41 lines
2.3 KiB
Plaintext
41 lines
2.3 KiB
Plaintext
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474 Part IV: Additional Considerations
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arbitra:ry requirements would be including only calls that sell for one point or more,
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or stating that the downside protection must be a certain percentage of the stock
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price. These obviously cannot suffice for stocks with different volatilities. Rather,
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the downside protection criterion should be stated in terms of "probability of down
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protection" or, alternatively, in terms of the volatility itself. In this manner, a uniform
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comparison can be made between volatile and nonvolatile stocks.
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CALL BUYING
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The option buyer can also constructively use the measurement of volatility to aid him
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in his option buying decisions. In Chapter 3, it was shown that evaluating the prof
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itability of calls based on the volatility of the underlying stock is the correct way to
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analyze an option purchase. One specific method of analysis is described. There are
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certain variables in this analysis that may be altered to fit the call buyer's individual
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preferences, but the general logic is applicable to all cases.
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As a first step, one should decide upon a uniform stock rrwvement for ranking
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call purchases. One might decide to rank all purchases by how they would perform
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if the underlying stock moved up in accordance with its volatility. The phrase "in
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accordance with its volatility" must be quantified. For example, one might decide to
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assume that eve:ry stock could move up one standard deviation, and then rank all call
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purchases on that basis. The prospective call buyer must also fix the time period that
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he wants to use. Generally, one looks at purchases to be held for 30 days, 60 days, and
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90 days.
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The exact steps to be followed in the analysis of profitability and risk can be list
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ed as follows:
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I. Specify the distance that underlying stock can move, up or down, in terms of its
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volatility.
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2. Select the holding period over which the analysis is to take place.
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PROFITABILITY
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3. Calculate the stock price that the stock would move up to, when the foregoing
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assumptions are implemented.
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4. Using a pricing model, such as the Black-Scholes model, estimate what the
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option price would become after the upward stock movement.
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5. Calculate the percent profit, after deducting commissions.
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6. Repeat steps 4 and 5 for each option on the stock. |