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Politics : Formerly About Advanced Micro Devices
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To: Dinesh who wrote (107942)4/26/2000 2:23:00 PM
From: Petz  Read Replies (2) of 1570433
 
Dinesh, comment on Black Scholes -- Basically Black Scholes assumes that stocks vary with a random walk pattern with no bias to either upside or downside. If a stock truly has a bias to the upside (refered to as a positive "alpha"), then Black Scholes will
1. say that call options are less valuable than they really are
2. say that put options are more valuable than they really are
3. say that short term calls are too valuable compared to long term calls

The third point comes about because the average change in stock price based on random walk theory is proportional to the square root of the number of days of movement. But, for a stock with a positive "alpha" (an uptrend), the average change in stock price is at least linear with time, and more accurately its exponentially growing with time.

Therefore, since option pricing on the exchanges does not veer much from Black Scholes, a good strategy -- for a stock with a positive alpha and very high volatility -- is to buy longer term calls and sell shorter term calls. Spreads can get messy to handle with your broker and the commisions double, so they are not for everybody.

BTW, strike prices up to 120 for May, June, July etc were added today.

Petz
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