36 lines
1.6 KiB
Plaintext
36 lines
1.6 KiB
Plaintext
The Intelligent Investor’s Guide to Option Pricing • 51
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5/18/2012
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20
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30
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40
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50
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60
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70
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80
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90
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100
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5/20/2013 249 499 999749
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Advanced Building Corp. (ABC)
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Date/Day Count
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Stock Price
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GREEN
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Notice that because this call option is struck at $70, the upside po-
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tential we have gained lies completely outside the cone of values the BSM
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sees as reasonably likely. This option, according to the BSM, is something
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like the bet that a seven-year-old might make with another seven-year-
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old: “If you can [insert practically impossible action here], I’ll pay you a
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zillion dollars. ” The action is so risky or impossible that in order to entice
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his or her classmate to take the bet, the darer must offer a phenomenal
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return.
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Off the playground and into the world of high finance, the way to
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offer someone a phenomenal return is to set the price of a risky asset very
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low. Following this logic, we can guess that the price for this option should
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be very low. In fact, we can quantify this “very low” a bit more by thinking
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about the probabilities surrounding this call option investment.
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Remembering back to the contention in Chapter 2 that the lines of
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the BSM cone represent around a 16 percent probability of occurrence,
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we can see that the range of exposure lies outside this, so the chance of
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the stock making it into this range is lower than 16 percent. Let’s say that
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the range of exposure sits at just the 5 percent probability level. What this
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means is that if you can find 20 identical investments like this and invest in
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all of them, only one will pay off (1/20 = 5 percent). |