37 lines
2.5 KiB
Plaintext
37 lines
2.5 KiB
Plaintext
200 • The Intelligent Option Investor
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After you enter a position and some time passes, it becomes clearer
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what valuation scenario the company is tending toward. In some cases,
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a bit of information will come out that is critical to your valuation of the
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company on which other market participants may not be focused. Obvi-
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ously, if a bit of information comes out that has a big, positive or negative
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impact on your assessment of the company’s value, you should adjust your
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position size accordingly. If you believe the impact is positive, it makes
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sense to build to a position by increasing your shares owned and/or by
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adding “spice” to that meal by adjusting your target leverage level. If the
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impact is negative, it makes sense to start by reducing leverage (or you
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can think of it as increasing the proportion of cash supporting a particular
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position), even if this reduction means realizing a loss. If the impact of the
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news is so negative that the investment is no longer attractive from a risk-
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reward perspective, I believe that it should be closed and the lumps taken
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sooner rather than later. Considering what we know about prospect theory,
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this is psychologically a difficult thing to do, but in my experience, waiting
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to close a position in which you no longer have confidence seldom does
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you any good.
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Obviously, the risk/reward equation of an investment is also influ-
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enced by a stock’s market price. If the market price starts scraping against
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the upper edge of your valuation range, again, it is time to reduce leverage
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and/or close the position.
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If your options are in danger of expiring before a stock has reached
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your fair value estimate, you may roll your position by selling your option
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position and using the proceeds to buy another option position at a more
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distant tenor. At this time, you must again think about your target leverage
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and adjust the strikes of your options accordingly. If the price of the stock
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has decreased over the life of the option contract, this will mean that you
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realize a loss, which is not an easy thing to do psychologically, but consid-
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ering the limitations imposed by time for all option investments, this is an
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unavoidable situation in this case.
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One of the reasons I dislike investing in non-LEAPS call options is
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that rolling means that not only do we have to pay another set of bro-
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ker and exchange fees, but we also must pay both sides of the bid-ask
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spread. Keeping in mind how wide the bid-ask spread can be with options
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and what an enormous drag this can be on returns, you should carefully |