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Technology Stocks : Dell Technologies Inc. -- Ignore unavailable to you. Want to Upgrade?

To: freeus who wrote (81395)	11/22/1998 3:18:00 PM
From: BGR	Read Replies (2) \| Respond to of 176387

Freeus, I was referring to the equity volatility and not the option price volatility. The more volatile an equity is and the more is the time to expiry, the more is the option price holding interest rates adjusted for dividend, option strike price and present stock price as constants. Without going into the math I present an intuitive explanation. I understand that you have recently sold short term covered calls (which you hope will expire worthless) on DELL. This is a very volatile stock and can make 3-5% daily runs for consecutive days thus reaching your strike price in a short while causing your stocks to be called. Given that scenario, the option price needs to be high enough to compensate you for the loss of your equity in case that happens and that price needs to increase as the equity volatility increases to attract further sellers of calls. However, as expiry comes closer, the stock has lesser and lesser time to make a run as the volatility stays constant or even increases. In that case the attractive price of calls will decrease as the sellers face lower probability of losing the stock. Thus option price is an increasing function of both stock volatility and time to expiry and incorporates the so-called time and volatility premiums. A lot of money may be made selling these over time for a diversified portfolio as insurance companies have proved. Conversely, a lot of money may be lost from buying derivatives just as most of us will pay premiums but never collect our AD&D insurance, for example. But even insurance companies take out re-insurance policies, which is why I prefer spreads over naked sells. Even then, most individual investors can afford neither the resources needed to calculate the optimal diversification and needed time span of the portfolio nor can create exotic derivatives matching the optimal parameters if somehow calculated successfully, thus making selling uncovered derivatives solely for the purpose of speculating on time and volatility premium loss an enormously risky prospect - not one that I recommend or follow myself. Using naked put/call sells as substitutes for limit buy/short of equities is of course a different issue. Short term equity trading is inherently riskier than long term holding because volatility trumps trend (i.e. long term growth prospects of the underlying company) making prices unpredictable. In the long run, however, the trend (as long as business fundamentals remain unchanged) turns out to be the winner and volatility effects are secondary. Look at DELL's 5 year vs. 1 year vs. 1 month chart to see what I mean. Derivatives are by definition even more volatile than equity thus making them riskier. But there is another factor which works against the buyer of derivatives - limited life span. One may switch short term equity holding to long term hoping a recovery, but not so for derivatives. Hope springs eternal, but options expire. So, I would change maybe to most definitely (most and definitely with capital M and D respectively) when talking about risks of trading derivatives short term. You have made a very good point about LEAPS. It is my personal unsubstantiated belief that Black-Scholes misprices LEAPS on equities as under that model equity price fluctuations are determined by volatility rather than trend. Unless future growth prospects are reflected in historic market volatilities, which I doubt, this means that companies with different growth rates but similar volatility (e.g. AMD and DELL) will have similar LEAPS prices. Given that LEAPS are long term derivatives and in the long term trend is more important that volatility, I reach the conclusion that B-S will overprice puts and underprice LEAPS for, as you say, quality growth companies. I may very well be absolutely wrong about this and have an open action item to research the literature about this issue, but have no time at hand right now. FWIW, at present 90%+ of my family's total investments outside our retirement plans are in LEAPS calls for companies which we consider to have good growth prospects (we do not venture outside our specific professional areas of expertise). That way we only need to keep an eye on quality and growth (fundamentals if you will), assuming LEAPS continue to be priced using B-S. Disclaimer: Under no circunstances should this be construed as investment advice. I am taking chances with my money and will lose it all if I am wrong. I have lost money in the past with this strategy when I either lost my nerve and/or received margin calls and sold LEAPS at phenomenal loses. Everyone should do their own research. -Apratim. PS: I was analyzing Ben's Max-Pain analysis and it seems that it is probably right on the mark for predicting share prices at expiry in the absence of some fundamental change. I will post my thoughts in the thread once I am done with the analysis.