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 |
TECHNICAL OR FUNDAMENTAL?
Which is a better form of analysis to use when trading options, technical or fundamental?
Talk about a loaded question! Well, when trading options, the fact is that the life of an option is limited to the terms of the contract. Since the majority of options traders focus on contracts that expire within three months, it's plain to see that fundamental analysis really isn't going to help much.
That's not to say that certain fundamentals won't be helpful in making a decision to place a trade, but you probably don't care whether that offshore drilling company is projected to grow at a 15% annual rate for the next five years. You'd rather know if other traders are buying or selling on shorter-term news. Fundamental events that will help you understand what's going on in technical charts include earnings reports, press conferences, industry forums, shareholder meetings, and other news that will find its way to the financial news stations or journals.
Such fundamental news produces buying and selling activity that can be observed in a security's price chart. Adding technical indicators such as volume, moving average convergence/divergence (MACD), and the relative strength index (RSI) can take much of the guesswork out of who is buying and who is selling. The important thing to remember is that it's not so much about whether you know for certain that a stock is going up or down. Instead, focus on times when the probability is much greater that a stock will move one way as opposed to the other, based on what has happened most often in the past.
History tends to repeat itself, and the premise of technical analysis states that all that is fundamentally known is already priced into the chart. So it's reasonable to assume that when you're studying a chart, you are essentially killing two birds with one stone -- that is, you're reading into the technicals and fundamentals at the same time.
GREEKS
What is gamma?
Gamma is the rate of change in delta for a $1 move in the underlying security. The delta is how much the value of the option increases or decreases for a $1 move in the underlying. An option's delta fluctuates between zero and 100 as the underlying moves. Since changes in delta are not random, gamma is really the value that is given to measure just how fast an option will gain or lose deltas. If you were to look at a curve of gamma on a series of options with deltas ranging from zero to 100 in a linear fashion, you would see that gamma is highest for at-the-money options and lowest for in-the-money and out-of-the money options. Since an option's delta can't be any lower than zero or higher than 100, both extremes represent zero gammas.
As far as the types of risks that are present in an options portfolio, gamma risk is important when considering the options strategy you will use. Generally, when placing certain delta-neutral? strategies such as at-the-money calendar spreads, gamma risk can be high (changes in delta are highest at-the-money and thus the least stable at that strike in the option chain). For these strategies, you normally want the deltas to remain as close to zero as possible. If the gamma is high on a calendar spread, a small move in the underlying could jeopardize the spread very quickly.
When buying long calls and puts, a conservative trader can reduce the gamma risk by buying more time (that is, by buying options that expire after 30 or 60 days). At-the-money gammas increase as the expiration of an option draws closer. When there is more time built into an option's premium, the rate at which its deltas change slows, effectively lowering the gamma risk.
BID/ASK SPREADS
Why do some options consistently have bid/ask spreads between five and 10 cents, while others never seem to be any less than 25 cents?
That all depends on the liquidity of the options, which is generally relative to the liquidity of the security. Stocks that trade tens of millions of shares each day are in high demand since there is a lot of institutional interest. As such, the options tend to be more liquid as well. This works by the basic, fundamental principle of supply versus demand. The more options that are traded on a stock, the tighter the spread. Even though one trader could put a large spread out there on the stock, most likely there will be thousands of others who are willing to take 20 cents, and still thousands more who will take 15 cents, and so on. This continues until you can't really take any less than the tightest spread, which is five cents. Any less, and the market makers hardly have any business to run or profits to make.
Return to March 2004 Contents
Originally published in the March 2004 issue of Technical
Analysis of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2004, Technical Analysis, Inc.