The problem with Black Scholes for out-of-the money options, is the model was based upon a Guassian or Normal distribution, and the market does behave in a Gaussian/Normal way. The tails for the distribution for the stock market is much wider than for Gaussian/Normal.
Thanks for the comment! The long call profit and loss chart is similar to the married put p/l, but the long call by itself is not a true parity trade to the married put position.
The true parity trade to the married put is a long call + depositing money that would have been used to buy shares of stock in an interest bearing account. The risk with using long calls is over trading or over leveraging your position.
With this married put setup we would invest $19,308 but would only risk $2,308 of that investment, or 12%. Yes, if you purchased one long call you would only be risking $2,270. However, let's say both you and I had $100,000 accounts and $20,000 in free capital. If I entered this married put above I would have invested about 1/5th of my capital but I am only risking 2.3% of my total portfolio. The married put forces us into an ideal sized trade, emphasizing proper position sizing.
If you purchase 1 SEP 170 call for $22.70, you are investing 1/10th of your free capital and risking 2.27% of your $100,000 portfolio. But, what do you do with the other $17,730 of free capital? Most investors will now buy 3 calls of XYZ, 5 calls of ABC, 4 calls of 123, etc. This leaves most of their $20,000 in free capital exposed in the market with the potential to lose 1/5th of their total account value if there is a drastic market turn. Thus, we are no longer at parity as too much of the portfolio is at risk.
If you use long calls you have to practice discipline, money management and proper position sizing in order to avoid leveraged losses.
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Jarinek84, you bring up valid points. I used the comparison of the 2013 JAN 17.5 call as that option would represent the 'parity' trade to the 2013 JAN 17.5 put in the married put trade. I also used the comparison of holding the option to this point as that is where we stood with the married put position. This makes a fair comparison between the two.
The 2013 JAN 15 call would have a loss of over -70% today from the initial purchase price, but at one point during the trade would have had about a 40% gain.
But as you mentioned each investor has their own risk-reward tolerance and must decide which positions suit their portfolio based on account size, market sentiment and exposure to risk.
We are often surprised by investors who tell us they like to use leveraged options positions to avoid the capital required to buy stock but will still invest $5,000 or more into one long call or spread position. The issue there is that they are risking too much of their portfolio into one position that may result in a 100% loss if not managed properly. When we use long calls or leveraged positions we still make sure that the monetary amount at risk does not represent more than 1-2% of our total portfolio value.
Insuring High Dividend Securities - Good Idea Or Waste Of Time? [View article]
Hello Jarinek84, investing in the married put position allows us to avoid the 'Lie of Leverage'. Does the long call have a similar risk-reward profile on a static profit and loss chart? Yes. Does the long call require less capital? Yes. Is a long call a parity trade to the married put? No.
On December 21st, 2011 the 2013 JAN 17.50 call was priced at $0.34. If you opened 1 contract, it would cost you $34.00. In comparison, opening 100 shares of NLY and purchasing the 2013 JAN 17.50 put option cost us $2,015.00. So, is the long call better? Not exactly...
Although we have invested $2,015 into the position we are only risking $2.65 per share for a potential 13 month trade. Because we own the stock and the timing of the entry, we would receive 5 dividend payments at an average of about $0.54 per payment, or $2.70 total. If we stay in the position through expiration we would have a true risk of -$0.05 (guaranteed profit of $0.05), assuming the dividend payment is not lowered, of course.
The true risk of the long call is $0.34, or 100% of the investment. Yes, if you only bought 1 contract your risk is only $0.34, but you are risking 100% of that value. You do not receive the dividend when trading a long call. Looking at the closing prices for the 2013 JAN 17.5 call on NLY since DEC 21, 2011, the option never reached a profit. The call is currently priced at $0.03 which would be a loss of -$0.31, or -91.2% of what you invested.
If we liquidated the NLY married put right now we would have a loss of -$0.12, or only -0.6% of our invested capital.
You might say that a loss of -$0.31 is not that bad, but that is under the assumption that you only purchased 1 contract. As we know, long call investors looking to use leverage would typically purchase more calls and this risk a higher monetary amount due to the leveraged risk.
Thanks for the comment, and let me know if you would like to run through some other examples or thoughts comparing the long call to the married put position.
In one conference call, can't remember which one, they said the cost of retrofitting an existing truck to operate on natural gas was $50K and the payback was about a year.
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I can see how having a few "beta" stores for testing out various formats would be a good idea, but once an optimal format is found, I would think replicating it would multiply the improvement across all of the stores. I don't think varying geographies could dictate significant differences in store formats.
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Thanks for the comment! The long call profit and loss chart is similar to the married put p/l, but the long call by itself is not a true parity trade to the married put position.
The true parity trade to the married put is a long call + depositing money that would have been used to buy shares of stock in an interest bearing account. The risk with using long calls is over trading or over leveraging your position.
With this married put setup we would invest $19,308 but would only risk $2,308 of that investment, or 12%. Yes, if you purchased one long call you would only be risking $2,270. However, let's say both you and I had $100,000 accounts and $20,000 in free capital. If I entered this married put above I would have invested about 1/5th of my capital but I am only risking 2.3% of my total portfolio. The married put forces us into an ideal sized trade, emphasizing proper position sizing.
If you purchase 1 SEP 170 call for $22.70, you are investing 1/10th of your free capital and risking 2.27% of your $100,000 portfolio. But, what do you do with the other $17,730 of free capital? Most investors will now buy 3 calls of XYZ, 5 calls of ABC, 4 calls of 123, etc. This leaves most of their $20,000 in free capital exposed in the market with the potential to lose 1/5th of their total account value if there is a drastic market turn. Thus, we are no longer at parity as too much of the portfolio is at risk.
If you use long calls you have to practice discipline, money management and proper position sizing in order to avoid leveraged losses.
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The 2013 JAN 15 call would have a loss of over -70% today from the initial purchase price, but at one point during the trade would have had about a 40% gain.
But as you mentioned each investor has their own risk-reward tolerance and must decide which positions suit their portfolio based on account size, market sentiment and exposure to risk.
We are often surprised by investors who tell us they like to use leveraged options positions to avoid the capital required to buy stock but will still invest $5,000 or more into one long call or spread position. The issue there is that they are risking too much of their portfolio into one position that may result in a 100% loss if not managed properly. When we use long calls or leveraged positions we still make sure that the monetary amount at risk does not represent more than 1-2% of our total portfolio value.
Thanks again for the comment, and happy trading!
Insuring High Dividend Securities - Good Idea Or Waste Of Time? [View article]
On December 21st, 2011 the 2013 JAN 17.50 call was priced at $0.34. If you opened 1 contract, it would cost you $34.00. In comparison, opening 100 shares of NLY and purchasing the 2013 JAN 17.50 put option cost us $2,015.00. So, is the long call better? Not exactly...
Although we have invested $2,015 into the position we are only risking $2.65 per share for a potential 13 month trade. Because we own the stock and the timing of the entry, we would receive 5 dividend payments at an average of about $0.54 per payment, or $2.70 total. If we stay in the position through expiration we would have a true risk of -$0.05 (guaranteed profit of $0.05), assuming the dividend payment is not lowered, of course.
The true risk of the long call is $0.34, or 100% of the investment. Yes, if you only bought 1 contract your risk is only $0.34, but you are risking 100% of that value. You do not receive the dividend when trading a long call. Looking at the closing prices for the 2013 JAN 17.5 call on NLY since DEC 21, 2011, the option never reached a profit. The call is currently priced at $0.03 which would be a loss of -$0.31, or -91.2% of what you invested.
If we liquidated the NLY married put right now we would have a loss of -$0.12, or only -0.6% of our invested capital.
You might say that a loss of -$0.31 is not that bad, but that is under the assumption that you only purchased 1 contract. As we know, long call investors looking to use leverage would typically purchase more calls and this risk a higher monetary amount due to the leveraged risk.
Thanks for the comment, and let me know if you would like to run through some other examples or thoughts comparing the long call to the married put position.
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Synthetic diesel looks pretty cool as well, lot's of stuff on the horizon.
Thanks
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http://bit.ly/T6Fuct
Not too sure about that ROIC 40.7% listed in the table.