Q&A
Explore Your Options
| Got a question about options? Tom Gentile
is the chief options strategist at Optionetics (www.optionetics.com), an
education and publishing firm dedicated to teaching investors how to minimize
their risk while maximizing profits using options. To submit a question,
post it on the STOCKS & COMMODITIES website Message-Boards.
Answers will be posted there, and selected questions will appear in future
issues of S&C. |
Tom Gentile of Optionetics
|
OPTION SPREADS
I was told that to lower my risk in buying calls or puts, I could
spread them. What does this mean?
To spread an option means to buy a call or put and sell one simultaneously
to hedge it, either in the same month (as with vertical spreads) or different
months (diagonal spreads). As an option purchaser, a trader has the right
to buy or sell the underlying instrument at a specific price in the future,
depending on whether it's a call or a put. Should the buyer decide to exercise
the option before expiration, the seller is obliged to deliver, or take
delivery of, the underlying. When you both purchase an option and sell
one, you accomplish several things:
1. Reduce the cost of the long option, lowering your risk
2. Lower your breakeven
3. Gain a higher return on investment
4. Slow losses, which allows time for trade adjustments and more
peace of mind
5. Become less likely to get "wiggled" out of a trade
due to high volatility in the stock.
The vertical spread is commonly used. I'll describe a bull call spread
as an example. Suppose it's November, and stock XYZ is trading at $50.
You want to buy a February call on XYZ, thinking that the stock will advance
before then. The February 50 call is trading at $5. Now, suppose you don't
want to pay $5, but do want to take advantage of an upward move at the
lowest possible risk. You can receive a $3.50 credit on the 55 February
call by selling it. If you are buying the 50 call at $5 and selling the
55 call for $3.50, your net debit is $1.50, or 97% less risk than buying
the stock! Now, should the stock advance to 55 or above by expiration in
February, you make $3.50 on the trade, or a maximum potential of 233% return
on investment.
The major reason some traders do not spread options is the limited reward
potential of the trade, as dictated by the difference between strikes of
the long and the short position minus the original debit. Some would rather
just buy the calls in view of potentially unlimited gains. This is a decision
best made according to your own risk tolerance.
VOLATILITY SKEW
What is a volatility skew, and how important is it when trading
spreads?
In order to understand what a volatility skew is, you must first understand
what volatility is. There are two types that concern options traders: historical
and implied. Simply put, historical volatility is the amount the stock
has fluctuated over a specific period of time, calculated as a percentage.
The stock can often be expected to fluctuate by this percentage over the
same time frame in the future. While historical volatility is primarily
concerned with what a stock has done in the past, implied volatility is
what the market predicts the rate of change will be over the life of an
option.
When the historical volatility of the stock and the implied volatility
of the options are different, you have what is called a volatility skew.
This is extremely important to recognize when designing an options trade.
For example, if the implied volatility is higher than the historical volatility,
then the market is anticipating bigger moves than have occurred in the
past. That being the case, you would expect to pay more for the premiums
on those options, and perhaps a spread would be more appropriate than the
outright purchase of a call or put. On the other hand, if the implied volatility
is lower than the historical volatility, the purchase of a call or put
might be appropriate.
Another type of volatility skew occurs between implied volatilities
on options with different months between them. This is perfect for calendar
spreads, in which there is some near-term volatility in the front-month
options. These types of skews can be difficult to find without the use
of options analysis software that can scan the universe of options. When
you do find them, however, they can be gold mines.
LEGGING INTO TRADES
Is it dangerous to open one side of a spread at a time?
This is known as "legging" into a trade, and doing so depends
on your risk tolerance and level of options-trading expertise. If your
intent is to open a spread or other type of combination strategy, it is
generally a good idea to open both sides simultaneously with a limit order.
This way, you are assured of being filled at a limit price that you have
designated.
Traders leg in to trades under the perception that they can get a better
price for the entire position if they shop at different exchanges for the
various legs. This can often be true, particularly if you use a broker
with good floor representation or one with direct access to the floor.
However, in the course of even a few minutes, markets can move away from
you, ultimately leaving you with one side of a spread unhedged or forced
to enter/exit the trade at an undesirable price. If you want to try this
method, you'd probably be best off with a direct-access broker or one with
a solid reputation for good floor representation.
Return to February 2003 Contents
Originally published in the February 2003 issue of Technical
Analysis of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2003, Technical Analysis, Inc.
