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 |
TRAILING STOP
Can you explain what a trailing stop is?
To do that, first, I have to explain what a stop order is. A stop order is an order placed with a broker to buy or sell a security when a certain price level is hit. The stop can be used to limit losses from an adverse move in the position, or to lock in a profit. When used to limit losses, it is sometimes referred to as a stop-loss order.
A trailing-stop order moves along with a favorable movement in the price of the security. Trailing sell-stop orders follow the upward movement of a security by a defined distance and remains in place as long as the security moves upward. Trailing buy-stops, on the other hand, will move lower by a defined distance as the security price falls. The "distance" is often expressed as a percentage or a dollar amount.
Say I purchase a stock for $25 a share, and within the next few weeks, it rallies up to $35. I have a $10 profit and I want to protect at least some of that. However, I also expect the stock to continue moving higher in the near future. As a result, I place a trailing-stop order $5 below the current stock price. At that point, the stop is at $30 and if the stock hits that price level, the position is closed. However, as the stock price rises, the trailing stop does as well. If shares climb to $45, the stop is now at $40 and the position will be closed out on a move back down to that price level.
RATE WORRIES
I am worried about the recent increases in interest rates. Is there any way to use my brokerage account that might help me make profits if rates continue moving higher?
There are a few index products that can be used to trade the bond market. Some track interest rates, while others consist of actual bonds. For example, the CBOE 10-year rate index ($TNX) tracks the yield on the benchmark 10-year Treasury note multiplied by 10. So as the yield on the 10-year note rises toward 5%, the TNX moves toward 50. Options are also listed on the index. So one possible rate play is to establish bullish trades on the CBOE 10-year rate index ($TNX), which will generate profits if rates continue climbing.
Alternatively, several exchange traded funds hold Treasury bonds. One of the more actively traded is the iShares 20+ Bond Fund (TLT). The TLT holds longer-term bonds. For example, as rates rose during the first quarter of 2006, the fund fell 5.4%. So another possible play on rates is to create bearish trades on the bond fund, which might include bull put spreads, bearish calendar spreads, or simply selling TLT shares short.
WHAT ARE WASTING ASSETS?
I’ve heard the expression that options are "wasting assets." What does this mean and can I use it to my advantage?
Options are called "wasting assets" because they lose value as time passes. The phenomenon is known as time decay or theta decay and is due to the fact that each options contract has a finite life and eventually expires. The more time left until the option expires, the more valuable the contract.
Some options consist only of time value; the premium has no real or intrinsic value. This is true of out-of-the-money (OTM) options. For example, if a call option has a strike price above the current price of the underlying asset, it has no intrinsic value; it consists only of time value.
On the other hand, if an option is in-the-money (ITM), it will have intrinsic value. For example, a call with a strike price of 50 will have intrinsic value if the stock is trading for $55. At that point, the owner of the call can exercise the option and take delivery of the stock for $50 a share (the strike price) and sell it for $55 a share (the market price). The difference between the stock price and the strike price is known as intrinsic value. In this case, the intrinsic value is $5.00 a contract. Options can consist of intrinsic value, time value, or both intrinsic value and time value.
The time value of an in-the-money call is computed as:
Time value for an in-the-money put option is computed as:Call time value = Call option price +Strike price - Stock price
It is important to note that time value decreases at an accelerating rate. An option with only one month of life remaining will see a faster rate of time decay than an option with six months remaining until expiration. Time value equals zero at expiration. At that time, if there is no intrinsic value (that is, the option is OTM), it will expire worthless. In-the-money options with intrinsic value (0.25 or more) at expiration are auto-exercised by the Options Clearing Corp. (OCC).Put time value = Put option price +Stock price - Strike price
Options traders use several strategies to take advantage of time decay. The simplest strategy is to sell OTM options and hope they expire worthless. Because this can be very risky, this is not an approach we recommend. Instead, look to sell premium with other limited-risk strategies that include calendar spreads, condors, butterflies, or vertical credit spreads. The best strategy generally depends on the outlook and volatility of the underlying asset.
Originally published in the July 2006 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved.
© Copyright 2006, Technical Analysis, Inc.
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