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Stoploss Strategy


  • Trader can hope to construct a stop-loss strategy by combining the two strategies
    • Suppose the trader is able to ensure that he has a covered call position each time the price of the underlying exceeds the strike price on the option and
    • A naked call position whenever the stock price goes down from the exercise price. If a trader sells call contracts standalone, he has a naked position exposure
  • If this was possible in the real world, traders would be able to earn riskless profits as the cost of setting the hedge would always be less than the theoretical price of the option
  • However, it is impossible to execute this in reality because of the following reasons:
    • Purchase of stock will always be slightly above the strike price and sale slightly below it
    • This difference would increase the cost of this stop-loss strategy.
    • In case one wants to decrease this difference to a really small amount, frequent buying and selling will be required, which in turn would again increase the cost of this trade
    • The difference in time of the associated cash flows and the time value of money also result in increased cost.

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