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
DOUBLING DOWN ON OPTIONS
Does doubling down on a losing options position by purchasing more and thus lowering the breakeven point work the same as it does with stocks? Thank you. - Fiorenzo Primavori, Genoa, Italy
Yes and no. As a way of dollar cost averaging, yes, this does work. If you decide to buy IBM 70 calls for 7 points and then the stock breaks down, you could purchase an equal number of call options for a lower premium, thus bringing your breakeven down closer to today's price. However, this method does not compare to doubling down on stocks. Stocks have no time value, so an investor can wait out the down time and scale into the stocks for an outlook of better days ahead. As a buyer of options, though, you only have so much time to be right. The scale-down method of buying options when you are wrong really only works for the short-term trader. The longer-term trader is likely to lose in the end.
One way of repairing a long call option is to buy, selling something against the purchase to help finance the trade. Let's assume you are long IBM calls at 70, and the stock doesn't immediately shoot up the way you expected. If you are trading leap options (long-term options), then a simple conversion to a bull call spread by selling higher strike calls would lower both the cost of the trade and the risk of the position. Just make sure you don't initiate this strategy if you are down more than 50% on the original call position; otherwise, you are likely to lock yourself into a losing proposition. Figure 1 shows both the original position and the repair.
FIGURE 1: LONG CALL REPAIR. Here's the original position and the repair.
There is another method for repairing a long call position. Let's assume you are bullish on IBM, and you buy one IBM January call option with a strike price of 70, which is close to the stock price. You pay 7 points for it. Looking at the expiration date, you have 60 days to expiration. The stock starts to drop, and so does your call option premium. If the premium drops to 50% of what you originally paid for it, you are more than likely going to see this option expire worthless. If you believe IBM is going to go up but now expect that move to occur after your current options expiration date, you could do the following:
1. Sell two IBM January 70 calls (one to close your position, and one to open a new short position)
2. Buy one IBM June 03 70 call (this is the buy side that covers the additional sale above).
This converts your long call into a calendar spread. Now you are capturing the time decay instead of losing it. At the same time, you have a long position out to June, which gives you more time to be right on your original assumption.
OPTIONS TERMS & SOFTWARE
Tom, it is very nice for all of us old friends of S&C who are now interested in options to see some pages devoted to them. It would be very useful if you would inform us about any software that calculates the "greeks" and gives theoretical profit and loss diagrams for composite positions in options - Vasilis Piperias, Xalkis, Greece.
Great question. I cannot function without some sort of options software to tell me whether I am buying an option or spread at a fair price. Options software for the most part relies on the following inputs to generate a good pricing model:
Price of the underlying asset - As the asset's price moves toward and away from the strike price, it affects the options premiums.
Options strike price - Option strikes will vary, with some having real value to them (in-the-money), and some having no real value (at-the-money and out-of-the-money).
Time to expiration - The more time until the option expires, the higher the premium.
Interest rates - These are factored into the premium, but are of little concern because they are low and don't change much.
Dividends - Dividends affect the underlying issue, and hence the option's price.
Volatility - The most confusing of all the factors, volatility affects the option's time value, increasing as volatility rises and decreasing as it falls. Volatility is a perception of the future, and is built into the premium.
Options software needs these inputs to not only calculate a model price (theoretical) but also give you sufficient greeks and risk graphs. There was a writeup in the October 2002 STOCKS & COMMODITIES on our Optionetics Platinum software, which is designed to do what you are looking for.
[For more options software, go to Traders.com and click on Traders' Resource. Choose the category Software, then enter "options" in the search box.-Ed.]
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Originally published in the December 2002 issue of Technical Analysis of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2002, Technical Analysis, Inc.