33 lines
2.6 KiB
Plaintext
33 lines
2.6 KiB
Plaintext
Chapter 28: Mathematical Applications 413
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ed an annualized total return (capital gains, dividends, and commissions) of at least
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12%. This would eliminate many potential writes, but would leave him with a fairly
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large number of writing candidates each day. He knows the downside break-even
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point at expiration in each write. Therefore, the probability of the stock being below
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that break-even point at expiration can be computed quickly. His final list would rank
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those writes with the least chance of being below the break-even point at expiration
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as the best writes. Again, this ranking is based on an expected probability and is, of
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course, no guarantee that the stock will not, in reality, fall below the break-even
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point. However, over time, a list of this sort should provide the rrwst conservative cov
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ered writes.
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Example: XYZ is selling for 43 and a 6-month July 40 call is selling for 8 points. After
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including dividends and commission costs for a 500-share position, the downside
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break-even point at expiration is 36. If the annualized volatility of XYZ is 25%, the
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probability of making money at expiration can be computed. The 6-month volatility
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is 17.7% (25% times the square root of½ year). The probability of being below 36
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can be computed by using the formula given earlier in this section:
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The expected probability of XYZ being below 36 in 6 months is 15.8%. Therefore,
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this would be an attractive write on a conservative basis, because it has a large prob
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ability of making money (nearly 85% chance of not being below the break-even point
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at expiration). The return if exercised in this example is approximately 20% annual
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ized, so it should be acceptable from a profit potential viewpoint as well. It is a rela
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tively easy matter to perform a similar calculation, with the aid of a computer, on all
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covered writing candidates.
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The ability to measure downside protection in terms of a common denomina
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tor - volatility - can be useful in other types of covered call writing analyses. The
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writer interested in writing out-of-the-money calls, which generally have higher
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profit potential, is still interested in having an idea of what his downside protection
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is. He might, for example, decide that he wants to invest in situations in which the
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probability of making money is at least 60%. This is not an unusually difficult
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requirement to fulfill, and will leave many attractive covered writes with a high prof
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it potential to choose from. A downside requirement stated in terms of probability
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of success removes the necessity of having to impose arbitrary requirements. Typical |