can take FIL 347.
Sometimes I actually teach that course because that's one of my specialties is options.
However, at the undergrad level, there are two ways you can take it.
You can introduce them to the hellscape of the math and go from there.
Or you can take a more practical approach. Here's what we do with options.
And just bring up the terminology and not so much the math behind it.
And that's the approach I'm going to take with this chapter five.
Is show you a little of the math, maybe scare you a little bit, and then from there we'll say,
okay, now let's talk about what these can do in a practical environment, in a corporate environment,
as well as an investment environment. The thing is that for investment purposes,
a lot of people jump into options on the speculative side.
They're just jumping in and see if they can make a quick buck.
But there is the other side of it where you are doing that for very specific hedge creating purposes.
And corporations use them all the time for hedging their operations.
And that's where it is important in a corporate finance class,
which this is largely a corporate finance class for you to know what they're all about.
But before I get too much into that, we look at the numbers today and we have a really odd day going on.
You notice that there was this bullish surge coming out of the bell and it rose,
and then it just decided it was going to head to the toilet.
It just started plowing down, and then just in the last, within the past 30 minutes, it bounced.
The traders saw that it was hitting back to zero and it was going to go negative,
and they just turned it around and it bounced as you can see visually on the spark charts.
It dipped a little in the negative territory and then it turned around.
Here's the thing, the Fed, of course, there's an interest rate cut coming,
and so that seems to indicate that the Fed with all of its data sees us going into a soft landing.
In other words, that difficult time we had during the lockdown.
Actually, the recession happened before the lockdown,
but crawling out of it was not normal because of the lockdown.
If you look at the data, 2020 was when we actually dipped into a recession,
a technical recession, two consecutive quarters of negative GDP growth.
Then after that, we should have just come back out, but we didn't because of the lockdown.
We've been mired in the after effects of the lockdown for quite some time.
We are recovering, and so there is this sense that the Fed did it right.
They thwarted the inflation that was caused by printing a lot of money
to keep the economy going during the lockdown, and then they clawed it back,
but they didn't claw it back so rapidly that we fell into a secondary recession.
So the fear that there is a black swan coming, the hell is about to happen,
that is not on traders' minds.
You have some that are apocalypse freaks and all that, but most traders see it as,
okay, we're going to make it out of this, we're going to grow.
It might not be spectacular growth, but it will be sustainable growth
coming into the rest of this year and into next.
The real thing that we're looking for right now is what's going to happen in the Christmas season.
And that's on every corporate mind, investor's minds.
Are we going to have a good Christmas season?
Is there going to be robust buy?
So make sure you get your wish list for Santa and fill out a whole page
because you're helping the economy the more you ask for from Santa Claus.
But notice here, I'm going to take you over to the S&P 500
and just have a quick look at what's happening with the trading of those big 500 stocks.
As you can see, it is really weak.
Typical day, 3.8 billion shares, we're half way, more than half way through the day
and we don't even have half of that volume.
It's a really quiet day.
The investors just aren't ready to jump all in.
There is a generally positive sentiment, but that sentiment is tempered by the question,
when do we really see the growth begin to happen at a good rate?
3% growth of GDP, all of that, 3.5%.
When is it going to happen?
They don't see it happening yet.
The numbers aren't supporting a robust expansion yet.
So that's why traders are staying off the playing field.
Now, something that you can look at from this that helps supplement it, first of all.
Now, notice there is just essentially a flatness right now.
It bounced a little bit, but the markets are just waiting to see what happens next.
And we do have an issue.
Crude oil is showing a little bit of life.
It's trying to find that trading band again,
that 72 to 79 that it had for so long earlier this year.
It's looking for that trading band one more time.
And the reason I explained this on Monday, there is concern in the Middle East.
And overnight, I don't know, I just got a sense that there was a little more concern than there had been,
that we're going to have a widening of the low-level combat situation that's in the Middle East right now.
We're just waiting to see what Israel is going to do to the Houthis in Yemen.
And we're going to wait and see if the Iranians step in to help and all that.
And of course, there's a little worry over in Eastern Europe about Putin,
but we've kind of gotten to the point where we figure that he doesn't have the will to do anything but threaten a nuclear response.
He's not, apparently he's crazy, but he's not stupid.
Now notice that gold has fallen. That's good news.
Because that just tells us that the gold bugs are not excited about some apocalypse happening.
Their data is not pointing to some grim future.
So there's a little bit of a sell-off in gold, and that's good news.
We'd love to see gold get below $2,500 again per ounce, but it's pretty good where it is.
Now, here's the thing that is a little bit concerning.
Bond yields are up.
Well, if the Fed is cutting interest rates, why are yields turning the other way?
Well, one thing that means that yields are up, so bond prices are down. Chapter 4, bonds.
Yields are up, so prices are down.
So there's a sell-off in the bond market, but clearly that's not translating into a buy frenzy in the equities market.
So that's more evidence that the money that is out there is just going into money markets, going into cash.
The wait and see is driving us all crazy.
Now, here we had an interesting situation, but right now the dollar is depreciating against both the euro and the British pound.
That would say that the interest rates in the United States are weakening.
There's no question that that's the case.
So then the question is, why are bond yields rising?
If the general sentiment is that the interest rate environment of the United States is weakening against the interest rate environment of Europe and England and Japan probably,
I haven't looked at that yet, why is the U.S. dollar doing what it's doing?
Well, if our interest rates are going down, that's why the dollar would be weakening.
But we're seeing over here today that yields on bonds are rising.
So then it comes to the question, how could those two happen at the same time?
The next factor in currency exchange rates, interest rates are a big factor in appreciation,
relative interest rates are a big factor in appreciations and depreciations.
But the next factor is general relative economic growth.
If the U.S. economy is growing at a slower pace than the European Union economy,
then the euro will strengthen against the dollar.
Put another way, the dollar will weaken against the euro.
So the explanation that we could probably reach for is that there is a sentiment that the Europeans and the British are probably,
the expectation is that they are growing at a slightly more robust rate than the U.S. economy.
That would be about the best other explanation of why there would be that weakening.
Now there's one more that could possibly be in play.
As a currency of a country, more of the currency is printed, that weakens that currency.
Okay, well the Fed has announced that it is easing up on interest rates,
which is the same thing as saying that the Fed is opening the money supply.
So if that is really what's bothering the currency traders,
that would explain why the dollar is weakening against the euro.
We're just starting to print more money, which weakens our currency against the currencies of our trading partners.
These are the chains of logic.
Now do I expect you to be able to do this on an exam yet?
No, I don't.
I'm just walking you through the logic of how this works.
And you notice today I slipped in that next factor in what can drive currencies, interest rates.
Now in 341, as I said, it's mostly a corporate course.
There's a lot of investment in it, but it's a corporate course.
Why would you care about that?
Because you're going to live in a very, very global corporate world
where those currency exchange rates are going to be something that you should at least have a good sense about.
You might even need more than a good sense about it.
But if that's what you want, you can take a really good sense.
You can take our course, FIL 344, I think it is, International Finance.
I teach that. Stella teaches that.
And it's a really fun course.
Math isn't that bad.
But taking it over here just really quickly, Nikkei, every blessed day,
they come out of the box on the opening bell in Tokyo in a pissy mood.
And it just slides down.
And as you can see, another day, like the typical day over in Tokyo,
it starts out just being in a bad mood, drops and drops,
and then it stops being grumpy and it just floats and maybe rises a little bit.
But it's just sort of like they're in a funky mood from most days right now.
Now, Britain opened with a strong pop.
But then from there, it just sort of floated and then finally gave back
some of that first opening bell gains by the end.
They're still trading over there for a few minutes anyway.
But I mean, as you can see, something was exciting overnight.
It popped the stocks on the opening in London.
And then just from there, there was no more information,
bullish information and really not much bearish information.
But about a little after lunchtime over there, the bears did take hold
and drop at some, but whatever that means.
But coming back over here, as you can see,
we're in sort of a standing, still kind of mode right now.
Let me very quickly focus on some sector stocks.
Look at telecommunications, for example, AT&T.
We will look at them first.
Down hard today.
They had a decent day yesterday.
So something is pissing off investors about AT&T.
So we would say, well, is that just AT&T or is that more broadly based in telecom?
Well, there's Verizon.
It's down as well a strong amount.
So you can see that if you begin to look a little more granularly at what's
happening in the stock market, that is not necessarily what's going on sector
by sector.
In this case, the telecom sector seems to be having a very bad day,
a really sour day.
So there's something upsetting investors about that.
Now, let's go over to oil, MRO.
Up.
And of course, crude oil prices are up.
So that should, their raw materials are up,
but that means they can pass along some price increases.
And so that's a good news for those who are in the oil.
Looking at another one, Conoco, Phillips.
And I can never remember this trading symbol number, how hard I tried.
CLP.
Right.
It's up.
So if you look at a closer level, the stock market, that's one thing.
But if you look sector by sector, you will see a lot of things more interesting.
On a day like this when the market is just sort of, the stock market overall is
just sort of sitting there looking stupid, you see that if you look at industry
level, you'll see some different things happening, which kind of give you more
information.
Go over to war stocks.
Lockheed Martin.
Down today a little bit.
Well, that's good news.
No draft for you guys.
And if you do get drafted, I do expect you to send pictures back, you know,
selfies in combat.
That would be really cool for my scrapbook.
Another one in that sector too, Halliburton.
It's a war materials company.
Ooh, that's up.
That's interesting.
Halliburton is a company that provides supplies globally to conflict areas.
It's sort of a background company.
Most people have never heard of it.
But at the same time, it kind of reads a pulse of the underlying flow of
militarism across the globe.
They would supply our troops with their chow and all that in Iraq, Afghanistan.
They provide food and resources, new uniforms, you name it.
They can do about anything to keep an army on its feet.
They're providing our things for our forward positions in countries you've
probably never heard of.
It's kind of one of those reach under the waves and see what the current is kind
of stocks if you're into military industrial types of environments.
It's something to look at.
Now, one more sector, just obviously automotive is one of mine.
So Ford, it's up very strongly today.
It had taken some butt beatings earlier in this month and last.
But something is good.
Now, GM, see if this is a trend in the industry today.
And it is.
The auto stocks are up.
So what I've tried to do here, and I had intended to do this last week, is to
show you that, yeah, there's the overall stock market, but we don't really trade
much in that.
We go for not some perhaps individual companies, but in our world in
professional finance, we kind of are interested in sector, telecom, war,
automotive, basics, consumer basics.
So we could look over here and look at Pfizer, PFE.
And it's down.
So we could look at another stock that's in consumer and medical stuff, Johnson
and Johnson.
And it's down.
You notice that there are patterns that are emerging if you know how to look.
Instead of just shotgunning looking at stocks the way I sometimes do, and I
quite admit that I do that.
But if you begin to look on a more professional level at stocks, I kick my
keyboard out.
I think I just did.
Okay.
So there's that to pay attention to.
And if you decide that you're going to be some kind of a trader or work in a
corporation, you will probably be more interested in sectors than you will in
individual stocks.
Now, without further ado, let me take you into the world of options.
And I'm going to do this in two parts today, mostly just terminology, not math.
I'll try to avoid the math, but I'll sneak it in here.
Now, I will tell you one other thing, too, is for years and years, professors and
some professionals out there, traders, have been using Excel to do options
calculations instead of having to do integrals and derivatives and all that
kind of insane stuff.
It started probably 15 years ago.
There were some templates that were being passed around in these message boards
before there was social media and all that, these message boards that were for
professionals, academics and others, sort of like the pre-Reddit subreddits of the
pre-Reddit era.
And there were these, we would get them, and then we would do a tweak.
Hey, we'll do this, and it might make it look more interesting.
It might be easier to see where to put your numbers in.
And so I have those, and I'm going to upload some of those spreadsheets so that
you can actually price options and you can do some pretty impressive things that
would be otherwise really not that easy to do.
For example, I don't know, have you heard of the Black-Scholes options pricing
model?
It is the holy grail of options developed by Black-Scholes and Merton back in the
1990s.
No, it was in the 1980s.
As a matter of fact, I was a Ph.D. student when it came out.
It's a monster equation with two integrals in it and unbelievable functions buried
hidden in it.
And so this is the way we actually calculate options in the real world.
Now, a couple of other models have come out since then, and you can choose which
one.
They usually give you about the same results.
But they are theoretical models, and they are the same equations that you would
find in some pretty heavy-duty physics.
And that's how we price options.
Now, everything is about pricing options because you see, in our world, one thing
that we are always looking for is an option that is not priced correctly.
And if it's not priced correctly, it will correct itself very quickly because
everyone will be using these options pricing models to find the correct price.
And when the price deviates from that, the traders jump in and arbitrage it away
very rapidly.
So that's sort of a backdrop.
But these Excel sheets do it for you.
Now, they're Python.
You can write these in Python, too.
But the elegance of Excel is that most of you are pretty comfortable with Excel.
You know how to put numbers in.
You don't have to write any fancy code.
It's been done for you.
And as I said, I'm going to upload a couple of these sheets for you so that you
can do the pricing very quickly.
Now, the one interesting thing is that options can...the Black-Scholes options
pricing model and the other ones that are like it, they have a couple of
assumptions that don't necessarily actually occur in the real world.
But you can get their prices, but it's god-awful hard.
This Excel sheet can do it for you.
However, you can't be using a Chromebook or even a Mac might fall apart.
I won't ever hit you with what's called the binary model.
I'll show you a binary model, but I will never hit you because for these ones
that don't abide by the options pricing model assumptions of Black-Scholes,
you have to do it in three yards in a cloud of dust.
You put in the numbers.
You get a number out.
Then you take that number and put it back in, and you get it out again.
And only over about 500 iterations of this will you get about the theoretically
correct answer.
So, but this Excel sheet does it.
But I caution you, I'll put them up here, and they can really take a while on an
older computer to run through the Excel calculations.
That's the backdrop.
Now, let's start.
The book's approach is a little different from mine, but I'm going to put up these
PowerPoints anyway just as a conversation starter.
And I apologize for this because I should have had this ready when I got up here.
Okay.
Now, the first thing is that the terminology is very standard, although there is a
shorthand version of some of these things that traders use.
And I will use those terms.
I'll introduce them.
For example, exercise price, you would hear me say strike or strike price.
I'd probably just say strike is.
Okay.
The underline, that's referring usually to the stock that's backing the option.
And there are other terms too.
Expiry, what day does the option expire on?
Settles to.
Now, in all of my time, options settled to cash.
However, I found out the hard way that brokerage houses are now doing a nasty,
nasty trick.
They're settling to the underline.
And that means that it costs you a fortune if you hold it to the very end.
But let's just start with some basic terminology, financial options terminology
for you to see.
And I'm going to ignore that.
An option is the right but not the obligation to buy or sell a stock at a specific
date.
Do I just have a small stroke or does that turn off?
Try that again.
There.
Now, here's what that means.
An option is a contract.
A contract.
Now, this contract, if I buy, let's say, a Ford option, the first thing would be,
is it a call or is it a put?
A call option gives you the right to buy a stock.
A put option gives you the right to sell a stock.
In either case, the contract specifies a guaranteed price at which you can buy or
sell.
That guaranteed price is the strike price.
So I'd buy one Ford call option striking at 10.
What that would mean is that I have the right but not the obligation to buy 100
shares of Ford at $10, regardless of the actual price of Ford.
Again, I buy a call option, a Ford call striking at, with a strike price of 10.
That means that I can buy Ford stock at $10 a share, regardless of what Ford's
actual price is.
Now, the Ford stock is called the underlying.
It is the basis of the contract, the underlying asset.
So in other words, if Ford goes to $25 a share, I have the right to buy it at 10.
That's my strike.
I got the contract.
Now, the writer, I am the purchaser.
The writer is whoever wrote this thing and sold it to me.
Now, the next thing.
I buy a one Ford call striking at 10.
Well, let me put it this way.
I buy a September 20, a September 20 Ford call at striking at 10.
In other words, the date of expiration is the 20th of September.
That's when it's over.
Now, I have the right but not the obligation to buy Ford at $10.
Suppose Ford goes to $18.
Well, I sure as hell am going to buy that option, exercise, I'm sorry, I'm going to
exercise my option and say, you who wrote me that option, I want 100 shares of Ford
at $10 and the writer must cough up those 100 shares.
So theoretically, and the way it used to be done, all I'd get is $8.
$18 minus the strike.
It would settle for cash.
Now they make you buy it at $10 and then instantly sell it for one reason or another.
So now we have I bought a September 20 call striking at $10.
So that's the first part of it.
Now, what's the price of it?
Suppose that Ford, oh, by the way, let me finish that.
Suppose that Ford has fallen to $8 a share on the 19th.
I just walk away, I say kiss my ass because I have the right but I don't have the obligation
to buy it at $10.
So Ford finishes out of the money below $10, I just walk away.
I let the option expire worthless.
It's out of the money.
But if it is $18 or $15 or $13 or whatever, it's in the money and I exercise my
option.
I exercise the right to buy it at $10.
So it's striking at $10 and all that's going to happen is if on the expiration date,
the price of Ford is below $10, I just walk away and say kiss my ass.
If it finishes the 20th above $10, I say hey, I'd like the difference between the strike
price and the price of the underlying.
So options are just pure bets.
If it finishes in the money, you make money.
If it finishes out of the money, you walk away.
But, of course, you have to pay for the option.
The option price is something that you have to, you're going to pay the rider.
And see, riders of options, the rider of that call, he is going to take money up front.
And he is betting that Ford will finish out of the money and I'll just walk away.
That's the side for riding and it's risky AF to do that.
Now there are two types of options a rider can do.
A rider can do a covered call, which means he actually has a stock and he just cashes
some of it to satisfy me.
And then there are naked, which means that he don't got that stock so he's just going
to have to pull it out of his wallet.
Now let me take this, you want a little journey here.
And I do this in a bass-ackwards kind of way, but I'm going to pull up Ford here.
Options.
Yeah, these are the 20s.
Now these are called options chains.
Now these are not, I would not trust these prices at all for these.
I would pull up a professional platform.
I use Thinkorswim by TD Ameritrade Schwab.
But okay, let's have a look here.
Now we go up here.
Now Ford right now is trading at 10.90.
So you can see all the blues, they're in the money right now.
Expiring, these are expiring on the 20s, and all of these are in the money.
Because if it expires today, I win.
And if you go down here, the first one that's out of the money is, what the heck is a strike at 10.82?
Whoever heard of that?
Usually they're in 50 cent or dollar increments.
That's a weird one right there.
But you see this one, this one's just out of the money right now.
Ford is just a little below $11 at 10.90.
So this guy is just out of the money.
Not much, but, and by Friday when it expires, it might be in the money.
So there's that.
So if I would, my own personal trading, I trade right around the money.
That way I'm not hoping to God something spectacular happens.
But as you can see now, they have bid and ask, just like stocks do.
So now if I wanted to buy, let's say that 11, I would pay $9.00.
Because everything is up for $100.
So I would pay $9.00.
If I wanted to write an option, I would get $10.00.
I wouldn't do either one of these.
So this option, you will win if by Friday Ford reaches $11.00 and,
I'm sorry, I'd buy it at 10 cents, and $11.10.
I'm sorry, $11.00.
No, 10 times, yeah, 10 times $1.00.
My ass.
Yeah, $11.00.
It'd have to reach $11.10.
See, because I'm going to spend 10 cents for each share to get this option.
So it doesn't, it's in the money at 11.
But I don't start making money until it gets above $11.10.
Because the option cost me 10 cents.
Do you follow that?
So just because it's in the money, you've still got to crawl out of the cost of the option,
the price of the option.
And in this case, the price to buy it is 10 cents.
But, I mean, if you're bullish on Ford, this is a very tight option.
It's expiring very soon.
Now let me take you out.
Let's look at the same option, but with an expiration date a week from the 20th.
That would be the expiration on the 27th.
Now let's look at that same one again.
It's 18 cents, not 10 cents.
Here's the reason.
There's a greater probability that Ford will make it above $11.00 in two weeks than there is in one week.
That is called theta.
Theta decays as you get closer to the option's expiration date.
So let's look even further out.
Let's look at the options chain out here on the fourth.
Here's 11.
Do you see it?
25 cents, because there's an even greater probability that it's going to get into the money in three weeks.
I thought that was a closing bell.
Wait a minute, I haven't done my trade yet.
Okay, do you follow?
In other words, the call price is going to increase as you've got more time for the stock to get to the money.
Well, you might say, well, wait a minute, fat boy, there's also more time for it to fall out of the money.
But why do I care?
If it's one penny below $11.00 on the expiration date, I'm zero.
It could fall to freaking $4.00 and I'm still zero.
The downside is actually not anything because only upside potential is being priced in the theta, the growth, the potential for a win on the stock.
As you buy these options farther out, you've got more chance to win, but you're going to pay a price for that bigger chance to win.
That's how options work.
Now, in a case like this, I mean, and another thing that will affect it is the volatility of the stock.
I mean, stocks that have higher volatility tend to have higher options prices.
The options have higher prices because there's more chance that it could bounce into the money and you get rid of it real fast.
That's all there is to that.
And I'm kind of ignoring put options here.
Put options are just the opposite.
You're betting that the stock price will fall.
So let's look at the put options for the options chain for the October 4, Ford puts.
Now, you notice that you're in the money the opposite way.
So in other words, $11 is in the money because Ford hasn't made it to $11.
You're betting that the stock will drop in price.
And if you're bearish on a stock, you buy put options on it because you make money if the stock drops downward.
In a case like this, and notice that they get pretty expensive pretty quick because Ford is at $10.90.
So $11.50 strike, you're in the money big time.
And the deeper in the money you're getting deeper in the money, the higher the put strike is because the Ford's already below those prices.
So you're definitely going to win.
It's only here that you begin to get some fun happening because Ford is $10.90.
So a $10.50 put is out of the money.
This is a bet that Ford will fall below $10.50 per share.
And it would cost you $0.14 times $100 or $14 for that one.
But this is almost like fun money.
For the typical amateur, this is just casino.
You just grab one and see if I'd buy a Ford put while I think it's going to drop in price.
So I'd buy a Ford put, a $10.50 strike price put expiring on October the 4th.
And let's see if it falls.
Like I said, it's just a casino bet for most amateur options traders.
But let me tell you something I want you to think about behind the scenes here.
Let's look, let's go back to the front screen of Yee-Haw.
And let's look at the S&P 500, the Spider.
That's an ETF.
Now, is that really?
No, I didn't want that one.
SPY, I wanted the, there it is, that's the one I want.
There we go.
This is the underlying.
It's an ETF, but it's an underlying.
It's a stock for all intents and purposes.
And I am investing in this because I want to ride the market up.
If we have a black swan, I am scurrued because I had my whole life savings in my S&P 500 portfolio.
Well, you know what?
If you come to me crying that you were screwed,
I played a tiny little violin because I said,
you know what you could have done?
Suppose that you think it's a black swan if the Spider falls below, let's say, $480.
Well, I can go over here to the options and I can reach out here.
Let me see what I can do.
Let's go out here to October the 18th.
And I'm going to go down here to the putz.
I'm going to go down to the putz for God's sake.
Have I missed the putz?
Where are the hell are the putz?
There they are.
Well, look at this.
Do you see how I can hedge?
This is called a protective put floor.
That's not that expensive to buy a protective put floor.
So that if the Spider does fall through the earth, well, I'll lose on the Spider,
but I will win on the put option because it's a bet on the fall.
Now, I wouldn't buy it close to the money.
Those things get damn expensive out here.
But out here, if you just want to hedge against, let's say,
if you wanted to hedge against the S&P 500 falling below $525,
well, that would cost me $198 for an insurance policy.
That's what it is.
It's just an insurance policy.
Now, it doesn't kick in until the market falls below $525.
So you're going to lose a little in your portfolio.
It's like a deductible on your car insurance.
But at the same time, protective put floors,
if you really are concerned about having something bad happen to a stock or to a portfolio,
buy some freaking way out of the money putz.
And then if that really bad thing happens,
you've lost money on the stock by it collapsing, but you make money on the putz that you brought down.
That is hedging.
That's what we mean by hedging.
It's hedging a risk.
You know, you're going to pay.
It's like an insurance premium.
You pay insurance on your car.
You probably won't have an accident.
But if you do have an accident, the insurance covers it for you.
That's what put options do for you.
They are for professionals.
We use these to hedge risks in our business enterprises.
We use these to hedge risks in our portfolios.
We aren't betting.
This isn't a bet.
This is just prudent financial management.
That's why in FIL 341, I use a book that brings it up.
We don't kill you with it, but we make you aware that here is part of corporate management.
As a matter of fact, I've made arrangements and then I didn't teach 347.
There's a fellow at Aon Insurance, Reinsurance.
Now, insurance companies buy piles of bonds.
Safe, right?
That's what they do with their money.
They buy bonds, all their profits and their retained earnings and all that.
Well, the problem is that bonds, as you saw in Chapter 4, bonds have price volatility.
And so they don't like that, so they hedge them with put options on bonds.
Simply because if the price drops too much on the bonds, their portfolio would take a bad hit.
And Aon doesn't want that.
So they have these options on bonds so that if the price falls below a certain price,
then the put option is in the money and they make money on the puts,
even though they lost money on the bond price fall.
That's just how they do it.
As a matter of fact, you can even do it both ways.
And there are, I won't get too much into strategies,
but you can buy combinations of calls and puts so that if it goes outside of a certain region,
you're protected.
But if it stays within a certain region, it's just, you pay, you just deal with volatility yourself.
The other side of it is the ones that are really cool,
but if there are the ones where if only if the underlying goes up or down, either, you make money.
But if it stays in a certain range, you just lose what you paid for the position.
Those are called straddles and butterflies.
They have very fanciful names. I don't know why.
Anyway, this is the basis why we do what we do.
And I also was sneaking in there all of the cool terminology that we use.
And I wasn't, I didn't pull up one damn equation to do it for you.
But I will say this again on Wednesday.
I'm just going to talk to you like you are traders and say, just use the terminology.
That's the best way people can learn anything.
It's just by hearing it a couple of times.
Now, just to play this, notice again though, I want you to see something.
Notice the, let me go here.
This one was what? The fourth? Good grief.
Those options change along.
Okay, that was the 18th of October.
Okay, notice it on the call and put side.
Let's take one right around the money.
What is the, what are we right now?
Let's take a 564, which is just out of the money on the call side.
In other words, if you want this to win, the spider has to get above 564.
Okay, now let me take, let's see the price of that one.
What is it? Oh, okay.
$890 for that one. See, it's so close to the money that there's a really good probability
that by the 18th of October, it's going to cross into the money.
Now, but let me go down here and look at the put.
The put for that.
564 was it? Was that what I did? Yeah.
Okay, that's 951.
A little more expensive, but it's in the money, of course.
Right now, the spider is just a little bit below that.
So now let me pull in here and let me get, grab one that's, the expiration is really close.
Let me grab October the 4th.
No, let's do September the 30th.
Okay, let's look at that 564 on, 564.
This is on the call side.
You see how it's cheaper?
That's the theta decay.
We're getting closer, this one is closer to the expiration,
so there's less chance that it will get into the money.
And on the put side, the same thing is happening.
See that one? Cheaper.
The theta decay.
As you get closer, as your options get closer to the expiration date,
they become cheaper simply because, and we use the term,
it's actually a mathematical calculation, and that spreadsheet calculates theta for you.
But it's theta decay.
The closer you get to the expiration date, the more that decay is going to show up.
So, interestingly enough, you can have, and this is the game that I play sometimes,
I buy an option that's out of the money, and quite a long time.
I buy longer options, like two months out.
And then what I do is, I, even though theta decay is in there, it's still very weak.
So any price movements in the underlying really get magnified in the options price.
So I could have just a little blip in the options price,
and if the theta decay hasn't set in, that option can jump in price,
even though it's out of the money.
That's just some of the things that happens with options.
They follow a process in physics, if you were taking upper level undergrad or grad level courses in physics,
the equations are what are called the gas diffusion equations from classical physics.
We've known the equations for well over 150, 170 years.
And then it occurred to some finance geniuses,
oh my God, options do the same thing.
Think about a gas that is being released into a vacuum tube.
As it's released, it expands like this.
Think about the time to expiration of an option increasing.
As time to expiration increases, theta becomes bigger.
It's the same equation.
A difficult equation, but it's the same physical process.
Except we're in finance and we don't see a physical thing,
we see a numerical thing, but it is identical.
Now very quickly, just I've filled you with enough.
Let me see if there's anything worth talking about.
I talked about this.
And this one is pretty much options, expiration dates, strike price.
Okay, now this equation, these are math equations that you probably didn't see much of
in your college algebra or calculus courses.
These are called two state equations.
In other words, if the value is below a certain amount, it's one thing.
If the value of the input is above a certain thing, it's another.
So in other words, if you are talking about a call option, exercise it's due today.
Its expiration is today.
That option will be worth either nothing if you're out of the money,
or it will be worth the stock price minus the strike price if you're in the money.
So in other words, with that Ford at $11 a share,
on the expiration date, the price will either be, you will get either nothing,
or you will get the price of Ford minus the strike price.
So in other words, if the stock price is, if the stock Ford is, I've got one call at $11, striking at $11.
If that is, if I'm on the expiration date, if it is at $12, I will make $12 minus $11.
But if it is below $11, I will, I would theoretically make $11 minus $12, but the max is zero.
So it's essentially a binary result.
You either get nothing, and all you lose is what you paid for the option previously,
or you get the stock price minus the strike.
That's why we really like to see the stock get above our strike price.
My last one just pissed me off. I bought Rivian, and I had that at strike price of something like $12,
and it got up there to almost $16, and I held it.
Nope, it's still going to go further. I didn't dump it.
And of course, Rivian finished at a son of a bitch $10, so I lost, I mean if I had exercised earlier.
And that's one last thing is, the difference, options, some options, you can trade them, you can buy and sell them,
you can exercise at any point, you can exercise any time you want.
Some, you can do it only on the expiration date.
That's the difference between American and European options.
And so I strongly recommend that you stay in the world of American options,
because then you can get the hell out of them at any point.
And of course, I could have gotten out of Rivian.
I mean, if I had, first of all, my strike price was $10, and at one point it got a little above $16, I think, or something like that.
I would not only, if I had sold it, there was still theta in it, so it was worth more than $6,
because it was worth the price minus the strike, that would be the $6, but there was also theta premium in it too.
So if I had dumped it, the theta premium, I think I could have sold it for like $17.80.
But no, I'm going to hold on to this, the sky's the limit.
Well, the hell it was, it went right back into the toilet.
And so by the expiration date, I was out of the money.
And so it just pissed me off.
But that's what you can do with it, and that's what that equation is about.
That's on the expiration date.
Now remember, on the expiration date, there's no theta, no theta premium.
So this is just purely what the option is worth, because you're going to exercise it.
Let's see if there's anything else I can talk about.
Yeah, time value, that's, they don't use the word in the book.
I'm using the word theta. Theta is time value.
There are a couple, this is one of the Greeks.
There are these Greek letters that we use to describe different phenomena within the option.
And I'll just give you the big ones.
There's the delta, and then there's the gamma, and then there is the holy theta.
And then there are a couple.
There's one, it's pronounced by people these days as vega.
Its actual pronunciation in Greek is vega.
But the vega, that is a measure of the option's reaction to volatility in the underlying.
And then there's one called rho, R-H-O.
That is the sensitivity of the option's price to interest rates.
So you've got delta, gamma, theta, vega, and rho are the Greeks.
And I'm not going to teach you the equations, because that Excel sheet will get them for you.
But I'll tell you what you can read from them.
And it is a world, and if you get into options, it's the Hotel California.
You can check out, but you can never leave.
I've had three of my best students.
They came out, they were sitting in classrooms just like this, and I could see in their eyes they were going to be options traders.
And sure enough, two of them have already made it to the point.
You do your time, retail, listening to customers scream at you because they did stupid things.
But once they had done that time, they got up there, and they're now in the options trading.
That's where the excitement is.
And it's quite a world, and you don't stay too long in that world before you burn out and go do something else with your life.
But this is what I'm teaching you here.
And again, the purpose for you in a course like this is that you can understand them well enough that you can create hedges.
Hedges are so important in business these days.
As a matter of fact, that's what a hedge fund does.
It does it for a corporation that doesn't have anyone who can do it internally.
That's what hedge funds are.
Anyway, that's all I have for you.
Go home.