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 |
LEAPS QUESTION
I know that there is a point in time when LEAPS turn into short-term
options and change their names. Can there be any problems with renaming
for me if I still hold such an option?
Long-term Equity Anticipation Securities (LEAPS) have different symbols
than do short-term options. However, as time passes and the options become
short-term options, the symbol will change. The symbol change, however,
will not affect the value of the options contract. It is merely a cosmetic
change and your brokerage firm will make the necessary adjustments. There
is nothing to worry about.
TRADING THE BIG MOVES
Is it sensible to buy a straddle after the underlying share had made
a big move up or down?
Sometimes placing straddles around big percentage gainers or losers
makes sense if you expect a reversal in the stock or a continuation of
the trend. However, it makes more sense after a large percentage move higher.
Why? Because option premiums often see a significant increase in implied
volatility (IV) when a stock makes a big move down and, since implied volatility
is an important factor in determining the value of an option premium, the
jump in IV means that the options have become more expensive. This isn't
usually the case when a stock makes a big move up. Instead, IV option premiums
often fall when a stock moves higher, which makes them cheaper.
In addition, since a straddle involves the purchase of puts and calls,
it is better to establish the trade when implied volatility is low and
expected to increase. At that time, the options are cheaper, but might
become more expensive. So the straddle can be a good strategy when a stock
makes a big move up and is expected to move down or continue higher. However,
if the stock has suffered a large percentage loss and implied volatility
is up, buying the straddle is not necessarily a good bet. The IV might
fall and cause the options to lose value, which is known as a volatility
crush.
CALENDAR SPREADS -- PUTS VS CALLS
If I have no bias on the stock movement, I can understand why a put
calendar spread is better than a call calendar, because of the possibility
of having to pay for the dividend. But aside from that, if the stock is
in the current sideways pattern, can it affect your decision on whether
to use puts or calls? For example, if it is nearer the resistance level,
would you use a put calendar, and if it is near the support level, a call?
When choosing a put or call, don't you want to choose the one that will
be the more likely direction longer term after the option you sold expires?
The calendar spread is a strategy that works well when the stock is
moving sideways or trending only modestly. It is not a great strategy to
use if you expect an explosive move higher or lower. To review, the calendar
spread involves the purchase of a longer-term option and the sale of a
shorter-term option with the same strike price. The idea is to use time
decay to your advantage because short-term options see a faster rate of
time decay when compared to long-term options. Once the short-term option
expires, the strategist can choose from among several follow-up actions:
1) Exit the position entirely by closing the longer-term option,
2) Sell another short-term option, or
3) Hold the longer-term option and hope that it appreciates.
The calendar spread can be created with puts or calls. The selection of
puts or calls is based on the outlook for the stock and the possibility
of appreciation of the longer-term option. If the trader expects a move
higher, then the calendar is created with call options because once the
short-term call expires, the other call might appreciate in value. In that
case, the premium from the short-term call has helped finance the purchase
of the long call. If the stock is set to trend lower, puts are better because
the long put might increase in value over time.
If the stock is expected to trade sideways, the put calendar spread
is often better. For one, the put calendar spreads are generally cheaper
than call calendars at the same strike price, due to the way options are
priced. Puts are generally cheaper than calls. In addition, if you are
trading a stock that pays a dividend, you won't be required to pay the
dividend on short puts (long stock) as you would on short calls (short
stock). This would only happen if you were assigned on ex-dividend day,
but it does happen. Therefore, if you have a moderately bullish outlook
on the stock, use calls. Otherwise, puts are superior when establishing
calendar spreads for two reasons: 1) Puts tend to be cheaper, and 2) There
is less risk of having to pay the dividend.
WHAT RATE TO USE
The risk-free rate is one of the determinants of options prices.
What is the best rate to use? The short-term Treasury bill rate, since
it's basically risk-free?
The short-term Treasury-bill rate can work as an approximation of the
risk free rate. In addition, consider using the rate that matches up to
the expiration of the option contract. For example, if the option expires
in 90 days, use the three-month T-bill. The six-month T-bill will work
for options that expire six months from now. Or you might use the two-year
Treasury note if you're looking at options that expire in January 2007.
Originally published in the July 2005 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2005, Technical Analysis, Inc.
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