38 lines
2.6 KiB
Plaintext
38 lines
2.6 KiB
Plaintext
264 • The Intelligent Option Investor
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Market risk is a factor that investors in levered instruments must
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always keep in mind. Even an ITM call long-term equity anticipated
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security (LEAPS) in the summer of 2007 might have become a short-tenor
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out-of-the-money (OTM) call by the fall of 2008 after the Lehman shock
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because of the sharp decline in stock prices in the interim. Unexpected
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things can and do happen. A portfolio constructed oblivious to this fact is
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a dangerous thing.
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As long as market fluctuations only cause unrealized losses, market
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risk is manageable. But if a levered loss must be realized, either because of
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an option expiration or in order to fund another position, it has the poten-
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tial to materially reduce your available investment capital. Y ou cannot ma-
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terially reduce your investment capital too many times before running out.
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A Lehman shock is a worst-case scenario, and some investors live
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their entire lives without experiencing such severe and material market
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risk. In most cases, rather than representing a material threat, market risk
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represents a wonderful opportunity to an intelligent investor.
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Most human decision makers in the market are looking at either
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technical indicators—which are short term by nature—or some sort of
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multiple value (e.g., price-to-something ratio). These kinds of measures are
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wonderful for brokers because they encourage brokerage clients to make
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frequent trades and thus pay the brokerages frequent fees.
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The reaction of short-term traders is also wonderful for intelligent
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investors. This is so because a market reaction that might look sensible or
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rational to someone with an investment time horizon measured in days or
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months will often look completely ridiculous to an investor with a longer-
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term perspective. For example, let’s say that a company announces that its
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earnings will be lower next quarter because of a delay in the release of a
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new product. Investors who are estimating a short-term value for the stock
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based on an earnings multiple will sell the stock when they see that earn-
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ings will likely fall. Technical traders see that the stock has broken through
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some line of “resistance” or that one moving average has crossed another
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moving average, so they sell it as well. Perhaps an algorithmic trading
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engine recognizes the sharp drop and places a series of sell orders that are
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covered almost as soon as they are filled. In the meantime, someone who
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has held the stock for a while and has a gain on it gets protective of this gain
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and decides to buy a put option to protect his or her gains.
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