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. |
Tom Gentile of Optionetics
|
TECHNICAL OR FUNDAMENTAL?
Which is a better form of analysis to use when trading options, technical
or fundamental?
Talk about a loaded question! Well, when trading options, the fact is
that the life of an option is limited to the terms of the contract. Since
the majority of options traders focus on contracts that expire within three
months, it's plain to see that fundamental analysis really isn't going
to help much.
That's not to say that certain fundamentals won't be helpful in making
a decision to place a trade, but you probably don't care whether that offshore
drilling company is projected to grow at a 15% annual rate for the next
five years. You'd rather know if other traders are buying or selling on
shorter-term news. Fundamental events that will help you understand what's
going on in technical charts include earnings reports, press conferences,
industry forums, shareholder meetings, and other news that will find its
way to the financial news stations or journals.
Such fundamental news produces buying and selling activity that can
be observed in a security's price chart. Adding technical indicators such
as volume, moving average convergence/divergence (MACD), and the relative
strength index (RSI) can take much of the guesswork out of who is buying
and who is selling. The important thing to remember is that it's not so
much about whether you know for certain that a stock is going up or down.
Instead, focus on times when the probability is much greater that a stock
will move one way as opposed to the other, based on what has happened most
often in the past.
History tends to repeat itself, and the premise of technical analysis
states that all that is fundamentally known is already priced into the
chart. So it's reasonable to assume that when you're studying a chart,
you are essentially killing two birds with one stone -- that is, you're
reading into the technicals and fundamentals at the same time.
GREEKS
What is gamma?
Gamma is the rate of change in delta for a $1 move in the underlying
security. The delta is how much the value of the option increases or decreases
for a $1 move in the underlying. An option's delta fluctuates between zero
and 100 as the underlying moves. Since changes in delta are not random,
gamma is really the value that is given to measure just how fast an option
will gain or lose deltas. If you were to look at a curve of gamma on a
series of options with deltas ranging from zero to 100 in a linear fashion,
you would see that gamma is highest for at-the-money options and lowest
for in-the-money and out-of-the money options. Since an option's delta
can't be any lower than zero or higher than 100, both extremes represent
zero gammas.
As far as the types of risks that are present in an options portfolio,
gamma risk is important when considering the options strategy you will
use. Generally, when placing certain delta-neutral? strategies such as
at-the-money calendar spreads, gamma risk can be high (changes in delta
are highest at-the-money and thus the least stable at that strike in the
option chain). For these strategies, you normally want the deltas to remain
as close to zero as possible. If the gamma is high on a calendar spread,
a small move in the underlying could jeopardize the spread very quickly.
When buying long calls and puts, a conservative trader can reduce the
gamma risk by buying more time (that is, by buying options that expire
after 30 or 60 days). At-the-money gammas increase as the expiration of
an option draws closer. When there is more time built into an option's
premium, the rate at which its deltas change slows, effectively lowering
the gamma risk.
BID/ASK SPREADS
Why do some options consistently have bid/ask spreads between five
and 10 cents, while others never seem to be any less than 25 cents?
That all depends on the liquidity of the options, which is generally
relative to the liquidity of the security. Stocks that trade tens of millions
of shares each day are in high demand since there is a lot of institutional
interest. As such, the options tend to be more liquid as well. This works
by the basic, fundamental principle of supply versus demand. The more options
that are traded on a stock, the tighter the spread. Even though one trader
could put a large spread out there on the stock, most likely there will
be thousands of others who are willing to take 20 cents, and still thousands
more who will take 15 cents, and so on. This continues until you can't
really take any less than the tightest spread, which is five cents. Any
less, and the market makers hardly have any business to run or profits
to make.
Return to March 2004 Contents
Originally published in the March 2004 issue of Technical
Analysis of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2004, Technical Analysis, Inc.
