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 |
STOCK OPTIONS AND SPLITS
I was wondering what happens to stock options when the underlying stock splits. Does the call's strike price go down? An example would really help me out - James Kramer
When the underlying issue splits, so do the options. For example, if you own a January 50 call on stock Xyz when the stock splits 2-for-1, you will own two January 25 calls post-split. Sometimes, stocks will have a fractional split, such as a 3-for-2, in which case you will own three options for every two you owned prior to the split. A word of caution when trading options that split at odd intervals, such as the 3-for-2: after the split, there just isn't a lot of demand for options with strikes of 331/3, for example. Generally, when you're purchasing options on stocks that are going to split like this, you want to calculate which strikes would remain whole numbers after the split (if you're planning on holding them that long), so that the liquidity will still be there.
OFFERING PRICE
I have a relatively good understanding of options, but am not sure where to place my offering price when placing an order to buy (or sell). For example, at one point during trading today the CBOE February 88.00 DJX call was trading at 2.00. The bid was 1.95 and the ask was 2.15. I looked at the delta, gamma, and implied volatility, and the option seemed fairly priced at 2.00. Where should have I placed my order to ensure a fill? At 2.00, or at the difference between the bid and ask (2.05), and so on? Or is it a judgment call? Thanks - ADB
It all depends on how quickly and fairly you wish to get filled, and how much you are willing to pay for "fair value" of the option. Generally, there is enough intraday volatility in most stocks and indexes to accommodate an offer at least a nickel or dime below the best market ask. Any more than that, and you will need to exercise patience. Highly liquid options on issues such as Microsoft (MSFT) and Cisco (CSCO) will have tight spreads with the bid/ask spread as little as five to 10 cents, allowing for little negotiation between you and the market maker. However, options on stocks (and many indexes) that have low volumes can be in the range of 25 cents to as much as a couple of dollars between the bid/ask spread. Either way, to ask for a price at the bid or under is a losing proposition for the market maker until the underlying moves away from the strike. A patient trader is often rewarded by letting the markets come to him or her, rather than simply accepting the market price.
If you have access to an options calculator, it is easier to assess the fair value of an option relative to its implied volatility, stock price, strike, and expiration date. Simply enter the numbers and you will get the fair value of the option. This way, you can compare the resulting number with the asking price of the option in question and see if they line up. If there's a large discrepancy in pricing, you may want to pass on the trade - there are plenty of other options (pun fully intended!).
CALENDAR SPREADS
If I have 10 choices [of calendar spreads], each of them trading at a 40-cent debit with no earnings or volatility coming up, how do I choose my trade? When I look at the position graphs, what factors would help me decide between these 10 choices?
First, for the benefit of other readers, let's define a calendar spread. The traditional calendar spread is the purchase of a long-term option and the sale (short) of a short-term option, typically at-the-money? and of the same strikes. The spreader incurs a debit at a reduced price that will increase as the stock trades sideways, and subsequently the short contract expires worthless. The amount by which the short-term options decrease in value at expiration should be greater than the time decay on the long position, thus creating a profit (see Figure 1).
FIGURE 1: CALENDAR SPREAD. The amount by which the short-term options decrease in value at expiration should be greater than the time decay on the long position, thus creating a profit.
More important than the price of the underlying stock is the level of implied volatility in the short contract relative to the long contract. This is known as a volatility skew. What this means is that the short-term options have higher premiums built into them than the long-term options, thus making them more expensive on a relative basis. This usually occurs, for example, after a collapse in the stock price, when traders purchase more short-term put options either to protect their underlying stock or take advantage of a possible quick profit, if the stock keeps falling. Typically, there is a higher demand for short-term options over longer-term options, making them more expensive on a relative basis when implied volatilities are higher.
When the volatility comes back down, a lot of premium is sucked out, and the option can be bought back at much cheaper prices. On the other hand, the long-term option doesn't lose as much value, since the volatility remained at fairly low levels. When this happens, the spread is said to widen and the spreader can close out the position at a profit.
The higher the volatility of the short-term options, the higher the potential profit of the trade. Look for the curve that shows the greatest reward-to-risk ratio for your 40 cents, as well as the widest range in which the stock can trade and still allow the position to remain profitable.
Return to May 2003 Contents
Originally published in the May 2003 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2003, Technical Analysis, Inc.