38 lines
2.4 KiB
Plaintext
38 lines
2.4 KiB
Plaintext
104 Part II: Call Option Strategies
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NVS: 40 VVS: 40
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NVS July 40 call: 2 VVS July 40 call: 4
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If these two calls are ranked for buying purposes, based strictly on a percentage
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change in the underlying stock, the NVS call will appear to be the better buy. For
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example, one might see a list such as "best call buys if the underlying stock advances
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by 10%." In this example, if each stock advanced 10% by expiration, both NVS and
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WS would be at 44. Thus, the NVS July 40 would be worth 4, having doubled in
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price, for a 100% potential profit. Meanwhile, the WS July 40 would be worth 4 also,
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for a 0% profit to the call buyer. This analysis would lead one to believe that the NVS
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July 40 is the better buy. Such a conclusion may be wrong, because an incorrect
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assumption was made in the ranking of the potentials of the two stocks. It is not right
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to assume that both stocks have the same probability of moving 10% by expiration.
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Certainly, the volatile stock has a much better chance of advancing by 10% ( or more)
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than the nonvolatile stock does. Any ranking based on equal percentage changes in
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the underlying stock, without regard for their volatilities, is useless and should be
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avoided.
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The correct method of comparing these two July 40 calls is to utilize the actual
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volatilities of the underlying stocks. Suppose that it is known that the volatile stock,
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WS, could expect to move 15% in the time to July expiration. The nonvolatile stock,
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NVS, however, could only expect a move of 5% in the same period. Using this infor
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mation, the call buyer can arrive at the conclusion that WS July 40 is the better call
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to buy:
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Stock Price in July
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VVS: 46 (up 15%)
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NVS: 42 (up 5%)
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Coll Price
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VVS July 40: 6 (up 50%)
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NVS July 40: 2 (unchanged)
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By assuming that each stock can rise in accordance with its volatility, we can see that
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the WS July 40 has the better reward potential, despite the fact that it was twice as
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expensive to begin with. This method of analysis is much more realistic.
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One more refinement needs to be made in this ranking process. Since most call
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purchases are made for holding periods of from 30 to 90 days, it is not correct to
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assume that the calls will be held to expiration. That is, even if one buys a 6-month
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call, he will normally liquidate it, to take profits or cut losses, in 1 to 3 months. The
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call buyer's list should thus be based on how the call will peiform if held for a realis
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tic time period, such as 90 days. |