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 |
BEARSIH STRATEGIES
Tom, I have noticed you have been pretty much bearish in this market for the better part of the year. Which strategies have worked best with the bearish tone you have projected?
That depends. Let's look at a few stocks I have been bearish on for the past few months, and the strategy I picked for them. For example, I decided Cisco [CSCO], Computer Associates [CA], Charles Schwab & Co. [SCH], Ford Motor Co. [F], Eli Lilly [LLY], and Cvs [CVS] were all bearish by simply looking at the patterns, but it was the volatility that told me what strategy to take. These stocks were all cheap to begin with, and the low implied volatility convinced me not to take too complicated a strategy. Instead, I simply bought 60- to 90-day put options only. They all moved the way I expected, and the trades were all quite profitable. I was also bearish on IBM, Microsoft (MSFT), and a variety of index options such as the DJX (Dow Jones industrials) and the OEX (Standard & Poor's 100). Because these were all quite high in price, there was an opportunity to spread the risk by using vertical debit spreads.
As an example, let's use IBM when it was back at $100. We expected it to drop, actually going below $80. There were several possibilities to play this stock to the downside. Three of them were:
1. Sell the stock short: To sell 100 shares of IBM short at $100, the trader would have to put up margin for the trade (to ensure the trader has enough capital in case the trade went against him). The margin can vary, but for the sake of example, let's put a price of $5,000 margin to short 100 shares of stock at $100, or 50% of the price of the stock position. Risk is unlimited, because there is no limit to how far up IBM can go. The maximum reward on this trade would be $100 per share. That would only happen if IBM were to go to zero. Don't think it can't -- we have seen too many stocks plummet in the last few years.2. Buy a put option: This tactic is meant to increase leverage while decreasing risk. Buying one IBM put option with a strike price of $100 allows us the leverage of being able to sell 100 shares of IBM, but with nowhere near the cost. In fact, this particular option costs 10 points, or $1,000, to hold until expiration. That's 80% less than the margin it took to short the stock. The problem here is that you risk losing the premium if IBM stays at or goes above $100 by expiration date.
3. Best of both worlds -- buying and selling put options (bear put spread): I think this is the best alternative. For example, if you were to buy a put option on IBM with a strike price of $100, you have the right to sell IBM at $100 per share. Selling a put option on IBM, let's say at $80, could force you to buy IBM at $80 per share. What could be better than to sell high and buy low? By spreading your strike prices this way, you are also lowering your risk on the trade, because you are collecting premium for the options you are selling, reducing the cost basis for the entire trade. The only problem here is that you are also limiting your profit potential, which is why you want to be selective on which strike prices you choose to spread.
PRICE FIRST?
So price isn't the only thing I should consider when I trade options?
Correct. You need to consider three elements. Price is one, because that is where we as traders start -- which strike price is best suited for your risk and reward outlook? The second element we need to consider is the time factor. Too many people I know have been right on the direction of the markets, but gave themselves too little time to benefit from their knowledge. The third is volatility, which means buying outright options when volatility is low, and spreading your risk when volatility is higher.
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Originally published in the September 2002 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2002, Technical Analysis, Inc.