34 lines
2.0 KiB
Plaintext
34 lines
2.0 KiB
Plaintext
Accepting Exposure • 221
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Downside: Fairly valued
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Upside: Overvalued
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Execute: Sell a call contract (short call); sell a call contract while
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simultaneously buying a call contract at a higher strike
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price (short-call spread)
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Risk: Unlimited for short call; difference between strike prices
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and premium received (short-call spread)
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Reward: Limited to the amount of premium received
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Margin: Variable for a short call; dollar amount equal to the differ-
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ence between strike prices for a short-call spread
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The Gist
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The market overestimates the likelihood that the value of a firm is above its pre-
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sent market price. An investor accepts the overvalued upside exposure in return
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for a fixed payment of premium. The full amount of the premium will only flow
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through to the investor if the price of the stock falls and the option expires OTM.
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There are two variations of this investment—the short call and the
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short-call spread. This book touches on the former but mainly addresses
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the latter. A short call opens up the investor to potentially unlimited capital
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losses (because stocks theoretically do not have an upper bound for their
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price), and a broker will not allow you to invest using this strategy except
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for the following conditions:
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1. Y ou are a hedge fund manager and have the ability to borrow
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stocks through your broker and sell them short.
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2. Y ou are short calls not on a stock but on a diversified index (such
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as the Dow Jones Industrial Index or the Standard and Poor’s 500
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Index) through an exchange-traded fund (ETF) or a futures con-
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tract and hold a diversified stock portfolio.
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For investors fitting the first condition, short calls are margined in the
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same way as the rest of your short portfolio. That is, you must deposit initial
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margin on the initiation of the investment, and if the stock price goes up, you
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must pay in variance margin to support the position. Obviously, as the stock
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price falls, this margin account is settled in your favor. For investors fitting the
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second condition, when you originally sell the call option, your broker should |