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 |
BEST WAY TO PLAY GOLD
I'm looking for ways to play gold with options, but have not found any. Are there any ways to play the recent rally?
Gold has been hot lately and its volatility can create interesting trading opportunities. Some traders use gold futures to participate in the movement in the metal. Long-term investors sometimes buy and hold gold. The new StreetTracks Gold Trust (GLD) is an exchange traded fund that holds the precious metal. Shares of the fund trade on the New York Stock Exchange (NYSE) and the bullion is held in a bank vault. Shares of GLD can be bought and sold like shares of stock. However, no options are listed on the gold fund yet. That might change soon.
If you are looking for a way to play gold in your brokerage account with options right now, there are a few choices. The first is to trade options on the gold mining companies. Newmont Mining (NEM) is the largest gold mining company by market value and its options contract is actively traded and liquid. Since the share price tends to move in the same direction as the price of gold, it offers a way to play the metal. The correlation between such stocks and the gold is not perfect, but as gold moves higher, shares of the gold mining companies generally respond.
Traders can also use indexes of gold mining stocks. The Philadelphia Stock Exchange (PHLX) offers options on the PHLX Gold and Silver Mining Index ($XAU), an index of 16 leading mining companies. The American Stock Exchange (AMEX) lists options on the AMEX Gold Bugs Index ($HUI), which is an index of 15 different mining companies. Since both track the share price performance of gold mining companies, they tend to move in the same direction as the precious metal.
INSUFFICIENT FUNDS
I understand an option that is in-the-money (ITM) at expiration will be auto-exercised. What happens if I have a call option auto-exercised, but I don't have cash in the account to buy the stock?
If a call option is auto-exercised at expiration, it is in-the-money by 0.25 or more. Auto-exercise is an Options Clearing Corp. (OCC) rule designed to protect investors. If you don't want an option exercised, you must notify your broker before the expiration date. If a call option is subject to auto-exercise and sufficient funds are not held in the account, the account holder will face a margin call and the broker will request additional funds to buy or call the stock.
If the funds are still insufficient, the position will be closed out, which will involve selling the shares out of the account at the current market price. The account will be credited the difference between the stock price and the strike price of the option. As a final note, however, it is a good idea to consult the options department at your brokerage firm to find out how the situation will be handled before any contract is exercised or assigned.
VOLATILITY AND OPTIONS CONTRACTS
I know volatility can affect the value of my option contract, but why does this happen and how can I predict it?
Volatility is one of the most important factors affecting option prices. Why? Recognize that an option is a contract that gives the owner the right to buy (in the case of a call) or sell (for a put option) the underlying asset at a specific price known as the strike price. Since each contract has a fixed strike, the volatility of the asset and the movement in price is important when considering what that contract should be worth.
For example, if stock XYZ has been in a range between $30 and $32 during the past three years, a call option that expires in one month with a strike price of 35 will probably not be worth much because there is not a very good chance that the stock will rise above $35 by expiration. There is little incentive to buy a call option when it is likely that the stock can be purchased in the stock market for a lower price in the future. That option is not worth much.
On the other hand, if stock ZYX is volatile and has been in a $30-80 range during the past six months, the same call option with a strike price of 35 will be worth more because there is a greater chance it will rise above $35 by expiration. In that case, the contract is valuable because if ZYX rallies back to the upper end of its range, then each call option can be exercised to buy 100 shares at $35.
Therefore, the volatility of the underlying asset has an important effect on option premiums. All else being equal, assets with high volatility have higher option premiums. Assets with low volatility will have lower option prices.
Each option contract has a level of implied volatility (IV), which can be computed using an option-pricing model or found using option quotes and chains. For example, option contracts on Google (GOOG) currently have average IV of 40%, Biogen Idec (BIIB) is near 33%, and Intel (INTC) is roughly 30%. The IV tells you what the volatility of the underlying stock is expected to be. IV changes over time; as it does, the change in implied volatility will cause changes in the value of the option premiums. As IV rises, options become more expensive. When it falls, premiums get cheaper. In conclusion, tracking implied volatility will tell you how volatility is affecting your option premiums over time.
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Originally published in the August 2006 issue of Technical Analysis
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