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
EUROPEAN VERSUS AMERICAN
At the end of your November 2003 column, you referred to the European-style settlement, saying that you could sell options without the risk of unexpected early assignment. Could you please explain what you meant by this? -D. Streich
There are two types of settlement with options: European style and American style. European options cannot be exercised on any date prior to expiration, though they can be bought and sold at any time. American-style options can be exercised at any time prior to expiration.
Though there are virtually no equity options traded on US exchanges that are European style, the majority of index options are. This can be very helpful when setting up a strategy. If you're more certain of where an index may lie at expiration in the future, but not certain of the near term, employing a strategy involving the short sale of a European-style option makes sense.
Another beneficial aspect of European options is that because a trader must hold them for a required length of time before exercising them, they tend to be more expensive than their American counterparts. Therefore, in strategies where there are both short and long positions such as calendar spreads, you can sell short-term, European-style options against long positions that are American style, thus taking in a greater premium. For example, there are Standard & Poor's 100 options traded on the CBOE that are both American and European style: the OEX and the XEO, respectively. So for a calendar spread, you would sell a European-style option against an American-style long position to take advantage of this anomaly.
One last note: unlike American-style options, which settle on the Saturday following the Friday expiration, European options settle on the same Friday they expire. With this in mind, should you need to liquidate your positions, it's best to do so on the Thursday prior to expiration.
Some traders tell me they buy options that expire in three months or more because, relatively speaking, they're "cheaper." I'm confused. How are longer-term options cheaper than shorter-term options?
As far as the actual dollar amount you pay, short-term options are indeed less expensive. But relatively speaking, short-term options lose more time value in comparable time frames than do longer-term options. If you were to compare the dollar amount each option loses on a delay basis (this is known as theta), the loss is greater for short-term options. Since the majority of an option's time premium decays in the last 30 days, generally, it's not a good idea to purchase or hold onto options that expire within one month.
Let's use a hypothetical example to illustrate: XYZ on November 10, 2003, is trading at $30. Suppose you are looking to buy an at-the-money option on XYZ and you see that there are several expirations available. December's 30 call is $2.00, January 2004's 30 call is $3.00, and April 2004's is $4.50. Since each of these premiums represents 100% time value (since they're all trading at-the-money), you can see that the cost of time for December is $2.00 per month, while January is $1.50 per month ($3.00 for two months), and April is $0.90 per month ($4.50 for five months).
Taking the time to expiration into account can make a big difference in your profitability and serve to help your peace of mind, if trading short-term options is a stressful proposition for you. In addition, longer-term options provide ample opportunity to make adjustments with hedges and so on, should the trade go against you.
How do interest rates affect the price of an option?
Since options are derivatives, they have a "cost of carry" that is priced into the time value of the option itself. This cost of carry for calls is equal to the risk-free interest rate less the dividend over the period of time to expiration. On the other hand, a put contract's time value in part assumes the dividend of the stock less the interest rate. The reason calls are more expensive with rising interest rates is that long calls are paired with short stock (that is, the writer of the call will be assigned short stock). Therefore, the short sale of the stock earns interest. This interest is factored into the time premium of the call itself. As interest rates rise, calls become more expensive, since the short position in the underlying will accumulate that interest in the form of cash.
Return to January 2004 Contents
Originally published in the January 2004 issue of Technical Analysis of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2003, Technical Analysis, Inc.