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 |
EXITING A SPREAD
I once read about three ways to exit a spread, but I don't remember
them all. I know I can close the position through an offsetting transaction.
What are the others?
Spreads include combinations of options that are bought (or long) and
options that are sold (or short). If a trader holds a spread with a combination
of long and short options, three things can happen. The first is to close
the position by initiating an offsetting or closing transaction. In that
scenario, the strategist would buy back the short options and sell the
long ones.
Alternatively, the position can be held through expiration and the options
can expire worthless. This often happens with successful credit spreads.
For example, if a strategist is in a bear call spread, which is created
by selling a call and purchasing a call with a higher strike price, the
trade creates a credit. This credit is earned because the short call with
the lower strike price will have a greater premium than the long call.
If the stock falls and remains below the strike price of both call options
at expiration, the options can expire worthless and the strategist keeps
the credit. Thus, with some spreads, letting the options expire is a viable
and desirable way of exiting the position.
The third way is through exercise and assignment. The short side of
the spread might face assignment if it is in-the-money at or near expiration.
In a bear call spread, if the stock price climbs and is above the strike
price of the short option toward expiration, the strategist might face
assignment. However, assignment and exercise may be the least common method
for exiting a spread. In many cases, if the strategist is at risk of assignment
on the spread, the position is closed using the first method--exiting the
trade through an offsetting transaction.
WHERE DO OPTIONS TRADE?
I understand most stocks are listed on either the New York Stock
Exchange or NASDAQ, but where are options listed?
Today, six US exchanges trade puts and calls. The three largest are
the International Securities Exchange (ISE), the Chicago Board Options
Exchange (CBOE), and the American Stock Exchange (AMEX). The Philadelphia
Stock Exchange (PHLX), the Pacific Stock Exchange, and the new Boston Options
Exchange (BOX) also list options. However, unlike stocks that are listed
on one exchange, contracts in the options market have multiple listings.
Many contracts trade on more than one stock exchange and, in some cases,
on all six.
PLACING STOPS
I'm confused about the right method for employing stops. Should I
place a stop on an options position using a contingent order based on the
technical stock price found on the chart? Or should I calculate from the
risk graph what the option price would be at the technical stop and base
the stop-loss on the option price?
Stops can be used in different ways. There is no one right answer, and
their placement varies, depending on the volatility of the market, time
horizons, the investor's risk tolerance and ability to watch the market,
and the type of trade in question.
For example, I use mostly contingent stop orders. I travel about 50%
of the time and it's difficult for me to track the market throughout the
trading day. As a result, I like to place my orders and exit strategies
using charts and price levels, regardless of what option strategy I use.
In addition, my stops vary depending on my objective. For example, I
put limit orders on the profit side. Once my target is hit, the trade is
closed. I place stop market orders on the stop-loss side using the previous
pivot points on the chart. A break below that level, and the position is
closed.
To answer your question, use what is right for you, but be sure to use
something. It can be a contingent order based on a stock chart, a percentage
loss, or a certain number of points. Regardless, make sure to know the
stop price when the position opens. There are traders who watch the market
throughout the day and use mental stops, but this method takes time and
discipline. It's easy to move stop-limits higher or lower when the market
turns against you, but that defeats the purpose of a stop-loss. In my opinion,
it is better to know the acceptable loss point and enter the stop-loss
order at the time of the initial trade. Then stick to it!
MARKET BREADTH
Recently, Optionetics' Closing Wrap-Up noted that "market breadth
was positive by a 9-to-7 and 8-to-7 margin on the Big Board and the NASDAQ,
respectively." Could you explain what "market breadth" means?
Market breadth refers to the number of stocks that advance on a given
day compared to the number of stocks that decline. For example, on August
8, 2005, 1,224 stocks advanced and 2,080 stocks declined on the New York
Stock Exchange (NYSE). The ratio of 2,080 to 1,224 is approximately the
same as five stocks advancing for every three stocks declining. So "Big
Board" breadth was approximately five-to-three negative. The same analysis
is often applied to Nasdaq trading. Technicians like to see a series of
positive market breadth days, as it indicates that the market is performing
well and more stocks are rising than falling.
Originally published in the October 2005 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2005, Technical Analysis, Inc.
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