27 lines
1.6 KiB
Plaintext
27 lines
1.6 KiB
Plaintext
Chapter 1: Definitions 13
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This statement is true no matter what the stock price is. The only reservation is
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that with the stock deeply in- or out-of-the-money, the actual difference between the
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January, April, and July calls will be smaller than with XYZ stock selling at the strik
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ing price of 50.
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Time Value Premium Decay. In Figure 1-3, notice that the price of the 9-
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month call is not three times that of the 3-month call. Note next that the curve
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in Figure 1-4 for the decay of time value premium is not straight; that is, the rate
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of decay of an option is not linear. An option's time value premium decays much
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more rapidly in the last few weeks of its life ( that is, in the weeks immediately
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preceding expiration) than it does in the first few weeks of its existence. The rate
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of decay is actually related to the square root of the time remaining. Thus, a 3-
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month option decays (loses time value premium) at twice the rate of a 9-month
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option, since the square root of 9 is 3. Similarly, a 2-month option decays at
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twice the rate of a 4-month option (-..f4 = 2).
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This graphic simplification should not lead one to believe that a 9-month option
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necessarily sells for twice the price of a 3-month option, because the other factors
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also influence the actual price relationship between the two calls. Of those other fac
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tors, the volatility of the underlying stock is particularly influential. More volatile
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underlying stocks have higher option prices. This relationship is logical, because if a
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FIGURE 1-4.
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Time value premium decay, assuming the stock price remains con
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stant.
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9 4
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Time Remaining Until Expiration
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(Months)
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0 |