Q&A
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.
Collar Adjustments
I have a collar on a stock. I am still very bullish and the stock has come down quite a bit, so when does it make sense to buy back the call for a profit and let it ride?
The collar is becoming a more popular strategy after the latest selloff. A lot of investors who want to buy are looking at how far some stocks have fallen. The problem is, prices are still falling and volatility is high. Fear is at an extreme, and many investors are reluctant to buy stocks despite the bargains that now seem to exist.
The collar offers a limited-risk way to buy stocks. The trade is a combination of a protective put (long puts, long stock) and a covered call (long stock, short calls). It is created by buying shares, buying puts, and selling calls (and can also be applied to an existing position). The put provides a floor under the stock and the sale of calls helps pay for the put. In addition, since implied volatility is so high right now, option premiums are very expensive and it makes sense to sell some call premium to pay for the put options.
If you entered a collar and the stock falls, a few adjustments are possible. For example, if the stock has made a dramatic move lower and you expect a massive bounce, you can take the collar off entirely and simply hold shares. By doing so, you are banking profits on both the puts and the calls. Then, if and when the stock rallies, you can sell the shares and close the position out entirely.
Buying back the calls is another option. By closing out the calls only, you bank profits on that portion of the collar and are left holding a protective put, which is very delta-positive. The position will make money if the stock moves higher and will also have limited risk to the downside by the put option. The position has the same risk-reward profile as simply buying calls, which only makes sense if you have a very bullish outlook for the stock. When considering whether to close out the puts and calls or to buy back the calls only, the strategist is making a decision about whether to hold a hedged or unhedged position. Selling the puts takes the hedge off and leaves the position exposed if the stock falls further.
Another possibility is to roll the position down by closing out the long puts and short calls, while also buying puts and selling calls with a lower strike price and perhaps more time left until expiration. By doing so, you are buying yourself more time for the trade to work.
It is important to note that rolling will also increase the risk or cost of the trade, but it will certainly create a position that is much less risky than owning shares outright without hedge. A good time to roll a collar down is near expiration or when the strategist can buy puts around an important technical support level.
Legging Into Spreads
Have you ever seen such powerful market swings on a daily basis? It seems like every day there is a 300–400 point move in the market. Is this a good time to be legging into spreads?
I have never seen a market like the one we saw in the first half of October 2008. A 1,000-point intraday move in the Dow Jones Industrial Average (Djia) has never happened before, but it did on October 10. We have also seen a number of 600-, 700-, and 800-point swings. It’s amazing! In the late 1990s and before the bear market from 2000 to 2002, the Nasdaq saw huge daily price moves in excess of 5%. It wasn’t quite as volatile as during the recent market decline and it was also different because tech stocks were screaming higher, not lower. Nevertheless, it was also a period of extremely high volatility.
I will repeat what I told traders during the 1990s: Be very careful about legging into trades, especially in highly volatile markets. For example, when entering a straddle, it might be tempting to buy the put first, wait for the stock to fall, and then buy the call. If you’re right, it will really tilt the risk–reward of the trade in your favor. The danger is being wrong. If the stock moves higher after you buy the put, you will pay more for the call, and that changes the risk–reward of the straddle in an unfavorable way.
Then, you might be tempted to ride it out and wait for the stock to turn lower again before buying the call. That, in turn, leaves you holding only puts and defeats the purpose of trading a straddle in the first place. In other words, by legging, you go from a nondirectional trader looking for a move higher or lower in the stock to a directional player looking for a move lower.
It takes a lot of discipline to leg into trades, especially in today’s highly volatile markets. If you simply can’t resist the temptation, then when you open each side of the trade, it’s important to consider each leg of the trade as a separate trade until the spread is completed. If it turns against you, then it might be better to close it out at a loss rather than enter a position with an uninteresting risk–reward profile.
Plan an exit strategy before legging into the position. Or simply enter the trade as one order and avoid legging. With the advance in online trading, many brokers offer the ability to enter spread orders automatically for one credit or debit. Specify the prices you’re willing to pay and avoid legging.