41 lines
2.6 KiB
Plaintext
41 lines
2.6 KiB
Plaintext
780 Part VI: Measuring and Trading Volatility
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A common mistake that calendar spreaders make is to think that such a spread
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looks overly attractive on a very volatile stock. Consider the same stock as above, still
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trading at 100, but for some reason implied volatility has skyrocketed to 80% (per
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haps a takeover rumor is present).
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Stock: JOO
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Implied Volatility: 80%
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Coll
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May 100 call
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June 100 call
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Theoretical Value
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12.55
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16.81
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On the surface, this seems like a very attractive spread. There are two months
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of life remaining in the May options (and three months in the Junes) and the spread
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is trading at 4.36. However, both options are completely composed of time value
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premium, and most certainly the June 100 call would be worth far more than 4.36
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when the May expires, if the stock is still near 100. The fact that many traders miss
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when they think of the calendar spread this way is that the June call will only be
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worth "far more than 4.36" if implied volatility holds up. If implied volatility for this
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stock is normally something on the order of 40%, say, then it is probably not reason
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able to expect that the 80% level will hold up. Just for comparison, note that if the
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stock is at 100 at May expiration - the maximum profit potential for such a calendar
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spread - the June 100 call, with implied volatility now at 40%, and with one month
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of life remaining, would be worth only 4. 77. Thus the spread would only have made
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a profit of a few cents (4.36 to 4.77), and if the underlying stock were farther from
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the strike price at expiration, there would probably be a loss rather than a profit.
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The point to be remembered is that a calendar spread is a "long volatility" play
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(and a reverse calendar spread is just the opposite). Evaluate the position's risk with
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an eye to what might happen to implied volatility, and not just to where the stock
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price might go or how much time decay there might be in the position.
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RATIO SPREADS AND BACKSPREADS
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The previous descriptions in this chapter describe fairly fully and accurately what
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the effect of volatility changes are. More complicated strategies are usually nothing
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more than combinations of the strategies presented earlier, so it is easy to discern
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the effect that changes in implied volatility would have; just combine the effects on
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the simpler strategies. For example, a ratio call write is really just the equivalent of
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a straddle sale - a strategy whose volatility ramifications are fairly simple to under
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stand.
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Ratio spreads, on the other hand, might not be as intuitive to interpret, but they
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are fairly simple nonetheless. A call ratio spread is really just the combination of some |