43 lines
3.5 KiB
Plaintext
43 lines
3.5 KiB
Plaintext
284 Technical Analysis of Stock Trends
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of the futures price. Of these variables, volatility is the only one that cannot be observed
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directly. Considering all the other variables are known, however, it is possible to infer from
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option prices an estimate of how the market is gauging volatility. This estimate is called the
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“implied volatility” of the option. It measures the market’s average expectation of what the
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volatility of the underlying futures return will be until the expiration of the option. Implied
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volatility is usually expressed in annualized terms. The significance and use of implied
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volatility is potentially complex and confusing for the general investor, professionals having
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a decided edge in this area. Their edge can be removed by serious study.
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Exercising the option
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At expiration, the rules of optimal exercise are clear. The call owner should exercise the
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option if the strike price is less than the underlying futures price. The value of the exercised
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call is the difference between the futures price and the strike price. Conversely, the put
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owner should exercise the option if the strike price is greater than the futures price. The
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value of the exercised put is the difference between the strike price and the futures price.
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To illustrate, if the price of the expiring futures contract is 7 ,600, a call struck at 7 ,500
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should be exercised, but a put at the same or lower strike price should not. The value of the
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exercised call is $1,000. The value of the unexercised put is $0.00. If the price of the expiring
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futures contract is 7 ,500, a 7 ,600 put should be exercised but not a call at 7 ,600 or a higher
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strike. The value of the exercised put is $1,000 and that of the unexercised call is $0.00.
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The profit on long options is the difference between the expiration value and the option
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premium. The profit on short options is the expiration value plus the option premium.
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The expiration values and profits on call and put options can often be an important tool
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in an investment strategy. Their payoff patterns and risk parameters make options quite
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different from futures. Their versatility makes them good instruments to adjust a portfolio
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to changing expectations about stock market conditions. Moreover, these expectations
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can range from general to specific predictions about the future direction and volatility of
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stock prices. Effectively, there is an option strategy suited to virtually every set of market
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conditions.
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Using futures options to participate in market movements
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Traders must often react to rapid and surprising events in the market. The transaction
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costs and price impact of buying or selling a portfolio’s stocks on short notice inhibit many
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investors from reacting to short-term market developments. Shorting stocks is an even
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less palatable option for average investors because of the margin and risks involved and
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semantical prejudices.
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The flexibility that options provide can allow one to take advantage of the profits from
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market cycles quickly and conveniently. A long call option on Dow Index futures profits
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at all levels above its strike price. A long put option similarly profits at all levels below its
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strike price. Let us examine both strategies.
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Profits in rising markets
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In August, the Dow Index is 10,000 and the Dow Index September future is 10,050. You
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expect the current Bull Market to continue, and you would like to take advantage of the
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trend without tying up too much capital and also undertake only limited risk. |