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
I know that there is a point in time when LEAPS turn into short-term options and change their names. Can there be any problems with renaming for me if I still hold such an option?
Long-term Equity Anticipation Securities (LEAPS) have different symbols than do short-term options. However, as time passes and the options become short-term options, the symbol will change. The symbol change, however, will not affect the value of the options contract. It is merely a cosmetic change and your brokerage firm will make the necessary adjustments. There is nothing to worry about.
TRADING THE BIG MOVES
Is it sensible to buy a straddle after the underlying share had made a big move up or down?
Sometimes placing straddles around big percentage gainers or losers makes sense if you expect a reversal in the stock or a continuation of the trend. However, it makes more sense after a large percentage move higher. Why? Because option premiums often see a significant increase in implied volatility (IV) when a stock makes a big move down and, since implied volatility is an important factor in determining the value of an option premium, the jump in IV means that the options have become more expensive. This isn't usually the case when a stock makes a big move up. Instead, IV option premiums often fall when a stock moves higher, which makes them cheaper.
In addition, since a straddle involves the purchase of puts and calls, it is better to establish the trade when implied volatility is low and expected to increase. At that time, the options are cheaper, but might become more expensive. So the straddle can be a good strategy when a stock makes a big move up and is expected to move down or continue higher. However, if the stock has suffered a large percentage loss and implied volatility is up, buying the straddle is not necessarily a good bet. The IV might fall and cause the options to lose value, which is known as a volatility crush.
CALENDAR SPREADS -- PUTS VS CALLS
If I have no bias on the stock movement, I can understand why a put calendar spread is better than a call calendar, because of the possibility of having to pay for the dividend. But aside from that, if the stock is in the current sideways pattern, can it affect your decision on whether to use puts or calls? For example, if it is nearer the resistance level, would you use a put calendar, and if it is near the support level, a call? When choosing a put or call, don't you want to choose the one that will be the more likely direction longer term after the option you sold expires?
The calendar spread is a strategy that works well when the stock is moving sideways or trending only modestly. It is not a great strategy to use if you expect an explosive move higher or lower. To review, the calendar spread involves the purchase of a longer-term option and the sale of a shorter-term option with the same strike price. The idea is to use time decay to your advantage because short-term options see a faster rate of time decay when compared to long-term options. Once the short-term option expires, the strategist can choose from among several follow-up actions:1) Exit the position entirely by closing the longer-term option,The calendar spread can be created with puts or calls. The selection of puts or calls is based on the outlook for the stock and the possibility of appreciation of the longer-term option. If the trader expects a move higher, then the calendar is created with call options because once the short-term call expires, the other call might appreciate in value. In that case, the premium from the short-term call has helped finance the purchase of the long call. If the stock is set to trend lower, puts are better because the long put might increase in value over time.
2) Sell another short-term option, or
3) Hold the longer-term option and hope that it appreciates.
If the stock is expected to trade sideways, the put calendar spread is often better. For one, the put calendar spreads are generally cheaper than call calendars at the same strike price, due to the way options are priced. Puts are generally cheaper than calls. In addition, if you are trading a stock that pays a dividend, you won't be required to pay the dividend on short puts (long stock) as you would on short calls (short stock). This would only happen if you were assigned on ex-dividend day, but it does happen. Therefore, if you have a moderately bullish outlook on the stock, use calls. Otherwise, puts are superior when establishing calendar spreads for two reasons: 1) Puts tend to be cheaper, and 2) There is less risk of having to pay the dividend.
WHAT RATE TO USE
The risk-free rate is one of the determinants of options prices. What is the best rate to use? The short-term Treasury bill rate, since it's basically risk-free?
The short-term Treasury-bill rate can work as an approximation of the risk free rate. In addition, consider using the rate that matches up to the expiration of the option contract. For example, if the option expires in 90 days, use the three-month T-bill. The six-month T-bill will work for options that expire six months from now. Or you might use the two-year Treasury note if you're looking at options that expire in January 2007.
Originally published in the July 2005 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2005, Technical Analysis, Inc.
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