34 lines
2.2 KiB
Plaintext
34 lines
2.2 KiB
Plaintext
Option Fundamentals • 27
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Here we have a stock trading at $50 per share, and we have bought
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one put option and one call option. The put option is struck at $20 and
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is trading for $0.35. The call option is struck at $80 and is trading for
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$0.40. Note that the top part of the diagram looks like the top part of the
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long-stock diagram and that the bottom part looks like the bottom part
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of the short-stock diagram. Because a stock investor cannot be simulta-
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neously long and short the same stock, we cannot use such terminology
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as effective buy or effective sell price. In this case, we use breakeven and
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abbreviate it BE.
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This option strategy illustrates one way in which options are much
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more flexible than stocks because it allows us to profit if the stock moves
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up (into the call’s range of exposure) or down (into the put’s range of
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exposure). If the stock moves up quickly, the call option will be in the
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money, but the put option will be far, far, far out of the money . Thus, if
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we are ITM on the call, the premium paid on the puts probably will end
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up a total loss, and vice versa. For this reason, we calculate both break-
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even prices as the sum of both legs of our option structure (where a leg
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is defined as a single option in a multioption strategy). As long as the leg
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that winds up ITM is ITM enough to cover the cost of the other leg, we
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will make a profit on this investment. The only way we can fail to make a
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profit is if the stock does not move one way or another enough before the
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options expire.
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Flexibility without Directionality Is a Sucker’s Game
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Despite this great flexibility in determining what directional invest-
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ments one wishes to make, as I mentioned earlier, option market mak-
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ers and floor traders generally attempt to mostly (in the case of floor
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traders) or wholly (in the case of market makers) insulate themselves
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against large moves in the underlying stock or figure out how to lim-
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it the cost of the exposure they are gaining and do so to such an ex-
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tent that they severely curtail their ability to profit from large moves.
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I do not want to belabor the point, but I do want to leave you with one
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graphic illustration of a “typical” complex option strategy sometimes
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called a condor : |