34 lines
2.1 KiB
Plaintext
34 lines
2.1 KiB
Plaintext
156 • The Intelligent Option Investor
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I’ll break the process into three steps:
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1. Create a BSM cone.
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2. Overlay your rational valuation range on the BSM cone.
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3. Look for discrepancies.
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Create a BSM Cone
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The heart of a BSM cone is the forward volatility number. As we have seen,
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as forward volatility increases, the range of future stock prices projected by
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the BSM (and expected by the market) also increases. However, after hav-
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ing looked at the market pricing of options, we also know that a multitude
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of volatility numbers is available. Which one should we look at? Each strike
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price has its own implied volatility number. What strike price’s volatility
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should we use? There are also multiple tenors. What tenor options should
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we look at? Should we look at implied volatility at the bid price? At the ask
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price? Perhaps we should take the “kitchen sink” approach and just average
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all the implied volatilities listed!
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The answer is, in fact, easy if you use some simplifying assumptions
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to pick a single volatility number. I am not an academic, so I don’t neces-
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sarily care if these simplifying assumptions are congruent with theory.
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Also, I am not an arbitrageur, so I don’t much care about very precise
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numbers, and this attitude also lends itself well to the use of simplifying
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assumptions. All we have to make sure of is that the simplifying as-
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sumptions don’t distort our perception to the degree that we make bad
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economic choices.
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Here are the assumptions that we will make:
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1. The implied volatility on a contract one or two months from expi-
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ration that is ATM or at least within the 40- to 60-delta band and
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that is the most heavily traded will contain the market’s best idea
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of the true forward volatility of the stock.
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2. If a big announcement is scheduled for the near future, implied
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volatility numbers may be skewed, so their information might
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not be reliable. In this case, try to find a heavily traded near ATM
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strike at an expiry after the announcement will be made. If the
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announcement will be made in about four months or more, just try |