35 lines
1.5 KiB
Plaintext
35 lines
1.5 KiB
Plaintext
The Intelligent Investor’s Guide to Option Pricing • 69
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Now let’s say that our analysis is absolutely right. Just after we buy the
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call options, the company makes its announcement, and the shares pop up
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by 5 percent. This changes the strike–stock price ratio from 1.05 to 1.00.
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All things being held equal, this should increase the price of the option
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because there would be a larger portion of the range of exposure contained
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within the BSM cone.
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However, as the stock price moves up, let’s assume that not everything
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remains constant but that, instead, implied volatility falls. This does hap-
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pen all the time in actuality; the option market is full of bright, insightful
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people, and as they recognize that the uncertainty surrounding a product
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announcement or whatever is growing, they bid up the price of the options
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to try to profit in case of a swift stock price move.
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In the preceding diagram, we’ve assumed an implied volatility of 35
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percent per year. Let’s say that the volatility falls dramatically to 15 percent
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per year and see what happens to our diagram:
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20
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25
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30
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35
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40Stock Price
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45
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50
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55
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60
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Advanced Building Corp. (ABC)
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65
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Stock price jumps
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Implied volatility drops
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GREEN
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The stock price moves up rapidly, but as you can see, the BSM cone shrinks
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as the market reassesses the uncertainty of the stock’s price range in the
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short term. The tightening of the BSM cone is so drastic that it more than
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offsets the rapid price change of the underlying stock, so now the option is
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actually worth less! |