36 lines
2.6 KiB
Plaintext
36 lines
2.6 KiB
Plaintext
810 Part VI: Measuring and Trading Volatility
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Expected profit is computed by calculating the profitability of a position at a
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certain stock price times the probability of the stock being at that price, and summing
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that multiple over all possible stock prices. When the concept was first introduced,
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the "probability of the stock being at that price" was given as what we now know is
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the "endpoint" probability. In reality, a much better measure of the expected profit
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of a position can be obtained by using one of the more advanced probability estima
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tion models presented above.
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In generalized expected return studies done using the fat tails Monte Carlo sim
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ulation, certain general conclusions can be drawn about some strategies.
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• A bull spread is an inferior strategy when the options are fairly priced, no matter
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which distribution is assumed. This more or less agrees with observations that
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have been made previously regarding the disappointments that traders often
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encounter when using vertical spreads.
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• While covered writing might seem superior to stock ownership under the log
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normal distribution, the two are about equal under a fat tail distribution.
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• Most startling, though, is the fact that option buying strategies fare much, much
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better under a fat tail distribution than a lognormal one. This most clearly
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demonstrates the "power" of the fat tail distribution: A limited-risk investment
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with unlimited profit potential can be expected to perform very well if the fat tails
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are allowed for.
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Using the lognormal distribution more or less represents the conventional wisdom
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regarding option strategies - the one that many brokers promote: "Don't buy options,
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don't mess with spreads, either buy stocks or do covered call writes." The fat tail dis
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tribution column stands much of that advice on its head. In real life (as demonstrat
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ed by the fat tail distribution), strategies with limited profit potential and unlimited
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or large risk potential are inferior strategies.
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One should be aware that the phrase "expected return" is used in many quasi
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sophisticated option analyses (and even in analyses not using options). Many
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investors accept these "returns" on blind faith, figuring that if they're generated by a
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computer, they must be correct. In reality, they may be not be representative, even
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for comparisons.
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SUMMARY
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This chapter has demonstrated that probability analysis is an inexact science, because
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markets behave in ways that are very difficult to describe mathematically. However,
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probability analysis is also necessary for the option strategist; without it he would be |