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 |
STRADDLES
How do straddles make money? If the call moves up, doesn't the put lose just as much?
Straddles are a "delta-neutral" strategy. Since straddles are composed of both an at-the-money put and call, the deltas start at zero; hence the term. (Delta is the rate of change in the value of the option for each $1 move in the underlying stock.) If the stock were to move higher, the calls would appreciate and profit, while the puts would depreciate. This works the same way if the stock moves down, but vice versa. This is where the confusion sets in.
The profit on a straddle occurs in two ways. One is at expiration, and the second is anytime before then. The only way to profit at expiration is for the stock to move above or below the strike price of the straddle plus the entire debit of the trade. This part is not so difficult to understand. The second way is not so easy, and has to do with the phenomenon of deltas. Since there is both time value and real value at the onset of the trade, the deltas will increase or decrease slowly at first. As this happens, one option will begin to accelerate the rate of profit, while the other actually decelerates. Call deltas can't go lower than zero or higher than 100. If a call, for example, has a delta of 75, while the put's delta is -25 (puts can have negative deltas), then the net result is a 50-cent gain on the entire position as the stock move up $1. This profit curve accelerates as the stock moves higher, until it gains parity with the stock, dollar for dollar.
ASSIGNMENT
How do I know if I'm going to be assigned on an option that I've shorted -- in a spread, for example?
Generally, if there is less than 50 cents of time value on a short option, you have a greater chance of being assigned (long stock in the event of assignment on a short put, short stock in that of a short call). However, the more time remains before your option expires, the more the chances decrease, as most of the shorter-term options will be exercised first. Beyond this, it's sometimes basically a lottery as to whether you'll be assigned.
Realize that in order for you to be assigned, the person on the other side of your short position (the option buyer) is forfeiting all time value to exercise his option. For most people, that doesn't make sense. If, for example, you could sell an option that was 50 cents in-the-money for $1, why would you exercise the same option to be in a position that has less value by 50 cents? On 10 contracts alone, that's giving up $500!
In the case of a spread, assignment can be a good thing and is not to be feared. If, for example, you are in a bullish call spread in which you are long one strike call and short the higher strike, and you are assigned on the short strike, you would simply exercise the long position and take in a cash amount of the difference between the two strikes.
If thinking about the ramifications of assignment makes you dizzy, then consider placing spreads on options with European-style settlement. These options cannot be exercised until the day they expire, no matter how deep in-the-money the short position goes. In the US, many index options have European settlement, and that may be just the right instrument to give you peace of mind.
HISTORICAL VS. IMPLIED VOLATILITY
How does historical volatility relate to implied volatility, and is there a useful correlation between the two that can be used to make a profit?
Historical volatility is a measurement of the price action of the underlying security as it has occurred in the past. This is usually found through some sort of algorithmic formula that derives a percentage to indicate the potential future price volatility (annualized). There are actually several types of historical volatility, including beta, average true range, and statistical volatility. Statistical volatility is the most common for option traders, often measured against the security's implied volatility of the options to help assess the optimal strategy. If historical volatility measures a security's price action in the past, the implied volatility is the "market's" prediction of the security's price action going forward, and is reflected in the time value, or premium, of the option.
To make a comparison of the two volatilities useful, you would simply divide one by the other to derive a number greater or less than 1. For example, if you were to divide the historical volatility of the stock by the implied volatility of the option and arrive at a number greater than 1, then the option is selling at a discount to what the historical volatility suggests, and you would tend to look for debit strategies such as long calls and puts. Should the reverse be true, and the result is less than 1, then the options are selling at a premium, which indicates that the market believes the security will have greater volatility going forward than in the past.
This would result in inflated premiums, and a trader would look to implement a strategy involving the selling of options to take advantage of this. Typically, inflated premiums will "deflate" quickly as the security moves. Credit spreads, calendar spreads, and the like are all good strategies to consider when premiums are high.
Return to June 2004 Contents
Originally published in the June 2004 issue of Technical Analysis
of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2004, Technical Analysis, Inc.