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 |
OPEN INTEREST
What is open interest, and is it something I should be concerned about in my analysis of an option?
Open interest is the total number of options contracts for a particular strike that are "open," both long and short. Open interest is exactly what it sounds like - interest in an option. For the retail trader, there is really no way to know simply by looking at the open interest who is on what side of a trade and whether the trade is retail or institutional. It is also difficult to determine whether a large bump in open interest was in response to a different trade, in which the purchase or sale of the contract was simply a hedge meant for insurance purposes, and will never be "closed" per se. Open interest can be used effectively in conjunction with other indicators to help you determine the sentiment of the underlying position. This is more effective in highly liquid stocks that trade large numbers of contracts. Looking at the distribution of open interest over a series of strikes in and around the current stock price should give you some clue as to where a potential support or resistance level for that issue may be.
MARKET CONDITIONS
Should I adjust my strategy allocation in my trading portfolio to accommodate certain market conditions? For example, I've noticed that in the last two months, there has been virtually no direction in the major indices, but from March to June, it was straight up. What would you suggest? -W. North, Australia
Like a long-term investor who needs to diversify his portfolios between stocks, bonds, and cash, an options trader should consider diversifying capital to different strategies. However, since nothing is written in stone, I can only really suggest a template to start out with, so you can adjust it to your own risk tolerance and personality. Generally speaking, the market moves three ways - up, down, and sideways. In addition, there are periods of high volatility and low volatility, particularly with options. Knowing this, but not knowing which combinations of the multiple conditions will surface next, it would make sense to have a number of different types of trades on at the same time.
Let's break it down a little. Generally, during periods of low market volatility when the market is moving up, we can buy calls. If volatility is high and moving sideways, we might buy calendar spreads. During periods of low volatility and no direction, straddles are a good strategy to take advantage of the low price of options with an anticipated market breakout in either direction. So if all you knew were these strategies, you would actually have the majority of the market conditions covered - low volatility directional, high volatility nondirectional, and low volatility nondirectional.
You could use a pie chart-type method to divide the strategies into three parts, with the largest portion of your trading capital allocated to the prevailing trend. For example, if the market is bullish and volatility is low, you may want to put 40% of your capital into buying calls or call spreads, 30% into high-volatility, nondirectional options (such as calendar spreads), and 30% into low-volatility, nondirectional options (such as straddles). This way, you will profit with your calls and straddles if the current trend continues, but should the trend move sideways for a while, you'll profit on the calendar spreads. This will help to amortize the losses in time value of the calls and straddles.
As you can see, it pays to build your knowledge base of options strategies. Sometimes market conditions require strategies that need a little dusting, since they aren't used as often. For example, put ratio backspreads were useful when the market was selling off in 2000 and tech stocks were plummeting 50 points a week. Like clubs in your golf bag, you may not use these strategies all the time, but it pays to know about them for those times when your favorite strategies aren't profiting.
OPTIONS EXPIRATION
I've been told that 90% of options expire worthless. Is this true? If so, why would anybody want to take the risk of trading options?
First of all, the belief that 90% of options expire worthless is untrue and misleading. According to the CBOE, about 30% of options actually expire worthless, 10% are exercised, and the other 60% are simply traded in the marketplace - meaning that buyers sell their positions and writers buy back their positions to close.
Before making any judgment on the danger of options, keep in mind their inherent purpose. Options in and of themselves are hedging instruments, meaning that their intended purpose is to protect assets from adverse price movements. Institutional and retail investors alike purchase puts and calls to reduce the risks associated with holding an underlying asset. They do this to help protect their investments. However, much has changed since options' inception and in many cases, the options on a particular stock or index are as liquid as the stocks themselves. This is why many traders find options desirable as trading vehicles.
Options are called derivatives because they derive their value from the underlying asset. They are often traded with reckless abandon by inexperienced traders who do not fully understand the consequences associated with options' leveraged nature. These uninformed or inexperienced traders do in fact lose their shirts quite often in the options market, but many of their losses might be prevented with the proper education. All forms of trading require proper money management and learned trade management techniques. For example, if a trader is always buying 200-share lots in equities, he should also consider trading two option contracts. This way, he has truly reduced his risk exposure on the same equity by as much as 95% in many cases, while fully participating in the anticipated gains. However, what normally occurs with inexperienced traders is they conclude that they have 10 to 20 times more capital to spend as a result of this leverage, and thus, will often recklessly purchase as many options as their account size allows instead of instituting proper money management techniques. Not only that, but they sometimes buy short-term options that expire in less than 30 days - when there is the highest rate of time decay. This decay accelerates the closer you get to expiration, and it will inhibit your option's ability to appreciate in value, even if the underlying is moving in the direction you anticipated.
As I've said before in this column, in the end, it's not options that are dangerous; it's the people who trade them. Get the right education first, exercise proper money management, become a success, and then judge for yourself.
Return to October 2003 Contents
Originally published in the October 2003 issue of Technical
Analysis of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2003, Technical Analysis, Inc.