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. E-mail your questions
for Gentile to Editor@Traders.com, with the subject line directed to "Tom
Gentile Question." |
Tom Gentile of Optionetics
|
OPTIONS BASICS
I have been reluctant to get into options, because I don't understand
how underlying stock price affects premium price. I need to get some historical
data so I can see the relationships, and I can get hold of the Black-Scholes
algorithm. I have a stock feed that gives me OHLC and volume, and I am
looking for something that is free.
This is totally understandable -- most people fear what they do not know,
whether it's heights or racecars, or in this case, options trading. It
can be rather intimidating, not only for the newcomer, but also for the
trader who has experimented with options and realizes, the way you have,
that more than just price determines an option's value. Options premiums
are determined by several different factors. These are:
Price of the underlying asset -- When the price of the asset
is moving around, options premiums are affected as the price moves toward
and away from the strike price.
Options strike price -- The strike or exercise prices vary,
with some having real value (in-the-money), and some having no real value
(at-the-money and out-of-the-money).
Time to expiration -- The more time you choose until your option
expires, the more the option will cost in premium.
Interest rates -- This is factored into the price of an option,
but because interest rates don't change much and are quite low, they are
of little concern in options pricing.
Dividends -- If the underlying asset has dividends, then both
the options price and the underlying issue are affected.
Volatility -- The most confusing of all the factors, volatility
will affect the time value of an option, increasing if the volatility rises
and decreasing as the volatility falls. The option volatility is a perception
of the future built into the premium.
BLACK-SCHOLES PRICING
Would I get a reasonable premium price using the Black-Scholes
model?
Absolutely, if the factors above are correctly keyed in. There are several
types of option pricing models, but the Black-Scholes model is the most
popular and comes in two forms. The dividend-adjusted model is for stocks
with dividends, and the nondividend-adjusted model is used for futures
and stocks with no dividends.
PRICE VERSUS PREMIUM
What would you suggest is the best way for me to see the relationship
between stock price and premium?
Basically, the relationship between an underlying asset and the options
that are associated with it is called an options delta. By looking at the
delta, you can get a feel for how much that particular option is going
to change relative to the underlying. For example, if XYZ has moved up
10 points from the previous day's close, and the XYZ at-the-money call
options have moved up five points, then the delta of the XYZ call options
is 50. This means that the option should move about 50% of the price movement
of XYZ itself. Websites such as that of Optionetics allow you to view the
deltas of any optionable stock.
DIFFERNET STRATEGIES
I notice that you have different options strategies based on which
way a stock is moving. Do you have some backtested data that shows something
like a Sharpe ratio to tell me how well your strategies work?
Different strategies work better during bullish markets than bearish
ones and vice versa, as you probably already know. What you may not know
is that there are also different strategies for markets that have high
volatility versus low volatility. Mixing this all together with options
can create several different trading scenarios. Mathematical studies have
shown that trading these strategies correctly during extremely high or
low volatility tilts the scales in your favor, providing your assumptions
are correct. Our website does give you the ability to backtest any options
strategy from beginning to end. We have several years of real options data
to use on all optionable stocks.
STOCK MOVEMENT
I am sure your strategies work well if a stock is in a strong
trend or in a sideways price movement, but most stocks are somewhere in
between. Can you give some rules of thumb about how strong the trend must
be or what is the price range that will work -- for example, is it okay
if a stock ranges between +3% and -3%, but not if it is between +4% and
-4%?
I look for six-month trades if I am going to be directional, meaning
that there is a definite trend in place. For example, as of this writing,
Microsoft (MSFT) is definitely in a downtrend, no matter what the analysts
may say. I don't use percentages, but more important, lower highs and lower
lows, as with MSFT. The next thing I do is check the options volatility
for the stock to see if it's high or low. If it's very low, then simply
buying a put option may work; but if the options volatility is average
or high, I would probably spread off some of the risk by selling lower
strike puts against the higher strikes bought. Finally, I double-check
the risk-to-reward of the trade, and place the order.
Originally published in the July 2002 issue of Technical
Analysis of STOCKS & COMMODITIES magazine. All rights reserved. ©
Copyright 2002, Technical Analysis, Inc.
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