39 lines
1.7 KiB
Plaintext
39 lines
1.7 KiB
Plaintext
246 • The Intelligent Option Investor
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No. Buy/Sell Instrument
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Price of
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Instrument
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Effective
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Buy (Sell)
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Price of
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Stock Note
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1 Buy Stock $17/share $17/share Original purchase
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2 Sell Call option $1/share $16/share Selling a covered call
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to take profits when
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stock reaches $20/
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share leaves the
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investor with down-
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side exposure and $1
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in premium income.
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3 Sell Call option $0.75 ($11.75/
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share)
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Stock falls to $11, and
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investor sells another
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covered call to
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generate income to
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ameliorate the loss.
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In transaction 1, the investor buys the shares for $17. In transaction 2,
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when the stock hits $20 per share, the investor sells a covered call and receives
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$1 in premium. This reduces the effective buy price to $16 per share and
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means that the investor will have to deliver the shares if the stock is trad-
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ing at $20 or above at expiration. When the stock instead falls to $11, the
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investor—wanting to cushion the pain of the loss—sells another ATM cov-
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ered call for $0.75. This covered call commits the investor to sell the shares
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for $11.75. No matter how you look at it, buying at $16 per share and sell-
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ing at $11.75 per share is not a recipe for investing success.
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The first step in such a situation as this—when the price of a stock
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on which you have accepted downside exposure falls—is to look back
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to your valuation. If the value of the firm has indeed dropped because
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of some material negative news and the position no longer makes sense
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from an economic perspective, just sell the shares and take the lumps.
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If, however, the stock price has dropped but the valuation still makes
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for a compelling investment, stay in the position; if the investment is |