39 lines
3.0 KiB
Plaintext
39 lines
3.0 KiB
Plaintext
414 Part IV: Additional Considerations
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mitments to option purchases so that his overall risk in a one-year period can be kept
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down to nearly 10%.
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Example: An investor might decide to put 2½% of his money into three-month
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option purchases. Thus, in any one year, he would be 1isking 10%. At the same time
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he would be earning perhaps 6% from the overall interest generated on the fixed
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income securities that make up the remaining 90% of his assets. This would keep his
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overall risk down to approximately 4.6% per year.
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There are better ways to monitor this risk, and they are described shortly. The
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potential profits from this strategy are limited only by time. Since one is owning
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options - say call options - he could profit handsomely from a large upward move in
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the stock market. As with any strategy in which one has limited risk and the poten
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tial of large profits, a small number of large profits could offset a large number of
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small losses. In actual practice, of course, his profits will never be overwhelming,
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since only approximately 10% of the money is committed to option purchases.
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In total, this strategy has greatly reduced 1isk with the potential of making
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above-average profits. Since the 10% of the money that is invested in options gives
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great leverage, it might be possible for that portion to double or triple in a short time
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under favorable market conditions. This strategy is something like owning a convert
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ible bond. A convertible bond, since it is convertible into the common stock, moves
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up and down in price with the price of the underlying stock. However, if the stock
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should fall a great deal, the bond will not follow it all the way down, because eventu
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ally its yield will provide a "floor" for the price.
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A strategy that is not used very often is called the "synthetic convertible bond."
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One buys a debenture and a call option on the same stock. If the stock rises in price,
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the call does too, and so the combination of the debenture and the call acts much like
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a convertible bond would to the upside. If, on the other hand, the stock falls, the call
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will expire worthless; but the investor will retain most of his investment, because he
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will still have the debenture plus any interest that the bond has paid.
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The strategy of placing 90% of one's money into risk-free, interest-bearing cer
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tificates and buying options with the remainder is superior to the convertible bond
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or the "synthetic convertible bond," since there is no risk of price fluctuation in the
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largest portion of the investment.
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The Treasury bill/option strategy is fairly easy to operate, although one does
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have to do some work every time new options are purchased. Also, periodic adjust
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ments need to be made to keep the level of risk approximately the same at all times.
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As for which options to buy, the reader may recall that specifications were outlined
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in Chapters 3 and 16 on how to select the best option purchases. These criteria can
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be summarized briefly as follows: |