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 |
CLOSING OUT A LOSING BEAR PUT SPREAD
I set up a losing bear put spread, and the price is staying above
the price of the long put side of the spread. I want to exit the trade
- but if I sell the long put, will I be in danger of assignment if the
price drops?
As you know, the bear put spread is created with the simultaneous purchase
of a (long) put with a higher strike price and the sale of a (short) put
with a lower strike price. The position will generate profits if the stock
price falls below the strike price of the short put. If the stock is not
moving lower and the trader wants to exit the position, the best solution
is to exit the entire trade. Simply selling the long put will expose the
trader to greater risk. It means that the bear put spread has been converted
into a naked or uncovered short put.
For example, if the stock begins to fall, the short put will increase
in value. At that point, it will have to be bought back at a higher price.
If not, and the stock drops below the lower strike price, then assignment
becomes a risk. So yes, selling the long put in a bear put spread leaves
the trader in danger of assignment on the short put, which can result in
significant losses if the stock tanks. That's why it's better to close
out both sides of the spread rather than legging out one side at a time.
EXITING A TRADE ORDER EXECUTION
After a position has been placed and a trader wants to sell the option
to either make a profit or get out of a losing trade, is it better to place
a limit or a market order?
There are no hard and fast rules about using limit or market orders
when exiting a trade. Often, it depends on the situation and the urgency
of the trade. When entering orders, traders can often be selective and
set a limit price. So there is generally no rush to get into position.
The exit is often a different story. If the order is placed to exit
a long position at the bid price, it will probably get executed immediately,
with minimal slippage. This is especially true if it is a small order that
is routed electronically. On the other hand, the trader can try to place
a limit order to exit a long position just above the bid price and hope
the market makes a move in their favor. This can be done when there is
no hurry to exit the trade and/or it's a relatively slow market.
However, in fast markets, like some of the futures markets, it can be
more difficult during periods of higher volatility to set limit orders
and get filled quickly. In that case, it's probably better to exit the
position with a market order, get an immediate fill, and thereby protect
any profits or avoid any further losses. In sum, use limit orders when
the market is moving slow and you're not in a hurry. Use market orders
when the market is moving fast and you feel the need to get out.
STOCK SPLIT EFFECT ON OPTIONS
Apple Computer recently split its shares. I previously owned the
March 90 call options. The split was two-for-one, so what happens to my
options contract?
Options contracts are adjusted for stock splits. In the case of Apple
Computer [AAPL], the stock split two-for-one on Monday, February 28, 2005.
The stock price was therefore cut in half, but the number of shares outstanding
doubled. So if a shareholder owned 100 shares at $89 on Friday, February
25, he or she would wake up the following Monday to find that they owned
200 shares trading for $44.50. The total value of their shares remains
the same.
Similarly, the options contract will also be adjusted to reflect the
stock split. In the Apple example, the number of contracts doubles and
the strike price is reduced by half. Therefore, if the option owner holds
one March 90 call on February 25, they would thereafter own two March 45
calls.
The Apple two-for-one split is relatively easy to understand. But sometimes,
splits or special dividends can be a little more difficult to compute.
If there is ever a question about how the split affects the options contract,
the adjustment's details can be found at the Options Clearing Corp.'s website
(www.optionsclearing.com).
BEST OPTIONS FOR SYSTEM
I have developed a pretty good system that is often accurate and
makes small profits, but when it's wrong, it's wrong in a big way. What
type of options strategy is good at picking up small frequent winners and
then protecting traders like me from the infrequent big losers? How far
out should I buy- one month, three months, six months, nine months, or
LEAPs?
If you are using a system that produces lots of winners but big losers
when there is a false signal, then risk management is important. Focus
on slightly in-the-money calls or puts with contingency orders in place
in case the stock goes against you. The contingency order is a technical
trigger designed to get you out of the option due to a change in the stock
price. See if your broker provides this feature.
As for time, the expiration will depend on your average trading time
frame. In my short-term systems, I generally don't go out farther than
60 days to expiration. However, without knowing your system's details,
the timing question is difficult to answer. Consider doing paper trades
with different expiration dates and see which works the best.
Originally published in the June 2005 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2005, Technical Analysis, Inc.
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