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 |
FOCUSED ON THE FINANCIALS
The recent problems at the brokerage firms has me concerned about wider credit problems. Is there a way to protect my portfolio from future volatility in the banks and brokerage sector?
Good question. Volatility in the financial sector is at its highest levels in years because of worries about hedge fund and credit problems. The trend has had an important impact on overall levels of volatility in the stock market because the financials are the largest sector within the Standard & Poor's 500. As a result, the financial sector will have a strong influence on the volatility and performance of the entire US stock market.
Fortunately, there are a few ways to protect a stock portfolio from volatility in the financials. Two indexes come to mind: the PHLX Bank Sector Index ($BKX) and the Amex Broker/Dealer Index ($XBD). The BKX tracks the performance of more than 20 major banks. If the problems in the financial sector continue, the bank index is going to fall. As a result, buying put options or bear put spreads on the BKX would be one way to make money if the problems were to continue.
Similar strategies can be applied to the Amex Broker/Dealer Index. The XBD tracks the performance of a dozen brokerage firms. The XBD tends to be more volatile than the bank index, but the options aren't that active and tend to have wide spreads between the bids and offers.
Alternatively, the Select Sector Financial Fund (XLF) is another tool for trading the financial sector. The XLF is an exchange traded fund (ETF) that holds all of the financial-related stocks from within the S&P 500. It has very active and liquid options. In addition, since it is an ETF, shares can also be sold short, which can generate profits if the problems in the financial sector continue.
UNDERSTANDING AUTOMATIC EXERCISE
If I understand correctly, if my options are in-the-money at expiration, that means they will be subject to auto-exercise, right? Does this mean I should close them out before expiration, even if the option is only slightly in-the-money?
It is always a good idea to consult with your brokerage firm when there is a procedural question like this. That said, Options Clearing Corp. (OCC) rules require options contracts that are in-the-money at expiration to be automatically exercised. The automatic exercise rule is intended to protect customers from leaving money on the table.
For example, if I am holding a January ZYX 50 call option with XYZ trading for $51 a share, my call is $1.00 in-the-money (ITM). That means I can exercise my call option and buy (or call) the stock for $50 (the strike price of the call) and immediately sell it for $51 a share. That, in turn, results in a $1.00 profit.
Now, suppose it is expiration week and I am not available to exercise my option because I have been abducted by aliens. (It could happen!) In that case, I would be at risk of losing money if my option expired worthless. Under the OCC rules, that wouldn't happen. Instead, the call would be automatically exercised and I would call (or buy) the 100 shares for every call option contract into my account. I can then sell it through my broker at the market price.
Obviously, the automatic exercise rule has important implications; namely, if I am holding options at expiration and don't want them exercised, I need to do one of two things. One, close the open position before expiration. Or two, contact my broker with specific instructions not to exercise the option, even if it is in-the-money. Your broker should honor the request, but, again, check with them for their policy regarding automatic exercise.
PIN RISK?
What is "pin risk"? I've heard the term before, but have no idea what it is or why it matters.
Pin risk is a risk that option traders sometimes face at expiration. It relates to the stock price being at or very near the strike price of the option. It is an important factor to consider, especially when selling or "writing" options. For example, the seller of an XYZ January 50 call is faced with the stock trading near $49.80 on the day before expiration. A 25-cent move higher in the stock on expiration Friday will pin the stock very near the 50 strike price.
Faced with the stock price at the strike price of the option, the strategist is asked to sell 100 shares (for every call option) of XYZ at $50 a share at expiration. If the shares are not held in the account, the call is not covered. In that case, the strategist will be left with a short position in the stock, along with all of the risks associated with selling the stock short for $50 a share.
A put writer, on the other hand, faces the risk of having the stock sold or "put" to their account. Further, once assigned, there is no way to avoid it. The strategist must take (for puts) or make (for calls) delivery of the shares. So, the only way to really avoid pin risk is to close the position before expiration.