Trading Strategies Profit Making Techniques For Stock_1

34 WHY AND HOW OPTION PRICES MOVE However, you should use the annualized yields to compare two similar strategies, not to compare one strategy with other types of investments. For example, you make 9 percent for a one-month investment, but you do not know what your return will be for the remaining 11 months of the year. You might be able to reinvest at only 5 percent and would have been better off investing in a certificate of deposit at 8 percent for a year. All discussions of return should also be tempered with the risk. One strategy might make 10 percent while another strategy makes 9 percent. It might be that the second strategy is still the best strategy because the risk is significantly lower. Think in terms of the amount of risk you are taking for each unit of profit. Return-if-Exercised The return-if-exercised is the return that the strategy will earn if one or all of the short or written options are exercised. The return-if-exercised is not used if you have not sold short or written any options. The return is calculated by making the assumptions that the option is exercised and no other factor changes. The return is also affected by the type of transaction and account, which affect the carrying costs and the final position that the investor owns after the option is exercised. For example, in a covered call position, the return-if-exercised is the return on the investment if the underlying stock was called away. Suppose you are long 100 General Widget stock at $50 and short one General Widget $45 call options at $7. The option expires in three months. The return if exercised would be the $2 profit on the option divided by the $50 price of the stock. The annualized return would be ($2 ÷ $50) × (12 ÷ 3), or 1/25 × 4, or 16 percent. Note that the initial investment was assumed to be $50 for the stock. The return-if-exercised would be significantly different if the stock had been bought on margin. The cost of borrowing the money would then have to be taken into account. Also note that dividends or interest payments, if any, should be taken into account, as well as the interest earned, if any, on the proceeds of the short option. All of these carrying-charge-type factors will affect the return-if-exercised. Look at the same General Widget example but with these changes: the transaction is on margin, the broker loan is 12 percent, the holding period is three months, the return on the short option premium is 10 per-cent, and there is a dividend of 4 percent. Now, you would receive the $2 profitplusanassumed$0.50dividend(youmustlookcloselyatthechances that you will hold the position through the next dividend before making this assumption) plus an interest premium on the short option premium of $0.175 ($7 option premium times 10 percent divided by 4), for a total The Basics of Option Price Movements 35 income of $2.675. Expenses will be the cost of carrying the margin position of $0.75 ($25 borrowed times 12 percent broker loan rate divided by 4). Thus, the net income will be $2.675 − $0.75, or $1.925, on an investment of $25, for an annualized return of 30.8 percent. ThesecondGeneralWidgetexamplegivenassumedthatyousoldshort an in-the-money option and that the price of the UI did not decline to below the strike price—in other words, the price of the option did not change and the stock was called away by the exercise. But what if the price dropped below the strike price? The option would not have been exercised, and the preceding calculation would not occur. This shows the main problem with calculating the return-if-exercised. It assumes that the option is exercised, which requires that you make an assumption on the price of the UI. Also note that there is a greater chance that the return-if-exercised will be an accurate description of the eventual return to you the deeper in-the-money the option is. For example, writing a $40 call against an in-strument trading at $50 will give you a much greater reliability for expect-ing the return-if-exercised to be accurate than if you write a $60 call that is out-of-the-money. Return-if-Unchanged The return-if-unchanged is the return on your investment if there is no change in the price of the UI. This calculation can be done on any option strategy. It also assumes that the option price does not change and so de-scribes the most neutral future event. For this reason, it is a popular return to calculate. It is often the starting point for the option strategist for iden-tifying a possible investment. Of course, the chances of the UI price being exactly unchanged are very low. As a result, this is just the starting point for analysis of the strategy, not the final analysis. The calculation is done in much the same manner as the return-if-exercised, except that the strategy can include multiple legs, or options. There can be different strikes and types in the calculation. However, the return-if-unchanged does not usually use different matu-rities.Further,itisnot used incomplex options strategies thatuse different UIs. For example, you will not see the return-if-unchanged calculated on a position that includes options on both Treasury-bond and Treasury-note futures. Expected Return The expected return is the possible return weighted by the probability of the outcome. Theoretically, you will receive the expected return from this 36 WHY AND HOW OPTION PRICES MOVE strategy or trade. You might not receive on this particular trade but should expect to get in over a very large number of trades. In effect, you are look-ing at the trade from the perspective of the casino owner: You know you might lose on this particular bet, but you anticipate winning after hundreds or thousands of bets have been made. The most common way to calculate the expected return is to take the implied volatility and compute the probability of various prices based on the implied volatility (see Chapter 5 for more details). It is assumed that prices will describe a normal bell-shaped curve (though scientific studies suggest this is not accurate, it is usually close enough for vir-tually all option strategies). The precise math is beyond the scope of this book, but the following is a simple illustration of the principle: As-sume that the expected distribution of prices, as suggested by the im-plied volatility, suggests that the chances are 66 percent that prices of Widgeteria will stay within a range of $50 to $60. Your position has been constructed to show a profit of $1,000 if prices stay within that range. There is a 16.5 percent chance of prices trading above $60 and a sim-ilar chance of prices trading below $50. You will lose $1,000 if prices move above 60 or below 50. Your expected return is, therefore, the sum of the potential profits and losses multiplied by their respective chances of happening: (0.66 × 1,000) + (0.165 × −1,000) + (0.165 × −1,000), or $330. Another example looks at the expected return from the perspective of just the price of the UI and what it implies for the price of the option. Make the absurd assumption that the price of Widgets R Us can only trade at a price of $50 or $60 at expiration and that the current price is $55. Further assume that your study of implied volatility suggests that there is a 60 per-cent chance of prices ending at $60 and a 40 percent chance of ending at $50. The expected return from this position is (0.60 × $5) + (0.40 × −$5), or $3 − $2, or $1. This would then be a good value for an option, given all other things being irrelevant. The delta of an option is a very good approximation of the chance that an option will end in-the-money. This is not technically true but is close enough for even the most picky of arbitrageurs. This type of analysis has the advantage of acknowledging that dif-ferent strategies will have different variability of returns. The return-if-unchanged can look identical for two completely different strategies that diverge wildly as soon as the price of the UI moves away from unchanged. At the same time, it has the same advantage of being neutral to the fu-ture direction of the market. It assumes that there are equal chances of the marketclimbingasfalling.Asaresult,itisrecommendedthatoptionstrate-gists try to concentrate on using this form of analysis if they have the capa-bility to calculate the expected return. The Basics of Option Price Movements 37 Return-per-Day The return-per-day is the expected return each day until either expiration or the day you expect to liquidate the trade. For example, you might be comparing two covered call writing programs and want to know which one is best. Take the expected return and divide by the number of days until expiration. That way, you can compare two investments of differing lengths. Once again, the variability of possible returns can vary widely from the simple case presented here. The return-per-day should only be considered a starting point, much the same way that the return-if-unchanged is a start-ing point. The best strategies to use the return-per-day are the strategies that are more arbitrage or financing related, such as boxes or reversals. The variability of the possible outcomes is fairly limited, so the return-per-day makes more sense. ... - tailieumienphi.vn