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

OPTION SPREADS

I was told that to lower my risk in buying calls or puts, I could spread them. What does this mean?

To spread an option means to buy a call or put and sell one simultaneously to hedge it, either in the same month (as with vertical spreads) or different months (diagonal spreads). As an option purchaser, a trader has the right to buy or sell the underlying instrument at a specific price in the future, depending on whether it's a call or a put. Should the buyer decide to exercise the option before expiration, the seller is obliged to deliver, or take delivery of, the underlying. When you both purchase an option and sell one, you accomplish several things:

1. Reduce the cost of the long option, lowering your risk
2. Lower your breakeven
3. Gain a higher return on investment
4. Slow losses, which allows time for trade adjustments and more peace of mind
5. Become less likely to get "wiggled" out of a trade due to high volatility in the stock.

The vertical spread is commonly used. I'll describe a bull call spread as an example. Suppose it's November, and stock XYZ is trading at $50. You want to buy a February call on XYZ, thinking that the stock will advance before then. The February 50 call is trading at $5. Now, suppose you don't want to pay $5, but do want to take advantage of an upward move at the lowest possible risk. You can receive a $3.50 credit on the 55 February call by selling it. If you are buying the 50 call at $5 and selling the 55 call for $3.50, your net debit is $1.50, or 97% less risk than buying the stock! Now, should the stock advance to 55 or above by expiration in February, you make $3.50 on the trade, or a maximum potential of 233% return on investment.

The major reason some traders do not spread options is the limited reward potential of the trade, as dictated by the difference between strikes of the long and the short position minus the original debit. Some would rather just buy the calls in view of potentially unlimited gains. This is a decision best made according to your own risk tolerance.

VOLATILITY SKEW

What is a volatility skew, and how important is it when trading spreads?

In order to understand what a volatility skew is, you must first understand what volatility is. There are two types that concern options traders: historical and implied. Simply put, historical volatility is the amount the stock has fluctuated over a specific period of time, calculated as a percentage. The stock can often be expected to fluctuate by this percentage over the same time frame in the future. While historical volatility is primarily concerned with what a stock has done in the past, implied volatility is what the market predicts the rate of change will be over the life of an option.

When the historical volatility of the stock and the implied volatility of the options are different, you have what is called a volatility skew. This is extremely important to recognize when designing an options trade. For example, if the implied volatility is higher than the historical volatility, then the market is anticipating bigger moves than have occurred in the past. That being the case, you would expect to pay more for the premiums on those options, and perhaps a spread would be more appropriate than the outright purchase of a call or put. On the other hand, if the implied volatility is lower than the historical volatility, the purchase of a call or put might be appropriate.

Another type of volatility skew occurs between implied volatilities on options with different months between them. This is perfect for calendar spreads, in which there is some near-term volatility in the front-month options. These types of skews can be difficult to find without the use of options analysis software that can scan the universe of options. When you do find them, however, they can be gold mines.

LEGGING INTO TRADES

Is it dangerous to open one side of a spread at a time?

This is known as "legging" into a trade, and doing so depends on your risk tolerance and level of options-trading expertise. If your intent is to open a spread or other type of combination strategy, it is generally a good idea to open both sides simultaneously with a limit order. This way, you are assured of being filled at a limit price that you have designated.

Traders leg in to trades under the perception that they can get a better price for the entire position if they shop at different exchanges for the various legs. This can often be true, particularly if you use a broker with good floor representation or one with direct access to the floor. However, in the course of even a few minutes, markets can move away from you, ultimately leaving you with one side of a spread unhedged or forced to enter/exit the trade at an undesirable price. If you want to try this method, you'd probably be best off with a direct-access broker or one with a solid reputation for good floor representation.

Return to February 2003 Contents

Originally published in the February 2003 issue of Technical Analysis of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2003, Technical Analysis, Inc.