34 lines
2.3 KiB
Plaintext
34 lines
2.3 KiB
Plaintext
This would be a great trade if it weren’t for the prices one would have to
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accept to put it on. First, the 120 puts are offered at 0.25 and the 123 puts
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are 0.25 bid. This means that the put spread would be sold at zero! The
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maximum risk is 3.00, and the maximum gain is zero. Not a really good
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risk/reward. The 142–145 call spread isn’t much better: it can be sold for a
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dime.
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At the time, again a low-volatility period, many traders probably felt it
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was unlikely that the DJX will rise 5 percent in a 51-day period. Some
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traders may have considered trading a similarly priced iron condor (though
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of course they’d have to require some small credit for the risk). A little over
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a year later the DJX was trading around 50 percent lower. Traders must
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always be vigilant of the possibility of volatility, even unexpected volatility
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and structure their risk/reward accordingly. Most traders would say the
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risk/reward of this trade isn’t worth it. Strikes too far apart have a greater
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chance of success, but the payoff just isn’t there.
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Strikes with High Probabilities of Success
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So how does a trader find the happy medium of strikes close enough
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together to provide rich premiums but far enough apart to have a good
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chance of success? Certainly, there is something to be said for looking at
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the prices at which a trade can be done and having a subjective feel for
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whether the underlying is likely to move outside the range of the break-
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even prices. A little math, however, can help quantify this likelihood and aid
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in the decision-making process.
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Recall that IV is read by many traders to be the market’s consensus
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estimate of future realized volatility in terms of annualized standard
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deviation. While that is a mouthful to say—or in this case, rather, an eyeful
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to read—when broken down it is not quite as intimidating as it sounds.
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Consider a simplified example in which an underlying security is trading at
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$100 a share and the implied volatility of the at-the-money (ATM) options
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is 10 percent. That means, from a statistical perspective, that if the expected
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return for the stock is unchanged, the one-year standard deviations are at
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$90 and $110. 1 In this case, there is about a 68 percent chance of the stock
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trading between $90 and $110 one year from now. IV then is useful
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information to a trader who wants to quantify the chances of an iron |