34 lines
1.8 KiB
Plaintext
34 lines
1.8 KiB
Plaintext
The Intelligent Investor’s Guide to Option Pricing • 59
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the size of the BSM’s probability cone itself. When the cone changes size,
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the range-of-exposure area within the cone also changes. Let’s explore this
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concept more.
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How Changing Market Conditions
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Affect Option Prices
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At the beginning of Chapter 2, I started with an intuitive example related
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to a friendly bet on whether a couple would make it to a restaurant in time
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for a dinner reservation. Let’s go back to that example now and see how the
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inputs translate into the case of stock options.
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Dinner Reservation Example Stock Option Equivalent
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How long before seating time Tenor 3 of the option
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Distance between home and restaurant Difference between strike price and
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present market price (i.e., strike–stock
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price ratio)
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Amount of traffic/likelihood of getting caught
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at a stoplight
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How much the stock returns are
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thought likely to vary up and down
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Average traveling speed Stock market drift
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Gas expenditure Dividend payout
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Looking at these inputs, it is clear that the only input that is not known
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with certainty when we start for the restaurant is the amount of traffic/
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number of stoplights measure.
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Similarly, when the BSM is figuring a range of future stock prices,
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the one input factor that is unknowable and that must be estimated is
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how much the stock will vary over the time of the option contract. It is
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no surprise, then, that expectations regarding this variable become the
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single most important factor for determining the price of an option and
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the factor that people talk most about when they talk about options—
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volatility (vol).
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This factor is properly known as forward volatility and is formally
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defined as the expected one-standard-deviation fluctuation up and
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down around the forward stock price. If this definition sounds familiar, |