36 lines
2.8 KiB
Plaintext
36 lines
2.8 KiB
Plaintext
796 Part VI: Measuring and Trading Volatility
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move was needed to register a 4-standard deviation move. To see a specific example
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of how this works in actual practice, look carefully at the chart of IBM in Figure 38-
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4, the one that encompasses the crash of '87. Don't you think it's a little strange that
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the chart doesn't show any moves of greater than minus 4.0 standard deviations? The
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reason is that IBM's historical volatility had already increased so much in the days
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preceding the crash day itself, that when IBM fell on the day of the crash, its move
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was less than minus 4.0 standard deviations. (Actually, its one-day move was greater
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than -4 standard deviations, but the 30-day move - which is what the graphs in Figure
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38-3 and 38-4 depict - was not.)
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STOCK PRICE DISTRIBUTION SUMMARY
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One can say with a great deal of certainty that stocks do not conform to the normal
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distribution. Actually, the normal distribution is a decent approximation of stock
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price movement rrwst of the time, but it's these "outlying" results that can hurt any
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one using it as a basis for a nonvolatility strategy.
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Scientists working on chaos theo:ry have been trying to get a better handle on
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this. An article in Scientific American magazine ("A Fractal Walk Down Wall Street,"
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Februa:ry 1999 issue) met some criticism from followers of Elliot Wave theo:ry, in that
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they claim the article's author is purporting to have "invented" things that R. N.
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Elliott discovered years ago. I don't know about that, but I do know that the article
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addresses these same points in more detail. In the article, the author points out that
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chaos theo:ry was applied to the prediction of earthquakes. Essentially, it concluded
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that earthquakes can't be predicted. Is this therefore a useless analysis? No, says the
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author. It means that humans should concentrate on building stronger buildings that
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can withstand the earthquakes, for no one can predict when they may occur. Relating
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this to the option market, this means that one should concentrate on building strate
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gies that can withstand the chaotic movements that occasionally occur, since chaotic
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stock price behavior can't be predicted either.
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It is important that option traders, above all people, understand the risks of
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making too conservative an estimate of stock price movement. These risks are espe
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cially great for the writer of an option (and that includes covered writers and spread
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ers, who may be giving away too much upside by writing a call against long stock or
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long calls). By quantifying past stock price movements, as has been done in this chap
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ter, my aim is to convince you that "conventional" assumptions are not good enough
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for your analyses. This doesn't mean that it's okay to buy overpriced options just
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because stocks can make large moves with a greater frequency than most option |