Chapter III. Using OptionExpert cont`d
Contents
1. Create Position dialog box e Use this dialog box to create your next position and click Create Position dialog box OK ight lick eee ENS e An additional line of information will be added to the window in the second Create Position dialog box for each option you add 5 When you have finished creating all of the option positions required for the strategy click OK The dialog box is closed and the new position is transferred to the Position window Results of the analysis will appear in the Economic Analysis section Shortcut Method for Creating a Position I To create an option position 1 In the Option List double click on the option you want to use for the position The first Create Position dialog box will open and display the information for that option 2 Complete the position information by entering values in the Quantity and Price fields then click OK 4 When the second Create Position dialog box appears you can edit the position information by double clicking on the position and you can add positions by following step 4 above 5 When the position is complete click OK to transfer the information to the Position window Chapter Ill Finding Positions 65 66 AIQ OptionExpert User Manual2. analysis process the Indicated Value should always be scrutinized These steps are explained below Step 1 Select a Strategy Analysis Information Strategy Before you ask OptionExpert to analyze the available options and Ja Option Strategies 7 compute the most profitable option positions you first need to select a All Option Strategies strategy from the Strategy section of the Position Analysis window All Bearish Strategies All Bullish Strategies All Covered Strategies Covered Call Write Variable Ratio Call Write Sell Covered Strangle Sell Covered Straddle If you have chosen the underlying instrument because you want to make a strong bet that it will move in one direction you can select strategies to take particular advantage of the type of move you expect If you expect the underlying instrument to remain relatively flat or if you expect it to move strongly but you don t know in which direction Sell Strangl Buy Strande you would choose other strategies If you are unsure as to which Sell Straddle strategy is best you can let the system determine the best strategy iy a d based on your projection of price for the underlying instrument This Diagonal Bear Spread price projection is entered in the form of the Indicated Value Diagonal Bull Spread Bearish Time Spread Neutral Time Spread Bullish Time Spread I To select a strategy 1 Display the list of strategies by clicking the arrow
3. index value will be at the end of 45 days is of course unknown All you can do is make a series of alternative guesses which is what probability distribution is all about It simply shows the probability of various index values in the future The word probability is a scientific or mathematical expression for chance What is the chance that the value of the index will be exactly 275 at the end of 45 days That chance is actually very small What is the chance that the value will be greater than or equal to 275 According to the probability distribution in Diagram 1 the chance of the value being 275 or more is 50 The area under the curve represents 100 or all of the possible alternative index values The center line is 275 and the area under the curve to the right of that center line is 50 of the total area Hence the chance of the index value being 275 or more is 50 If you were going to buy an option on this index what is the chance of making money what is the chance of breaking even what is the chance of losing money Chapter Ill Finding Positions 47 48 AIQ OptionExpert User Manual Consider purchasing a call contract for a total cost of 350 including commissions This call contract has a strike price of 270 and expires in 45 days Therefore in order to break even on this option contract the index value has to be 273 50 or greater Any value less than 273 50 will cause this call contract to lose money Referring to Di
4. line crosses the zero profit line Any stock price less than 120 will result in a profit and prices above a loss The maximum loss is about 10 900 equivalent to the initial investment The screen below displays the Position Analysis window following a selection of positions under the Sell Option Write strategy using the same data as in the previous example that is the system is asked to select a short position One of the top write positions selected by OptionExpert is sell October 120 calls The position of three contracts results in a return on investment of 31 9 5 The Position Graph for this short position shows a breakeven value for the stock at about 128 Anything below this value indicated by the crossing of the line would be a profit Anything above the breakeven value would be a loss with maximum profit from the sale of the puts about 2 390 occurring below 120 As you can see from the graph the selling of naked options is a high risk position with limited profit potential 2 Let OptionExpert pick a bullish or bearish option position Depending upon your short term price projection Indicated Value for the underlying issue select either All Bullish Strategies or All Bearish Strategies then click Find Positions OptionExpert will evaluate all strategies within the category that your choice indicates including both single option and complex option positions and select those with the highest return on investme
5. on the Strategy Bear Spread list box Bull Spread ae Sell Option 2 Select the strategy you want by clicking on it Buy Option 3 The selected strategy will appear in the Strategy box Strategy list box ae f f 9y S The five ways to select positions are explored in the next section Step 2 Review adjust Situation Data There are seven Situation Data parameters any of which can be revised by simply typing new values in the Situation Data text boxes Adjustment of the two most important parameters Indicated Value and Volatility are discussed below Of the remaining values two Current Price and Dividend are downloaded from your data service Note and two Interest Rate and Position Capital are taken from You can change the default Properties The last value Analysis Date is automatically set by the values in Properties See system Customizing Properties section 5 Chapter Ill Finding Positions 58 Note If you enter an Indicated Value that is more than 30 above or below the current price a warning box will appear 54 AIQ OptionExpert User Manual Situation Data Current Price san E Volatity 33 Interest Rate 53 Dividend 0 12 Analysis Date os 17 99 Indicated Value 3640 Position Capital 50000 Indicated Value The Indicated Value is the projected price for the underlying instrument on the Analysis Date the date when all option positions are evaluated by the system This date
6. on the downside should the stock decline However if the stock should rise above the strike price of the call the writer stands to lose all appreciation above that price Covered call writing is a relatively safe conservative strategy that is very different from writing uncovered call options Writing calls against stock actually reduces the risk of stock ownership In exchange for limiting your profit potential on the upside the premium provides some downside protection The option premium may also be looked at as compensation for the appreciation opportunity that is given up Most likely the investor in a covered call position owns the underlying stock prior to writing the calls In other situations it is possible that the purchase of the stock will coincide with the writing of the calls although both are not necessarily disposed of at the same time The variable ratio call write which is a special type of covered call write is a sophisticated strategy that combines covered and uncovered call writing In a ratio call write the writer sells calls against more shares than are owned The most common ratio called the covered call ratio is 2 1 where two calls are sold against 100 shares of the underlying stock When you select Covered Call Write or Variable Ratio Call Write and click Find Positions a special dialog box Covered Positions Conditions is displayed which allows you to specify the number of shares in the underlying sto
7. position is shown in the Position window I To edit a position 1 Select the position you want to edit by displaying it in the Position window Then click the Edit button 2 The dialog box that appears Edit Position is used for editing position data Variable Ratio Call Write Edit Position UPC Symbol Description Piicel 1 100 ZKFAQ AOL Jan O1 85 Call 28 3 8 1 10 ZKFAY AOL Jan O1 87 1 27 1 8 Buy 100 1 AOL AMERICA ONLINE 87 1000 00 9700 00 25 00 2812 50 3 To make changes to this position proceed as follows e In the main window of the dialog box double click with your mouse the line you wish to change A second dialog box will appear containing the data from the selected line Variable Ratio Call Write Modify Position al Li 9 a sl am Modify Position dialog box displaying the selected o option position e Change the data in any of the individual boxes by clicking an insertion point in the box and typing in new data e When you have completed your changes to this line click OK The Modify Position box will close and the changes are transferred to the previous Edit Position dialog box 4 Repeat the above procedure for any other lines that require change 5 Click OK The dialog box is closed and all changes are transferred to the Position window Chapter Ill Finding Positions 63 Creating positions If you know both the strategy and
8. probable values is wider In order to accept or reject the call contract being considered you have to be able to determine its economic value and compare that economic value with other alternative option positions The criterion for evaluation of the economic value is expected profit Expected profit is not the same as the actual profit from the contract Actual profit is not known until the option expires Depending on the index value at the time of expiration the option will have value or may expire worthless The value at expiration depends on the value of the index With a strike price of 270 the option will expire worthless if the index is anything less than 270 If the index reaches 272 then the option has a value of 200 If the value of the index at expiration is 278 then the option will have a value of 800 etc What will happen in the future one has no way of knowing All you can do is take your best guess with the information that is available The information available is represented in Diagram 3 and again in Table 1 That information includes the option terms strike 270 and time to expiration 45 days and the current price of the option 350 per contract TABLE 1 Conditional Conditional Conditional Option Option Profit Expected Price Probability Value Cost Loss Profit 271 02 100 350 250 5 0 272 04 200 350 150 6 0 273 14 300 350 50 7 0 274 18 400 350 50 9 0 275 24 500 350 150 36 0 2
9. represents the average return average if you were to play this game or make this investment every single day for eternity On the average you would get back a profit of 183 every time you invested 350 Sometimes however you would get back 850 sometimes you would get back 250 and sometimes you would lose 150 But on the average played over and over again the average return would be 183 Of course you are not going to make this investment over and over again This is the only time you will see this particular situation But this mathematical process allows for the expected profit to be the most logical and mathematically correct criterion for making a selection among alternative investment situations The analysis shown in this example buying a single call contract is a simple one The analysis would be exactly the same although more complex for the various hedge and spread strategies In more complex strategies conditional option value and conditional profit or loss are computed from a total of all of the positions of which the strategy consists The option cost would be the sum of all the costs and revenues generated by the various positions The actual analysis process however is exactly the same Before you execute Find Positions Before executing Find Positions you must first select a Strategy You should also review the Situation Data and revise any of the data that you want to change Because of its importance in the
10. that surround the indicated value specified in Situation Data The values represent a range of scenarios based on probability any of which may or may not be profitable Then again based on probability distribution weights are assigned to each and a weighted average value is computed The resulting profit is defined as Expected Profit Assume for example that you are in a situation 45 days from the expiration date for a set of index options For the index you have entered an Indicated Value of 275 that is you are projecting that the value of the index 45 days from now will be 275 The volatility computed for this index is 15 This information allows the system to compute a probability distribution as shown in Diagram 1 The entire evaluation process is computational and is essentially hidden from the user j 1 70 Break nven ii probabslity 5 4 Probability w LT a ee TOT See TT Has 7 Index Value CLARA AM 1 Ra ea Diagram 1 is a probability distribution for the expected index value on the analysis date occurring in 45 days The horizontal scale is index value and the vertical scale is probability The probability distribution is centered around the index value of 275 which is the Indicated Value Notice that the distribution is skewed slightly to the right Research has shown that there is a greater chance of higher index values in the future than there is of equivalent lower values What the
11. the position you want to employ and you simply want to use the system to evaluate that position you can enter your own position using the Create command When you create an option position it is displayed in the Position window a tab is added which allows you to select it at any time and OptionExpert computes an analysis for the position which can be viewed in the Economic Analysis section I To create a position 1 Click the Create command button at the top of the Position window A Create Position dialog box opens This dialog box allows you to enter a single option position using option data from the Option List Create Position First Create Position dialog box 2 Enter the data for this option position as follows Inthe Symbol box enter the option symbol Use the option buttons to specify Buy or Sell e Complete the required information in the remaining three boxes 3 Click OK The second Create Position dialog box appears and displays the option position information you entered as a single line 64 AIQ OptionExpert User Manual Create Position x 26 75 308 00 Buy 5 100 TZJJ 3 16 Cancel Help Second Create Position dialog box 4 For complex strategies you can add positions as follows e Right mouse click anywhere in the white space in the main window to display the Position menu Edit Add Remove From the menu that appears select Add to display the first
12. 76 13 600 350 250 32 5 277 09 700 350 350 31 5 278 06 800 350 450 27 0 279 04 900 350 550 22 0 280 03 1000 350 650 19 5 281 02 1100 350 750 15 0 282 01 1200 350 850 8 5 Expected Profit 183 Expected ROI Le 52 350 Chapter Ill Finding Positions 49 50 AIQ OptionExpert User Manual Based on this information the probability distribution shown in Diagram 3 can be computed Again the distribution is skewed slightly to the right and shows that with a volatility of 15 you can expect the value at expiration to be somewhere between 271 and 282 Each possible index value has a different probability of occurring g i A F i T 4 3 e O IE E 4 if K i ci pa Yy 4 fi ay Fa Te r tot Tt 7 T moo a Fe vu oe oom ingas alu DIAGRAM J For example look at a value of 273 in Diagram 3 A value of 273 on the horizontal axis can be represented by a rectangular cell that is bounded by 272 5 and 273 5 making 273 the average value for the cell Doing arithmetic on the probability distribution itself you can see that the area under the curve is 14 of the total or a probability of 14 Another example would be the probability for an index value of 280 That probability is represented by the area under the curve that is above the value 280 In Diagram 3 this is 3 of the area under the curve or a probability of 03 An analysis for all the possible stock prices between 271 and 2
13. 82 is represented in Table 1 Column one of the table lists possible index values from 271 to 282 Column two is the probability of each of those specific values occurring Column three is the conditional option value at the expiration date Conditional simply means that one does not know what the option value will be but it will be directly related to the index value If the index value turns out to be 271 at expiration the option will have a value of 100 If the index is 272 the option will be 200 If the index is 282 the option will be worth 1200 These figures are based on the strike price for the option of 270 In this example for the sake of simplicity commissions are not included Commissions however are included in actual calculations in the OptionExpert system The fourth column of Table 1 is the option cost If you decide to select this option position and buy this call contract the cost is 350 It doesn t matter what the value of the index is in the future The fifth column is the conditional profit or loss that will occur conditional option value less option cost The profit or loss that occurs is conditional upon the index value If the index at expiration is 271 then the option value is 100 a loss of 250 If the index at expiration is 275 then the conditional option value is 500 a gain of 150 Column five then represents the outcome at expiration These values are the profit or loss values for each index
14. Section 2 Chapter Ill Finding Positions 43 What the Find Positions command does Position section with Position window and commands Note You can change the default values for the screens and conditions in Properties See Customizing Properties section 5 44 AIQ OptionExpert User Manual When you click the Find Positions command OptionExpert begins an evaluation of all the option positions that meet your requirements and conform with the strategy selected in the Strategy list Only those options that meet the screens and conditions specified through Properties will be included Any option that does not meet your requirements will be eliminated from the evaluation process Regardless of the ROI any position not meeting your minimum breakeven probability figure will not be selected Upon completion of the evaluation the Position window displays tabs for the most profitable positions ranked in order of position ROI A maximum of 10 positions will be selected The most profitable or number one ranked position always appears in the Position window If there are no profitable positions found the Position window will show a message to that affect Edit Create Track Position Buy Option Pos 1 Pos 2 Pas 3 Pos 4 Pos 5 Pos 6 Pos 7 Pos 8 Pos 9 4 Buy 2 ZIB AF Jan 01 130 Call 20 3 8 The tabs allow you to display and review the lower ranked positions found in the analysis When you selec
15. agram 1 the value of 273 50 is to the left of 275 the mean or expected value and the area under the curve to the left of 273 50 is equivalent to 20 or a 2 probability That is there is a one in five chance of losing money The optimistic side is that there are four chances out of five to at least break even on this contract The shape of the probability distribution in Diagram 1 is strictly determined by the risk associated with the Indicated Value as measured by the variance of the distribution The variance of the distribution is determined by the volatility of the index and the time to expiration In other words how much time is there between now and the expiration date for the index value to fluctuate Diagram 2 shows the effect of volatility on the shape of the probability distribution The two probability distributions shown in Diagram 2 are overlaid Both have an indicated or expected value of 275 One is the same distribution in Diagram 1 with a volatility of 15 The second has a volatility of 20 a D Volatlitye 15 eT 2 i 1 Fi a E F A Ma Volatility 20 fi NS 4 Fi fi a sa i d Ma o Se ah ingar Value DHAGRAAM 2 Xe y The higher the percentage the higher the volatility Therefore 20 is greater volatility than 15 or a greater chance of having more extreme values around the expected value of 275 As you can see the probability distribution with volatility of 20 is wider so the range of
16. ck that you own In addition you can specify the covered write ratio which allows you to sell calls against more shares than you own The system then evaluates every call option for the type of strategy you have selected Foie Amie OE APE Geel mm Covered Call Write position selected for IBM Variable Ratio Call Write position selected for IBM Chapter III Finding Positions 61 Displaying and editing positions Edit Position dialog box with middle option position selected 62 AIQ OptionExpert User Manual Displaying Positions When Find Positions completes the evaluation of positions the Position window displays tabs for the most profitable positions ranked in order of position ROI A maximum of 10 positions will be selected If there are no profitable positions found the Position window displays a message to that affect The most profitable or number one ranked position is initially shown in the Position window The tabs allow you to display and review other lower ranked positions found in the analysis Any selected position can be displayed so that you can view the position in detail and view an Economic Analysis computed for the position To view other positions simply click the numbered tabs located above the Position window Editing Positions The Edit command button located in the row of buttons above the Position window is used for editing positions This command is available for use only when an option
17. e optimum position needed to implement a Bearish Time Spread The selected position is shown in the Position window with the appropriate analysis in the Economic Analysis section Based on the Situation Data shown this position would result in a return on investment of 152 From the Position Graph for the bearish time spread it is easy to see why this kind of spread is considered speculative Although the profit potential is high the probability of making a profit is low Chapter Ill Finding Positions 57 Optimum Position for Selected Strategy 58 AIQ OptionExpert User Manual The position is profitable between stock prices of about 78 and 93 But if the price of the stock does not fall below 93 the position is unprofitable The advantage of this strategy over buying the put is that your investment is less and the potential profit is greater The System Selects both Strategy and Position 4 Ask OptionExpert to select both strategy and position When you select All Option Strategies the system evaluates every option and every strategy included in the list of strategies Select this alternative and click Find Positions and the system will do just that evaluate all strategies and select the optimum Only those options that meet the screens and conditions specified through Properties will be evaluated Any option that does not meet your requirements will be eliminated from the evaluation process You can change the defau
18. is normally set to the next option expiration date The Indicated Value is one of the main factors in evaluating option positions and hence in the selection of those positions with the greatest expected profitability OptionExpert computes the Indicated Value as a function of price price trend volatility and time to expiration If you don t concur with the value shown you can adjust it to your projected price for the Analysis Date Volatility The Volatility shown in Situation Data is computed from historical price information downloaded from your data service via the internet You may however choose to replace this value with one that incorporates market implied volatility MIV MIV is computed from an option pricing model by plugging in the current price of the option and calculating volatility Put and Call MIV values derived for the underlying symbol are listed in the Economic Analysis section of the Position Analysis window OptionExpert provides a special function that allows you to calculate a new volatility by combining MIV values with historical volatility using weighting factors for each type of volatility The result is a calculated or weighted volatility value To access this function click the green and red Volatility Calculator button located to the left of Volatility in the Situation Data section The Volatility Calculator dialog box will pop on to your screen See Situation Data in Section 1 of this chapter for help usi
19. lt values for the screens and conditions in Properties See Customizing Properties section 5 When the evaluation has been completed the Position window will list up to 10 of the most profitable positions ranked in order of position ROI When you select a position by clicking a tab the Position window will list the position and an analysis of the selected position will appear in the Economic Analysis section In the example above OptionExpert selected a Bear Spread position when asked to find the best option position for MSFT on 9 21 99 The Indicated Value shown in Position Data 84 59 reflects a bearish outlook for the stock and the Volatility 38 indicates relatively moderate volatility Chapter Ill Finding Positions 59 60 AIQ OptionExpert User Manual The Position Graph for the bear spread shows that the risk is limited while potential for profit is high should the stock drop in price as predicted Maximum loss is limited to about 13 200 and if the price of the stock falls below 91 the position becomes profitable The disadvantage of this strategy is that your entire investment is at risk However looking at the Position Graph you can see that the potential profit is much greater than the amount at risk 5 Find covered call write or covered variable call write positions With these strategies calls are sold with a long position in the underlying shares of stock used as collateral The option premium gives protection
20. ng the Volatility Calculator function Strategy List provides five ways to select positions The Strategy list provides a number of ways for you to designate the type of option positions you want to include in the analysis 1 Let OptionExpert find the best long or short single option position 2 Let OptionExpert find the best bullish or bearish option position 3 Choose a complex strategy and let OptionExpert find the best position 4 Ask OptionExpert to find both the best strategy and position 5 Let OptionExpert find the best covered call write or covered variable call write position 1 Let OptionExpert pick a single position Select either Buy Option or Sell Option and when you execute Find Positions OptionExpert will evaluate all options in the Option List and select those with the maximum return on investment The selection is based on the data in the Situation Data window The screen below shows a position selected using the Buy Option strategy Based on a bearish scenario for IBM on this date the system selected IBM October 125 puts as the optimum ranked 1 long position The Indicated Value for the IBM stock is 115 01 and the Volatility is 31 Long Position selected by system Chapter Ill Finding Positions 59 Short Position Selected by the System 56 AIQ OptionExpert User Manual The Position Graph for the long position shows a breakeven price for the stock of about 120 where the profit vs price
21. nt The selection is again based on the data in the Situation Data window with the Indicated Value and Volatility being the most critical items of data 3 Select a complex strategy and let OptionExpert recommend your position If you want to evaluate a particular complex option strategy such as a specific spread or straddle you can let the system determine the best position for that strategy The list of strategies provides 14 different spread straddle and strangle strategies The 14 strategies available are bull spread bear spread bullish time spread neutral time spread bearish time spread diagonal bull spread diagonal bear spread butterfly spread buy straddle sell straddle buy strangle sell strangle sell covered straddle and sell covered strangle When you determine which complex strategy you want evaluated select it from the Strategy list click Find Positions and OptionExpert will proceed to evaluate your selected strategy Again the evaluation of the position is based on the data in the Situation Data window and is highly dependent upon the projection of the Indicated value When the evaluation has been completed the Position window will display the most profitable position and tabs will be added for up to 10 positions ranked in order of position ROI An example of letting OptionExpert select an optimum position given the complex strategy selection is shown on next page In this example the user has requested th
22. question that remains is how to estimate the future value of the options OptionExpert provides two methods for determining future option values and allows the user to choose the analysis method that is used This choice is selected from the Analysis Method tab of Option Strategy Properties See Customizing Properties Section 5 The two choices provided for arriving at the approximate worth of an option at a specified date in the future are e Computed Expected The Computed or Actual mode involves a single solution of the Black Scholes theoretical option pricing model using the Indicated Value Volatility and other Situation Data values This calculation assumes that all Situation Data including the projected value of the underlying stock or index on the analysis date Indicated Value is exactly known The Expected or Theoretical mode uses a range of Indicated Values based on probability and produces an expected or theoretical result The Computed mode puts the burden on the user to make an accurate projection of the underlying value While the Expected mode also requires realistic Situation Data input the importance of the projected underlying value is somewhat less Because the Expected mode analyzes a range of scenarios any of which may or may not be profitable the impact of the projected value on the final result is not as great However since the Expected mode requires a good understanding of probability theory OptionExper
23. t a position by clicking one of the tabs the selected position will appear in the Position window and an analysis of that position will appear in the Economic Analysis section The selection process is greatly affected by large differences between the theoretical value and market price for the current date Part of the economic analysis assumes that the market price on the analysis date will be equal to the theoretical value on the analysis date Profit then is gained from not only the movement of the stock in the market but also by the movement of market price toward the theoretical value Position Profit The Economic Analysis window shows the results of the evaluation of the option positions selected in the Position window The number one position the best of all profitable positions found by the system is always displayed unless the user selects another from the alternative positions The criterion for deciding which is the best option position is percent ROI return on investment which is directly related to position profit Position profit is the gain that would be realized if the scenario represented by the data shown in Situation Data is in fact valid The gain is simply the future value of the position on the analysis date less the cost of entering the position The cost is readily available since current option prices are provided by your data service and are easily viewed in the Option List Position Analysis window The
24. t defaults to the Computed or Actual mode Chapter Ill Finding Positions 45 46 AIQ OptionExpert User Manual Computed Analysis method The Computed method of analysis involves a straightforward calculation of option value using the Black Scholes option pricing model The two most important parameters in this calculation are the Situation Data values for Volatility and Indicated Value Indicated Value which reflects the projected movement in price of the underlying instrument is particularly important The user should always examine the Indicated Value computed by the system and be in complete agreement with the scenario for future price performance that the value represents If the user does not agree with the scenario the value can and should be changed If you are in doubt as to future price movement you could select another underlying instrument or you might consider using the Expected mode of analysis see below Expected Analysis method The concepts behind this method of analysis include probability and probability distributions conditional value of the option conditional profit or loss of the option and expected profit of the option As is the case with the Computed method option value is computed from the underlying value or price but in this method a number of option values are computed for a number of different underlying values These values are chosen to represent a statistical distribution of values
25. ty of an index value of 272 is 04 or one chance in 25 In this case the average expected profit or loss is minus 6 150 divided by 25 Chapter Ill Finding Positions 51 52 AIQ OptionExpert User Manual Column six of Table 1 then is the conditional expected profit from each of the possible conditions or index values that can occur and shows losses running from 5 to gains as high as 36 The final figure of 8 5 represents the case where the index at expiration is 282 Profits would be 850 but you can also see from column 2 that this is only going to happen one in 100 times 01 So the conditional expected profit from an index value of 282 is only 8 50 850 divided by 100 The final step in this process is to sum column six The expected profit from the call contract is the total of all values in the column or 183 The expected return on investment is 183 divided by an investment of 350 which means an expected return on investment of 52 The economic evaluation for the call contract under consideration is 183 That number will be compared with total expected profits from other option positions in order for the best option position to be selected Is 183 what you are going to get back from this option contract No The actual return depends upon the actual index value on expiration day The actual return from this call contract if it is purchased will be one of the values in column five conditional profit or loss The 183 profit
26. value You still need to be able to evaluate the option contract now without really knowing what is going to happen in 45 days What you do know is the chance of each of these conditional profits or losses occurring and from this you can compute the sixth column in the table conditional expected profit Conditional expected profit is an average profit It is probability multiplied by conditional profit or loss column two multiplied by column five Conditional expected profit represents the average profit or loss that would occur conditional on the index value in column one The word average or expected means that even though you are only going to make this decision once the logical thing to do would be to evaluate it as if you were going to make this decision every day for the rest of your life If this same situation occurs every day from now on you have one chance in 50 to incur a loss of 250 because that is the loss if an index value of 271 occurs The probability of a value of 271 occurring is 2 one chance in 50 Hence the conditional expected profit is the average profit or loss from all these future games for the rest of your life One time out of 50 that you play the game you are going to lose 250 The average then is a loss of 5 250 divided by 50 conditional upon the index value of 271 One out of every 25 times that you play this game the index is going to be 272 and this will result in a loss of 150 The probabili
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