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.
A CALL ON VOLATILITY
I’m new to options and having some difficulty. Despite the broader market having more or less trended higher since September 2010, I’ve found my purchased calls, which I make sure aren’t expensive in their relative historical and implied pricing, are nonetheless resulting in net losses. Any insight into what I might be doing wrong would be appreciated.
First of all, I’m pleased to see you’re learning about the mechanics of option pricing with regards to the influences of volatility. The bad news is when you’re buying an option cheap with no other hedge, that trading edge can be quick to disintegrate as the purchased option’s greeks begin to influence the pricing.
For instance, let’s say you bought 10 at-the-money calls two months out for $1.70 per contract. When comparing the price to historical and implied volatility values, you estimate your edge as $0.30 with the call fairly priced at $2.00. The problem with buying the calls on this supposition? You aren’t trading volatility at that point. Your “cheap” purchase is inherently flawed almost immediately because you’ve left yourself open to delta or directional risk and, over the course of time, theta or time decay as well.
In fact, without a hedge such as shorting shares against the calls and establishing a synthetic straddle, buying cheap volatility and having implied volatility increase is likely to also be a losing proposition, as more often than not, that situation occurs while share prices are dropping.
In an extreme situation like heading into an earnings event, the long vega or volatility exposure might compensate you as a stock drops in price, but this is uncommon and definitely not a means to trading the perceived edge.
That said, it sounds as if you must decide which risks you’re willing to accept and then choose an appropriate strategy. If it’s an edge defined by long vega that you want to capitalize on, then a straddle, strangle, long calendar, or even a ratio backspread become candidates for positioning.
If your trading plan consists of you wanting to ride a bull, then the long call might be your approach. However, a bull vertical with its two legs or perhaps a three or four-legged spread such as a long butterfly or long condor, all of which can hedge your delta further, are wiser options to consider.
More Money
I’ve found moderate success buying verticals in bullish and bearish stocks but have had difficulty exiting for what I see as a fair price. Prior to expiration it’s been my experience that trying to cash in for the spread’s maximum profit, even when both legs are deep in-the-money, is difficult and I often feel as though I’m giving up too much profit in closing out the position early. Am I right in thinking this?
Welcome to the world of verticals and one where probability analysis, volatility, and perhaps the negative consequences of liquidity issues all come into play when the spread is fully in-the-money. Vertical spreads are great positions as delta, vega, and theta risks can be dramatically reduced and even reversed compared to a long outright call or put position.
A limitation to this, however, is that the vertical is much slower to compensate a trader when conditions in a stock turn out favorable for the likes of the long call or long put. One underlying factor that sums up much of your anxiety is volatility, which we’ll assume remains mostly flat during your holding period.
When stock and implied volatility are high, an in-the-money vertical can be expected to be worth a lot less than its maximum profit value at expiration. This is because the closer-to-the-money leg that you’re short will maintain greater extrinsic or time value than the long contract. This reflects the stronger likelihood of the stock jeopardizing the spread’s in-the-money status and prevents it from expanding in value too quickly prior to expiration.
Look back to a situation where you purchased a spread in a high-volatility stock. It might have looked comparatively cheap versus buying an outright call or put. As we just discussed, this also means even when the stock is cooperating directionally, your spread will be slow to move toward its maximum value because underlying volatility is still strong, despite its current bullish cooperation.
On the other end of volatility — that is, a low-volatility environment — the spread value from the time you enter until you exit will be priced closer to its maximum value versus a vertical whose share price is the same but maintains higher volatility. Now you’re dealing with both legs of the vertical having less or no time value. Hence, both options (when deep) are always that much closer to being worth the distance between the strikes.
Poor liquidity can result in reduced profits as well. Traders refer to this factor as “slippage.” Large slippage can be avoided by taking the time to look at a stock’s in-the-money options and gauge how they could be trading prior to entering into a vertical. If the prognosis looks dark, passing on a position should be considered an appropriate course of action.
Finally, if you are long and looking to exit, remember to check the pricing of the out-of-the-money option that lines up with the vertical’s associated short strike. Often enough, the out-of-the-money put versus the held in-the-money call vertical will be more active and maintain a tighter market. Purchasing that put can allow a trader to lock in better profits than closing the spread while having a teaser of an open-ended box position.