Equity & Options Trading Game and Tutorial For SEBC May 8, 2004 Sanjiv Parekh.

Equity & OptionsTrading Game and

TutorialFor SEBCMay 8, 2004

Sanjiv Parekh

Equity and Options Trading Game and Tutorial

Welcome

• Sloan Trading Room Task Force was established in 1997 by Prof. Andrew Lo.

• Trading room is used for research, trading games and simulations, and finance classes.

• Types of trading games include: equity, fixed income, derivatives, and foreign exchange.

• Information: http://mitsloan.mit.edu/trader

• Email Us: [email protected]


Agenda

• Today’s Game: 2 Stocks and 2 Options

• Trading Interface

• Trading Mechanics: Bid-Ask

• Accessing Private Information

• Two Practice Games

• Questions and Answers

• The Final Game


Case Scenario

• Two Stocks– Firm 1– Firm 2

• Two Options– 30 Call on Firm 1– 30 Put on Firm 1

• Two periods: Year 1 and Year 2

• 0% interest rate, no cost to borrow money

• Stocks are non-dividend paying


Private Information and Prices

• Different parties may have private information in the market. This information may give you an advantage in trading.

• Bid and Ask prices may reflect what private information other traders have

• If you know what the stock should be worth, take advantage of wrong prices through arbitrage


Game Setup

• The values of the stocks at the end of the two periods depend on what state the company is in

• Firm 1 has 3 different possible states in each period

• Firm 2 has 3 different possible states in each period


• Realized events determine each stocks’ realized dividends

• Realized dividends determine each stocks’ price

• Events are all equally likely

• Traders will receive private information about which event is realized

Firm 1

x Fails to win contracts

y Wins some contracts

z Wins all contracts

Firm 2

w Fails to win contracts

x Wins some contracts

y Wins all contracts

Stock Fundamentals


Firm 1 Payoff Tree

Now

Period 1

Period 1

Period 1

40

20

0

45

25

0

60

35

0

x

z

xyz

yxyz

xyz

Period 2

Period 0

• Stock values depend on events realized in Period 1 and Period 2

• Starting out, probability of each event is equal


Firm 1 Payoff Tree

Min: 0 Max: 25

E [Price] = 11.25

Now

Period 1

Period 1

Period 1

40

20

0

45

25

0

60

35

0

x, 1/2

z

x, 1/2y, 1/2

z

y, 1/2x, 1/2y, 1/2

z

xyz

Period 1

Period 2

Private Information:

Period 1: not z, Period 2: not z

• Use your Private Information to calculate the new expected stock price


Firm 1 Payoff Tree in Period 2

• Assume Event y occurred

• Private Information still holds

• What is the expected value of Firm 1 now?

Min: 0 Max: 20

E [Price] = 10

Period 1 40

20

0x, 1/2y, 1/2

zNow

Period 2


Options

• European style Call Options give you the right, but not the obligation, to buy a specified amount of an underlying security at a specified price upon expiry.

• European style Put Options give you the right, but not the obligation, to sell a specified amount of an underlying security at a specified price upon expiry.

• The specified price is known as the strike price


Options in this Game

• European Style Call on Firm 1 with strike 30

• European Style Put on Firm 1 with strike 30

• Options expire at the end of Period 2

• Option payouts will be realized at the end of Period 2


Firm 1 Option Payoff Trees

Now

Period 1

Period 1

Period 1

10

0

0

15

0

0

30

5

0

x

z

xyz

yxyz

xyz

Period 2

Period 0

30 Call

Now

Period 1

Period 1

Period 1

40

20

0

45

25

0

60

35

0

x

z

xyz

yxyz

xyz

Period 2

Period 0

Underlying Stock

• Create payout trees for options and use them to price options just like the stocks

Now

Period 1

Period 1

Period 1

0

10

30

0

5

30

0

0

30

x

z

xyz

yxyz

xyz

Period 2

Period 0

30 Put


Trading Mechanics

• Traders who want to sell stocks at a certain price post an Ask

• Traders who want to buy stocks at a certain price post a Bid

• Only Market Makers have the ability to post Bids and Asks


The Bid-Ask Spread

BID

158 1/8

Market maker buys

Market taker sells

ASK

158 7/8

Market maker sells

Market taker buys


Stay Within the Spread

Ask

sell buy

159 160

• Do not trade outside the spread• Be the market maker with unsophisticated traders in the market

$$$ $$$

Bid

sell buy

159 160


Being the Market Maker

Ask

90

89*

Bid

80

81*

New Bid Makes the Market

(Market Maker)

New Ask Makes the Market

(Market Maker)

• Bid-Ask spread goes from 10 to 8 once the new bid and the new ask make the market

MARKET


Being the Market Maker

Ask

90

91

Bid

80

79

Bid does NOT Make the Market

Ask does NOT Make the Market

MARKET


Terminology

• Going Long: buy the stock– You think the stock price will go up

• Going Short: sell the stock– You think the stock price will go down– Selling more units than you have, known as short

selling, ends up with negative number of units.– In this game, you can short sell as much as you want– Have to cover short position at end by buying back

the stock. Done automatically in the game.


Trading Interface

Stock NamesTraders in the FTSmarkets determine prices

Individualendowments

Seconds remaining for current trading period.

You can borrowor lend at a 0%interest rate

Realized payouts displayed here


Enter any trading name(at least 3 characters)

Type in the actual names of each trader on the team

Logging In

DO NOT PRESS CONNECT UNTIL ASKED TO DO SO

Equity & Options Trading Game and Tutorial For SEBC May 8, 2004 Sanjiv Parekh.

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