Q&A

Explore Your Options

with Tom Gentile

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.

Views on Volatility
Is it important to look at the volatility chart of an option that you would like to buy or sell? And if you are trying to determine whether volatility is high or low before you buy an option?

Option traders use different tools to measure volatility. Some option analysis software allows traders to plot historical volatility (HV) and implied volatility (IV). Both are helpful when looking at possible trading opportunities.

Historical volatility, for example, tells us how a stock (index, futures, exchange traded fund, and so on) has been behaving. If a stock is volatile, like shares of some of the banks recently, it will have high historical volatility. Stocks that trade quietly and in a range, like utilities, have low historical volatility.

There are different ways to measure HV, and one of the most common is to use the annualized standard deviation of closing prices over a period of days (nine, 20, 100, and so on). Obviously, we don’t do this by hand but rely on software to compute the number, which is expressed as a percentage. Some option analysis software, like Optionetics Platinum, allows us create HV charts and see changes over time (three months, six months, one year, and so on).

While historical volatility takes a look back at volatility, implied volatility is a measure of what the market expects for the future. Implied volatility is calculated using an option-pricing model and current option prices. If an option contract has high IV, it is a sign the market expects the stock to make a big move. If implied volatility is low, quiet or rangebound activity is expected. IV is also expressed as a percentage and can be viewed using a volatility graph.

When looking at volatility charts I look at both HV and IV to get a sense if options are cheap or expensive. For example, I might compare a 30-day historical volatility to 30-day implied volatility.

If IV has been rising on the chart and is significantly higher than the historical or actual volatility of stock, it is a sign that the options are expensive. A jump like this in implied volatility might happen before an event like an earnings report or a shareholder meeting, as the option prices get more expensive in anticipation of possible volatility in the share price.

On the other hand, if implied volatility has been moving lower and is significantly lower than historical volatility, it could be a sign that the options have become cheap. This might happen if a stock has seen several gaps higher and become very volatile, but the implied volatility has not yet risen to reflect the heightened volatility in the share price. (Implied volatility is more likely to move higher when a stock makes a volatile move lower, not higher. Implied volatility often falls when stocks move higher.)

Using charts to determine whether implied volatility is high (relative to past IV and relative to HV) can help determine the best option strategy. If implied volatility is low, options are cheap, and I’m more likely to be a premium buyer. If IV is high, options are expensive and I’m more likely to be a premium seller.

Taking a Hit
When an option is at a loss, do I ignore it or do I need to sell out of the position?

The best course of action when dealing with a losing trade will depend on the situation and how much time is left until expiration. Assuming this is a straight call or put purchase and not a more advanced strategy, the trader might want to offset his position if it has turned sour and there is still time value in the contract.

For example, if I bought Xyz January 50 calls and the stock is trading for $40 in June, the contract is out-of-the-money with six months of life remaining. Although it is $10 out-of-the-money, it will still have time value remaining. If Xyz is not moving fast enough, I might want to exit the position and sell to close the Xyz January 50 call to salvage the remaining time value.

If expiration is approaching and the option contract is deep out-of-the-money, the best course of action is probably to do nothing and let the option expire worthless. Closing the trade will cost more in commissions. The result will be a loss equal to the premium paid for the contract. Once it expires, the investor is out of the contract. There is nothing left to do.

The greatest uncertainty can occur if your losing position is at-the-money near expiration — for example, if Xyz is trading exactly at $50 at the January expiration. This is sometimes referred to as pin risk and can create a dilemma: should I close the position or run the risk of seeing a last-minute move above $50, which will result in the exercise of the contract? The answer will depend on whether you are willing take delivery of (call) the shares for $50. If you’re not sure, contact your broker and ask. They can often tell you what is optimal heading into option expiration.

Collar Correction
A few readers pointed out a mathematical error in Explore Your Options in the May 2009 Stocks & Commodities. At that time, I discussed a collar strategy where I bought iShares Xinhua China Index Fund (Fxi) for $25.30, bought Fxi May 20 puts for 85 cents, and sold May 30 calls for 85 cents.

I wrote that if shares climbed to $29 at expiration:

I would have a $3.70 profit on the shares ($29–$25.30) and both the puts and calls expire worthless for a loss of $0.85 and $0.85, or $1.70. My profit is then $2.00 per share, or 7.9%.

Oops! If the calls expired worthless, I would actually have a profit on the calls but a loss on the puts. The option trades would be a wash and my profit would be $29–$25.30, or $3.70, or 14.6%. Even better! Thanks to astute readers who caught my mistake.

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