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Money Making: Options With A Minimum Risk Part 1

When you trade on lowering or rate increase, it is unessential to subject yourself to risk of an unpredictable course change of the quotation of the share constituting a basis of the option contract. Instead you can insure substantially yourselves from losses, using an option spread – the simultaneous purchase and sale of options of one class under the same shares, but with the different prices and terms.

Today we will tell about two methods of work with options which are applied in the event that you find it difficult to specify a share price trend. The first is called “long call”. The second, more conservative, carries the name “spread”. We will be convinced that the use of “long call” gives higher potential for profit earning. However, that operation became profitable, it is necessary to have considerable seed capital. Potential of profitableness at “spread” is limited. Nevertheless, it can bring in the quite good income even if the price for shares will fall slightly. We hope that these series of articles are pushed for you to studying of work with options, and theoretical study of operations with options will occupy some time, but will be also very informative.

Long Call

Let’s assume that the price of shares of company Dreamer can change the trend which has developed lately, and there is a chance that it considerably will grow for January, 20th, 2000 (share price for May, 25th, 1999 constituted 57.56 US dollars). If we simply take shares Dreamer, relying only on own opinion, there is a risk that we simply won’t guess, and the price will fall off even more low. If we purchase a call the risk will consist that we will lose all enclosed means if strike price of a call is above, than share price Dreamer on exercise date.

Let’s allocate an option as which we will consider as the most perspective for position discussion on Dreamer: January 2000 LEAP (long-term equity anticipation security). At once under the price in the left top corner three indicators of annual volatility calculated on the basis of the last 100, 50 and, accordingly, 20 days of change of the prices are resulted. As last indicator of volatility has decreased, it means that options become cheaper, as demand for them decreases.

We can assume that in the market there will be many January options because they belong to the class LEAP. We liked an option January “00 60; expectational share price 7.78 (7.35 – accounting price, result of a mathematical model, and 0.43 – a difference bid/ask). The symbolical designation of January – A, and before exercise date of the given option remains 241 day. The standard deviation of volatility of share prices for this period constitutes 32.5 %.

That the transaction on an option was profitable, share price should constitute on exercise date of 67.78 US dollars. Then the profit will constitute 7.78 US dollars (above the price strike), and the option will cost 7.78 US dollars for the share as we assumed during purchasing. If on exercise date share price does not reach 60 US dollars, we will lose all put up money provided that we will hold an option up to the end. But if share price really grows on option exercise date, say, on 32 %, having reached $76.27 then the option will cost $16.27. Compare from $7.78, which we should pay by our calculations now to acquire an option. This is one standard deviation of volatility shares. This size grows out of multiplication of size of annual volatility on a root square the relation 241 days by 365 days in a year.

If we have been assured from the very beginning that share price AT&T will start to grow, and our confidence would be supported any fundamental or specifications, we would feel much quieter. So in this case we will put stop-loss and we will consider less brave alternative.

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