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 |
ABOUT THOSE OPTIONS SCANDALS
There has been talk lately about the options scandals that have involved many big companies. I am new to options trading and was wondering how these events might affect my trading.
The options backdating scandals involve a different kind of options contract than the ones you and I trade. The controversy involves the timing of options grants from employers to employees. Specifically, some companies are under investigation for retroactively setting the date of options to a time when the stock price was lower, which makes the option contract immediately more valuable. The scandal involves a type of option that is awarded to key employees by the company.
You and I trade a different kind of contract known as listed options. These contracts are not awarded to employees, but trade on the organized options exchanges such as the Chicago Board Options Exchange (CBOE), the International Securities Exchange (ISE), or the American Stock Exchange (AMEX). Since employee options and listed options are very different, the scandal will have no real effect on day-to-day trading for options strategists.
However, the scandal could affect you if you had a position in a company that is involved in the options backdating scandal, if a strategist had a bullish position in a company and the stock fell on news that management was under investigation for backdating of options. The only way the scandal would directly affect the strategist is if they had a position in a company under investigation and the news caused a reaction in the share price.
CREDIT SPREAD EXIT
What happens if I have a call credit spread and the stock moves against me? Do I wait until expiration to exit, or can I close the position early?
The bear call spread is an example of a call credit spread. It involves the sale of a call option and the purchase of a call with a higher strike price. Since a call with a lower strike will have a higher premium than a call with a higher strike, the trade is established for a credit. The idea is to have the stock stay in a range or fall and for the call options to expire worthless. If so, the strategist can keep the premium, or credit, from the spread.
If, on the other hand, the stock moves higher, the strategist will be forced to cover the position or face the risk of assignment. To close the position, the strategist must buy back the spread for a debit, which is equal to the cost of buying back the short call minus the premium received for selling the long call.
For example, say in mid-June, shares of XYZ are trading near $34.50 and the strategist thinks the stock will stay below $35 until July expiration. As a result, a bear call spread is created by selling the July 35 call for $2.50 and buying the July 40 call for 50 cents. The credit from the trade is $2.00 a spread ($2.50 ? $0.50) and the strategist can keep that premium (which is equal to $200, or $2.00 x the multiplier 100) if XYZ is below $35 a share as expiration passes in July. If so, the strategist can simply let those options expire.
But say XYZ begins moving higher. On July 14, one week before these options expire, XYZ is up to $37 a share. The July 35 call has benefited from the move higher in XYZ, but not enough to offset the loss of value due to time decay. It is currently bid for $2.25 and offered for $2.45. The July 40 call, meanwhile, is bid for 10 cents and offered at 15. It has little value because, with only one week remaining and XYZ at $37 a share, it is $3.00 out-of-the-money.
In this situation, the strategist is faced with a decision. With one week until expiration, the short call is in-the-money by $2.00 and the long call is out-of-the-money $3.00. Therefore, it might be wise to close the trade rather than face assignment on the short call. If so, the strategist can buy back the short call for $2.45 a contract and close out the long call for 10 cents. The result is a nickel profit of the short side of the spread but a 40-cent loss on the long side, or a total loss of 35 cents for the spread. Another way to look at it is: the initial trade resulted in a $2.00 credit, but closing the trade costs a $2.35 debit ($2.45 - 10). Therefore, the loss is equal to the credit minus the debit, or 35 cents ($35) per spread.
THETA AND TIME VALUE
I understand that time value equals the option price minus intrinsic value. But when I look at theta, it doesn't equal the time value number. Doesn't theta measure the time value of an option?
Time value is the amount of premium that exceeds the options' real or intrinsic value. In the credit spread example, when XYZ is trading for $37 a share, the intrinsic value of the July 35 call is $2.00 a contract because it is $2.00 in-the-money. Time value is anything above that. When the July 35 call is worth $2.45 a contract and XYZ is trading for $37, the time value is equal to 45 cents.
Theta is not the same as time value. Theta is the measure that represents how much value the option will lose per day. If the July 35 call has a theta of 0.10, it will lose 10 cents a day due to time decay. If the call is worth $2.45 today and the stock price remains unchanged, it will be worth $2.35 tomorrow. Theta and time value are two different measurements and generally will not be equal.
Originally published in the October 2006 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved.
© Copyright 2006, Technical Analysis, Inc.
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