Silicon Investor (SI) -- The First Internet Community

STOCKTALK

We've detected that you're using an ad content blocking browser plug-in or feature. Ads provide a critical source of revenue to the continued operation of Silicon Investor. We ask that you disable ad blocking while on Silicon Investor in the best interests of our community. If you are not using an ad blocker but are still receiving this message, make sure your browser's tracking protection is set to the 'standard' level.

Strategies & Market Trends : Mish's Global Economic Trend Analysis -- Ignore unavailable to you. Want to Upgrade?

To: mishedlo who wrote (62641)	1/24/2007 1:14:26 AM
From: jimmg	Respond to of 116555

option selling provides a bid and reduces volatility (until it doesn't). Not necessarily. The vast majority of option sellers employ a dynamic hedging strategy to extract the volatility premium of the option. Here's a brief example" "With non-linear derivatives, therefore, it is possible to capture gains from volatility by hedging a portion of the option's value. This is called the "delta", given by a mathematical formula derived from the formula used to determine price, and rebalancing the hedge as spot moves around and the delta changes. In the ABC Inc. example from above, we could have purchased a 1-month $50 call option on ABC giving us the right to purchase 100 shares. With the spot price at $50, the option is said to be at-the-money. At-the-money options have a delta of 50%, so to "delta-hedge" the option, we would have sold short 50 shares. If the ABC price proceeded to $25 the next week, we could buy back some of the 50 shares we were short (realizing a $25 profit on those shares). Any move back to $50 subsequently and we could sell more shares short again. If the ABC price went to $75 the next week, we could sell more shares short. This would enable us to buy these shares back if the ABC price went lower before maturity. The more times we can delta-hedge the option (or "dynamically hedge" the option), the more profit we will realize. Every time we realize a profit, we help to pay for the option. If you own an option and you delta hedge it, you will make money if the stock price goes up. You will also make money if the stock price goes down. You have to delta-hedge consistently in order to realize that profit, though. At the end of the day, you will only make money if you have realized delta-hedging profits that are greater than the premium you paid away for the option. The more the stock prices moves up and down, the more likely you are to realize delta-hedging profits. Conversely, if you sell an option and delta hedge it, you will lose money if the stock price goes up and you will lose money if the stock price goes down. Each time that you delta-hedge, you are realizing a loss. At the end of the day, you will only make money if your delta-hedging losses are less than the option premium you earned to sell the option in the first place. If you can understand delta hedging, then you can understand the way options are priced and what it means to determine good value in a premium. If we buy an option, then we are arguing that we will make more money dynamically hedging around it than we will pay in premium. If we sell an option, then we are arguing that we will make more money in premium than we will lose in dynamically hedging the option. One of the prime determinants of the price of an option is the volatility." finpipe.com