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.


    Return to July 2002 Contents