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 |
BUYING, SELLING, AND OPEN INTEREST
I came across something the other day while reading The Wall Street
Journal. In the "Leaps-Long Term Options" section, I noticed that the
put volume of a stock was quite high compared to the call volume, and the
strike price was out-of-the-money. Does this suggest that the "experts"
are buying puts because they think the stock will go down, or that they
are selling the puts and expecting the stock to go up? Is there any way
to get this buy/write volume for a particular strike price?
Unusual increases in volume or open interest can sometimes signal that
experts or well-informed investors expect the stock to make a significant
move in the future. At other times, large volume can represent a protective
purchase of puts, the sale of an open position, or maybe even part of a
more complex trade involving other stocks or options. So how do you know
what is happening?
Remember, all options trades involve a buyer and a seller. In order
to determine which one initiated the trade, you can try to see if the trade
occurred at the bid price or the ask price. If the trade happened at the
bid price, it was probably a sale. If the trade takes place at the ask
price, it was probably a buy. As you can see, unless you can watch the
market or have access to time and sales data for the options market, it
is often difficult to tell if a certain trade was at the bid or the ask,
and therefore it is hard to know if the position was a purchase or a sale.
Nevertheless, the price of the trade and whether it was at the bid or ask
can give you clues regarding whether it was a purchase or a sale.
Another factor to consider is the open interest. Open interest is the
number of options contracts that have been opened and not yet closed out.
For example, if the options contract has zero open interest and volume
is 1,000 contracts on the day, this is probably an opening transaction
-- either a purchase or a sale. However, if the contract already has 1,000
contracts of open interest, then the trade might be a closing trade. In
order to find out, check the market the next day. If the open interest
has dropped to zero, the trade was a closing transaction. If it has increased
to 2,000, the volume was part of an opening transaction.
TRADING LEVEL QUESTION
After looking at my broker's website, I noticed that customers get
assigned different level ratings indicating what types of options they
are allowed to trade in their account. I haven't opened an account yet,
so I was wondering what they look at and how they determine this rating.
Is it possible to get assigned a level that prevents you from doing trades
you would have liked? Thanks.
Brokerage firms are required to know their customers and make sure that
each account is not taking on too much risk given the individual's financial
resources, experience, and knowledge. Most of the information is gathered
at the time the account is opened. Before trading options, individuals
must complete both a new account form and an options approval document.
The new account form will provide information about personal and financial
background. In the options approval document, the trader lists past trading
history and experience, as well as the types of strategies they hope to
trade in the new account.
Based on the information in these documents, the brokerage firm will
assign a ranking or level to the individual trader. The brokerage firm's
compliance department will review the information and make the appropriate
decision. Brokerage firms can, and often do, deny requests to trade certain
strategies if the investor is not deemed to have enough experience and/or
financial resources.
The assignment of ratings or levels can vary from one brokerage to the
next, but all brokers generally use the same guidelines. For example, level
1 approval allows basic strategies like covered calls and protective puts.
More complicated or risky trades require a higher level of approval. Selling
uncovered calls is considered extremely risky and requires the highest
approval rating -- a level 5. Only traders with a great deal of experience
and significant financial resources can receive approval for level 5 trading.
Spreads and straddles generally fall in the middle --that is, traders with
level 3 approval can use strategies like straddles and strangles, as well
as bull or bear spreads.
In sum, it's really up to the brokerage firm to determine what level
of options trading approval is right for you. This will protect the firm
by ensuring that their customers are not taking on excessive risk, given
their experience and financial background. This will also protect less
experienced traders from taking on excessive risk that might result in
financial losses or even wipe out their trading account.
Originally published in the April 2005 issue of Technical Analysis
of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2005, Technical Analysis,
Inc.
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