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Advanced Option Lessons

A hands-on options curriculum covering real trading concepts. Read the lessons, work through examples, and test your knowledge.

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Module 17: Portfolio Engineering & Asset AllocationAdvanced 15 Min

Lesson 1: 17.1: Capital Asset Pricing Model (CAPM), Beta, & Security Market Line

Deconstruct CAPM, systematic vs unsystematic risk, equity beta, and the Security Market Line (SML).

1. The Capital Asset Pricing Model (CAPM)

CAPM quantifies the relationship between systematic risk and expected return: E[R_i] = R_f + β_i (E[R_m] - R_f).

Diversification eliminates idiosyncratic (unsystematic) firm-specific risk, leaving investors compensated solely for taking non-diversifiable systematic market risk.

★ Beta (β): Measures an asset's sensitivity to market return movements: β_i = Cov(R_i, R_m) / Var(R_m).

2. The Security Market Line (SML) & Jensen's Alpha

The Security Market Line plots expected return against beta. Assets above the SML generate positive Jensen's Alpha (α = R_i - CAPM Benchmark), indicating undervaluation.

Quant portfolios systematically hunt for positive alpha while managing aggregate portfolio beta.

A straight line of expected return rising with beta from 2% at beta 0 to 14% at beta 2
The CAPM line: E[R] = Rf + β × (market return − Rf) = 2% + β × 6%, with a risk-free rate of 2% and an expected market return of 8%. Beta values of 0, 0.5, 1, 1.5 and 2 give expected returns of 2%, 5%, 8%, 11% and 14%. The inputs are hypothetical, and a point above the line does not prove undervaluation or future alpha.
Interactive Option Simulation Lab

IV Crush Scenario Visualizer

LAB SIMULATOR ACTIVE

Implied Volatility (IV) Crush is the primary account-killer for option buyers after earnings announcements. Play with the controls below to see how option premium collapses depending on Vega.

Scenario Modeling
Trader Stance
Implied Volatility (Post-Earnings):80%
Option Vega Level:0.3
⚠️ You bought options with an inflated IV of 80%. As IV collapses down to 80%, your contract hemorrhages premium value purely from volatility erosion.
PREMIUM DECAY OUTCOME
Initial Value (80% IV)$390
Post-Crush Value$390
Resulting P&L:+$0

KNOWLEDGE RECONNAISSANCE

Q01.

According to CAPM, what type of risk are investors compensated for bearing in a well-diversified portfolio?

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