Published June 28th, 2007
in Making Money With Options.
I’m a big fan of simple option strategies. Complex does not always mean better. Some people often neglect option strategies that hedge risk. This might be an investor that buys a stock and also buy a put to protect against a drop. The analogy in this case is buying insurance in which the price of the put is the insurance premium. The problem of course is that insurance costs money. The better you insure yourself (buying a put closer to the money in our example) the more you pay.
The Fence Technique
Unlike insurance, we can reduce the cost of the premium. How so? Consider a stock trading at $100. Suppose we buy a protective put at a strike of 95. We could also sell a call option at a strike of 110. This would mean that we are covered if the stock falls below 95 and we would also participate in any upward move until 110 at which point the call option would be exercised. Thus, we have lowered the cost of buying the protective call by selling a 110 call. Of course this comes at the price of a maximum profit of only 10$ minus the cost of selling and buying the options. This simple technique should not be under estimated though for the solid investor who doesn’t want to take big risks.
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Published June 24th, 2007
in Finance.
The above graph shows the immense growth of the Israeli Stock Market. From the beginning of 2006 until last week, the TA25 made a whopping 33% return. This immense growth is evident by what I call the “hedge fund commercials” indicator. Business is good for hedge funds in Israel and these days you simply can’t escape all the commercials trying to convince you to put money in their funds. For those who want to know how to chose the right fund, you can check out the post I made about comparing returns of funds.
The index as a reference tool?
It has occurred to me that most of the general public does not know how to decipher returns of funds. The biggest obstacle for the general public is probably when it is faced with numbers that make no sense. There could be a fund making 26% this year. There could be another with 17%. The public can’t judge how good are these returns if it has no perspective. What is a good return? Would your opinion change if a fund made 25% in Israel but the index itself 33%?
Knowing how much the index has returned can give us a little perspective on what are good returns. We could argue that we would have been better of just buying an index fund that would have given us the 33% and let that be our gauge. The problem is that it doesn’t tell us the full story of the risk involved. Some funds take more risks. Other take less risks. Here is an example: Let’s assume that fund A had returns of 40% this year. They beat the index who only made 33% this past year alright. But what if they had taken more risks in the form of leverage? Let’s assume for simplicity they had taken on average 50% of leverage. Could we still compare it to the index which made only 33%? We certainly can’t. They assumed more risk.
Risky business
Consider again the example above. What would have happened if we would have taken the same 50% risk? If we invested $100 for instance, we’d take a loan for $50. At the end of the year we’d have 33% on $150 which amounts to $49.5. From that we’d have to pay back the $50 plus interest (assume 5%) of $2.5. We’d be left with $147. This amounts to 47% returns. This means that given the same risk we undertook as the hedge fund did, we achieved higher returns.
This small example above shows you that even comparing just the index with other fund returns isn’t enough. You also have to know how much risks the fund takes. Do they use leverage? do they invest all their money in stocks or diversify in other investments? All of these has to be taken into account. Remember, when there is a bull market like there is now, you can’t allow yourself confuse luck with skills.
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Published June 18th, 2007
in Black Scholes.
I am currently reading a very interesting book by Jean-Philippe Bouchaud called “Theory of financial risks”. It is very recommended if you are mathematically inclined. The book tries to build option pricing from a different angle than the classical replication argument. These include assumption of continuous trading, constant volatility throughout the life of the option and log-normal returns.
In the last post, I have already displayed some graphs showing how the returns do not adhere to a normal distribution but to a skewed distribution with fatter tails. The point of the authors is that if in the Black and Scholes world, perfect replication is possible and hence no risk is involved, why do these instruments exist in the first place? The replication argument is so elegant that sometimes we forget to ask ourselves the most important questions. I used to ponder the same question myself from time to time. The answer probably lies somewhere in the middle. The markets are not in total chaos but nor are they complete.
The book develops a model for pricing options from a different angle, where there is no perfect hedge. The Black and Scholes world is just a pathological case i.e the exception and nothing more.
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