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50 •   TheIntelligentOptionInvestor
In terms of how this chapter fits in with the goal of being an
intelligent option investor, it is in this chapter that we start overlaying
the range of exposure introduced in Chapter 1 with the implied stock
price range given by the BSM cone that was introduced in Chapter 2.
This perspective will allow us to get a sense of how expensive it will
be to gain exposure to a given range or, conversely, to see how much
we are likely to be able to generate in revenue by accepting exposure
to that range. Understanding the value of a given range of exposure as
perceived by the marketplace will allow us to determine what option
strategy will be best to use after we determine our own intelligent
valuation range for a stock.
Jargon introduced in this chapter is as follows:
Strikestock price ratio Volatility (Vol)
Time value Forward volatility
Intrinsic value Implied volatility
Tenor Statistical volatility
Time decay Historical volatility
How Option Prices are Determined
In Chapter 1, we saw what options looked like from the perspective of
ranges of exposure. One of the takeaways of that chapter was how flexible
options are in comparison with stocks. Thinking about it a moment, it is
clear that the flexibility of options must be a valuable thing. What would
it be worth to you to only gain upside to a stock without having to worry
about losing capital as a result of a stock price decline?
The BSM, the principles of which we discussed in detail in Chapter 2,
was intended to answer this question precisely—“What is the fair value of
an option?” Let us think about option prices in the same sort of probabilis-
tic sense that we now know the BSM is using.
First, lets assume that we want to gain exposure to the upside poten-
tial of a $50 stock by buying a call option with a strike price of $70 and a
time to expiration of 365 days. Here is the risk-return profile of this option
position merged with the image of the BSM cone: