36 lines
2.8 KiB
Plaintext
36 lines
2.8 KiB
Plaintext
128 Part II: Call Option Strategies
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amount . .. When XYZ falls to 32, the stock can be covered to ensure an overall profit
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of 2 points on the transaction. However, if XYZ continued to fall to 20, the investor
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who took no follow-up action would make 14 points while the one who did take fol
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low-up action would make only 2 points. Recall that it was stated earlier that there is
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a high probability of realizing limited losses in the reverse hedge strategy, but that
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this is balanced by the potentially large profits available in the remaining cases. If one
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takes follow-up action and cuts off these potentially large profits, he is operating at a
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distinct disadvantage unless he is an extremely adept trader.
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Proponents of using the follow-up strategy often counter with the argument
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that it is frustrating to see the stock fall to 32 and then return back to nearly 40 again.
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If no follow-up action were taken, the unrealized profit would have dissolved into a
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loss when the stock rallied. This is true as far as it goes, but it is not an effective
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enough argument to counterbalance the negative effects of cutting off one's profits.
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ALTERING THE RATIO OF LONG CALLS
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TO SHORT STOCK
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Another aspect of this strategy should be discussed. One does not have to buy exact
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ly two calls against 100 shares of short stock. More bullish positions could be con
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structed by buying three or four calls against 100 shares short. More bearish positions
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could be constructed by buying three calls and shorting 200 shares of stock. One
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might adopt a ratio other than 2:1, because he is more bullish or bearish. He also
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might use a different ratio if the stock is between two striking prices, but he still
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wants to create a position that has break-even points spaced equidistant from the cur
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rent stock price. A few examples will illustrate these points.
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Example: XYZ is at 40 and the investor is slightly bullish on the stock but still wants
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to employ the reverse hedge strategy, because he feels there is a chance the stock
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could drop sharply. He might then short 100 shares of XYZ at 40 and buy 3 July 40
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calls for 3 points apiece. Since he paid 9 points for the calls, his maximum risk is that
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9 points if XYZ were to be at 40 at expiration. This means his downside break-even
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price is 31, for at 31 he would have a 9-point profit on the short sale to offset the 9-
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point loss on the calls. To the upside, his break-even is now 44½. IfXYZ were at 44½
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and the calls at 4½ each at expiration, he would lose 4½ points on the short sale, but
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would make l ½ on each of the three calls, for a total call profit of 4½.
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A more bearish investor might short 200 XYZ at 40 and buy 3 July 40 calls at 3.
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His break-even points would be 35½ on the downside and 49 on the upside, and his
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maximum risk would be 9 points. There is a general formula that one can always |