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lecture6 (1) - Lecture 6: Portfolios with Stock Options...

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Lecture 6: Portfolios with Stock Options Steven Skiena Department of Computer Science State University of New York Stony Brook, NY 11794–4400 http://www.cs.sunysb.edu/ skiena
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Portfolios with Options The raw materials of investments we have include bor- rowing/depositing money, buying/selling options, and buy- ing/selling stocks. Combinations of options and stocks can be used in clever ways to engineer portfolios exploiting certain opportunities and eliminating particular risks. By combining put and call options, we can place bets which payoff under a variety of different market conditions.
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Bull/Bear Spreads A bull spread consists of a buying a call with strike price K 1 and selling a call with price K 2 > K 1 . I get max( S T - K 1 , 0) for the first call and my payment for the second option, but must pay max( S T - K 2 , 0) Both options pay off if S T > K 2 , so I gain K 2 - K 1 . If K 1 < S T < K 2 , I gain S T - K 1 If S T K 1 , I gain nothing.
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This strategy limits both my upside and downside risk/return. However, if the current spot price S 0 < K 1 , the options should be cheap and the strategy can show high returns if the stock price rises. Bull spreads can alternately be constructed by buying and
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lecture6 (1) - Lecture 6: Portfolios with Stock Options...

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