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
OPTIONS AND SHORT-TERM PRICE MOVES
I've been working on a system that works well in predicting the moves in the Dow Jones Industrial Average (DJIA) over one to two weeks. It is a purely technical system. I have been using the Dow Jones diamonds (DIA) exchange traded fund (ETF) as a vehicle for the system. What other "options" do I have? -- Mike
In addition to the DIA, you can also trade options on the DIA, index options on the DJIA, or Dow futures. The futures will require a separate trading account because futures and options on futures are regulated differently from stocks, stock options, and index options. You can trade DIA or index options in the same account as your DIA trades if you have option approval from your broker, which requires paperwork and a signature. Ask your broker.
If you have option approval, you can trade DIA options or options on the Dow Jones Industrial Index ($DJX). What's the difference? The DIA is an exchange traded fund and shares can be bought and sold like shares of stock. So like stock options, ETF options settle for shares. However, the DJX is an index and is really only a benchmark and can't be bought or sold. DJX options settle for cash, not shares. The amount of cash depends on the strike price of the options contract and the settlement value for the DJX at expiration.
In any event, both the DIA and the $DJX are designed to equal 1/100th of the DJIA. When the DJIA is near 13,000, the DIA will trade for $130 a share and the $DJX will be near 130. Both contracts are actively traded and either can be used as part of a trading system based on the moves in the DJIA.
When using options as part of a trading system, there are a few risks that must be factored into the system, one of which is time decay. Time decay results from the fact that options contracts have a fixed life and expire on a specific day -- the expiration date. The less time that is left, the less value in the contract. For that reason, options are often called "wasting assets."
So how do you get around the time decay? Simple: Focus on in-the-money (ITM) options -- that is, you buy options that have little time value. Remember, all options contracts consist of time value and intrinsic value. For an in-the-money call option, time value is computed as:If the option is out-of-the-money (OTM), the value of the option consists only of time value. In short, time decay will be a big factor affecting the value of an OTM option, but less of a factor for ITM options.Call Option Price + Strike Price - Stock Price = Time ValueTime value for an Itm put option is computed as:Put Option Price + Stock Price - Strike Price = Time Value
So if the DJX is near 130 and you expect a move to 135 over the next two weeks, the trade is established with the 120 calls with 30 or 60 days of life remaining. If, instead, you use the 135, the call is OTM and consists only of time value. Time decay will be a big factor working against your trade.
For your system, I would look at either the DIA or the DJX. In addition, when we have a short-term system, we generally use options as an alternative to stocks. However, we also use ITM options to mimic the stock movement and try to minimize the risk from time decay. Using OTM options gives greater leverage for the trade, but you are also fighting time decay.
COVERED CALL QUESTION
I had a covered call. I had sold a call with a 90 strike and expiration in May 2007. It was assigned May 9. I was surprised, since May 18 is an expiration day. The stock was at 94. Is assignment early a standard practice if the stock is in the money?
No. Early assignment is not standard practice, but it can happen as expiration approaches. The key to anticipating early assignment is to look at the time value remaining in the option contract. If it has little or no time value, there is a risk of early assignment. This will happen with Itm options as expiration approaches.
If you don't want to get assigned, then you should close out the contract by buying back the call option to close the trade. In your example, you are long the stock and short the call. So if the stock moves higher, the option is ITM and you don't want to face assignment, you might buy back the call and sell one with a higher strike price. Or you can close the trade altogether by selling the stock and buying back the call.
From what I understand, American-style options trade on the US exchanges and can be exercised and assigned at any time. What are European-style options? Do they only trade in Europe?
The term "American style" or "European style" does not refer to where the option contract trades. In the US markets, some options settle American style and some European style. The difference is that exercise and assignment can only occur at expiration if the options have the European-style settlement feature. American-style options can be exercised at any time prior to expiration. Most index options, such as the $DJX and S&P 500 ($SPX), settle European style. Stock and ETF options settle American style.
Originally published in the July 2007 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2007, Technical Analysis, Inc.
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