Saturday, June 6, 2009

a view on a particular option instrument

When we see 2 quotes for the same IBM call option by 2 sellers (say UBS vs Citi), these are essentially 2 "views" on IBM volatility. The UBS view may assume a low volatility from now till expiration, but ...

Q: does the UBS trader express a view on where underlying price will move? (Note "no-move" is also a view.)
My A: I don't think so. I feel the entire view is expressed (and encapsulated) in the implied volatility.

Q: If the Citi quote is very, very high, then can we conclude either Citi trader feels IBM will rise, or Citi assumes a high volatility???

Q: From a slightly different angle, what if Citi trader feels IBM will rise over the next month? How does that affect his pricing?
%%A: I feel he can simply use a higher volatility estimate. or he can delta hedge.

Whenever discussing a VIEW like "what if traders feel ...", we can't avoid comparing multiple strategies. Each strategy has a "risk/reward profile" (what I call RRP). In eq option world, a strategy is basically one or more positions you enter, whose combined portfolio MV is hopefully weather-proof. The layman's obvious and simple strategy can be smart or naive.  (ignoring spread strategies,) Basic, common strategies include

- buy underlier
- short underlier - risk? unlimited
- buy call, ITM or OTM - risk? low
- buy put, ITM or OTM - risk? low
- [7] (naked call) write a call, OTM - risk? unlimited
- [7] (naked call) write a call, ITM - risk? unlimited and bigger
- (covered call) buy underlier + write call of identical qty
- [a] write an IMT put - risk unlimited (loosely)
- [8] write an OTM put - risk unlimited (loosely)
- [1] buy underlier using a limit order "buy when it drops to a value price of $0.01"
- [3] (protective put) - buy underlier + buy an OTM put of the same qty

[3] the long underlier position has big downside risk. The put protects it, like a low-cost insurance.
[7] naked call is related to a short in underlier. When I write a naked call, i agree to go short in underlier at, say $44.
[8] when I write a put, I agree to buy into a long position
[8] When I write a put at $999, someone may unload his rotten corn (something worthless) on me and I end up buying the corn at $999. I end up with a massive losing long position.
[8] is comparable to [1], more comparable to limit order BUY, but more sophisticated.
[a] I don't know exactly why anyone would take this risk, but premium would be intrinsicVal + timeVal and a pretty high insurance premium

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