37 lines
2.8 KiB
Plaintext
37 lines
2.8 KiB
Plaintext
772 Part VI: Measuring and Trading Volatility
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wide apart. That will allow for a reasonable amount of price appreciation in the bull
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spread if the underlying rises in price. Also, one might want to consider establishing
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the bull spread with striking prices that are both out-of-the-money. Then, if the stock
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rallies strongly, a greater percentage gain can be had by the spreader. Still, though,
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the facts described above cannot be overcome; they can only possibly be mitigated
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by such actions.
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A FAMILIAR SCENARIO?
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Often, one may be deluded into thinking that the two positions are more similar than
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they are. For example, one does some sort of analysis - it does not matter if it's fun
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damental or technical - and comes to a conclusion that the stock ( or futures contract
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or index) is ready for a bullish move. Furthermore, he wants to use options to imple
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ment his strategy. But, upon inspecting the actual market prices, he finds that the
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options seem rather expensive. So, he thinks, "Why not use a bull spread instead? It
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costs less and it's bullish, too."
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Fairly quickly, the underlying moves higher - a good prediction by the trader,
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and a timely one as well. If the move is a violent one, especially in the futures mar
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ket, implied volatility might increase as well. If you had bought calls, you'd be a happy
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camper. But if you bought the bull spread, you are not only highly disappointed, but
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you are now facing the prospect of having to hold the spread for several more weeks
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(perhaps months) before your spread widens out to anything even approaching the
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maximum profit potential.
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Sound familiar? Every option trader has probably done himself in with this line
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of thinking at one time or another. At least, now you know the reason why: High or
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increasing implied volatility is not a friend of the bull spread, while it is a friendly ally
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of the outright call purchase. Somewhat surprisingly, many option traders don't real
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ize the difference between these two strategies, which they probably consider to be
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somewhat similar in nature.
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So, be careful when using bull spreads. If you really think a call option is too
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expensive and want to reduce its cost, ti:y this strategy: Buy the call and simultane
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ously sell a credit put spread (bull spread) using slightly out-of-the-money puts. This
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strategy reduces the call's net cost and maintains upside potential (although it
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increases downside risk, but at least it is still a fixed risk).
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Example: With XYZ at 100, a trader is bullish and wants to buy the July 100 calls,
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which expire in two months. However, upon inspection, he finds that they are trad
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ing at 10 - an implied volatility of 59%. He knows that, historically, the implied
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volatility of this stock's options range from approximately 40% to 60%, so these are |