32 lines
2.0 KiB
Plaintext
32 lines
2.0 KiB
Plaintext
180 • The Intelligent Option Investor
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Instrument Maximum-Loss Price Net Profit at Fair Value Estimate
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Stock $0 $1,472
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Option $22 (23.2 × stock loss) $10,203 (6.9 × stock profit)
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This is quite a handsome potential profit—6.9 times higher than we
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could earn using a straight stock position—but at an enormous risk. Each
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$1 drop in the stock price equates to a $23.20 drop in the value of the posi-
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tion. Note that the realized loss shows a step up from $22 to $23. This just
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shows that above the strike price, our only realized loss is the money we
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spent on time value.
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The last example is that of the fully levered OTM call options. Here is
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the table illustrating this case:
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Instrument Maximum-Loss Price Net Profit at Fair Value Estimate
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Stock $0 $1,472
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Option $25 (IRL 5 percent) $12,495 (8.5 × stock profit)
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There is no intrinsic value to this option, so the entire cost of
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the option is treated as an immediate realized loss (IRL) from inception.
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The “IRL 5 percent” notation means that there is an immediate realized
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loss of 5 percent of the total portfolio. The maximum net loss is again at
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the strike price of $25. The leverage factor at our fair value estimate price
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is 8.5, but again this leverage comes at the price of having to realize a
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5 percent loss on your portfolio—500 basis points of performance—and
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there is no certainty that you will have enough or any profits to offset this
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realized loss.
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Of course, investing choices are not as black and white as what I have
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presented here. If you want to commit 5 percent of your portfolio to a
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straight stock idea, you have to spend 5 percent of your portfolio value on
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stock, but this is not true for options. For example, I might choose to spend
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2.5 percent of my portfolio’s worth on ATM calls (nine contracts in this ex-
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ample), considering the position in terms of a 5 percent stock investment,
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and then leave the rest as cash reserve. Here is what this investment would
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look like from a leverage perspective: |