36 lines
2.7 KiB
Plaintext
36 lines
2.7 KiB
Plaintext
106 Part II: Call Option Strategies
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such an analysis for themselves, the details of computing a stock's volatility and pre
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dicting the call prices are provided in Chapter 28 on mathematical techniques.
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OVERPRICED OR UNDERPRICED CALLS
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Formulae exist that are capable of predicting what a call should be selling for, based
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on the relationship of the stock price and the striking price, the time remaining to
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expiration, and the volatility of the underlying stock. These are useful, for example,
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in performing the second step in the foregoing analysis, estimating the call price after
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an advance in the underlying stock. In reality, a call's actual price may deviate some
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what from the price computed by the formula. If the call is actually selling for more
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than the "fair" ( computed) price, the call is said to be overvalued. An undervalued
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call is one that is actually trading at a price that is less than the "fair" price.
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If the calls are truly overpriced, there may be a strategy that can help reduce
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their cost while still preserving upside profit potential. This strategy, however,
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requires the addition of a put spread to the call purchase, so it is beyond the scope
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of the subject matter at the current time. It is described in Chapter 23 on spreads
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combining calls and puts.
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Generally, the amount by which a call is overvalued or undervalued may be only
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a small fraction of a point, such as 10 or 20 cents. In theory, the call buyer who pur
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chases an undervalued call has gained a slight advantage in that the call should return
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to its "fair" value. However, in practice, this information is most useful only to mar
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ket-makers or firm traders who pay little or no commissions for trading options. The
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general public cannot benefit directly from the knowledge that such a small discrep
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ancy exists, because of commission costs.
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One should not base his call buying decisions merely on the fact that a call is
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underpriced. It is small solace to the call buyer to find that he bought a "cheap" call
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that subsequently declined in price. The method of ranking calls for purchase that
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has been described does, in fact, give some slight benefit to underpriced calls.
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However, under the recommended method of analysis, a call will not automatically
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appear as an attractive purchase just because it is slightly undervalued.
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TIME VALUE PREMIUM IS A MISNOMER
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This is a topic that will be mentioned several times throughout the book, most
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notably in conjunction with volatility trading. It is introduced here because even the
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inexperienced option trader must understand that the portion of an option's price
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that is not intrinsic value - the part that we routinely call "time value premium" - is
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really composed of much more than just time value. Yes, time will eventually wear |