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 |
BUYING VS. SELLING
What's the difference between buying an option and selling one?
Buyers of options have rights, and sellers have obligations. The buyer of a call has the right to buy the underlying security at an agreed-upon price (the strike price). The seller of the very same call has the obligation to the buyer to deliver shares of the underlying security if the buyer decides to exercise his rights.
The same is true of puts, but in reverse. The buyer of a put has the right to sell a stock at an agreed price (called the strike price). The seller of that put has the obligation to purchase the shares, or have them “put” to him, in the event that the purchaser exercises his or her rights.
EUROPEAN-STYLE INDEX OPTIONS
How can I effectively trade European-style index options? I am interested in the BKX (bank sector index). After doing some research, I'm hard pressed to see how an individual can trade the BKX options, for a couple of reasons. First, I found that the bid/ask spreads are huge, often $1.50 or more. Thus, any chance at a profitable gain on a long position would require an enormous move in the underlying.
Second, as expiration approaches, if the underlying is close to my strike price and I want to avoid assignment, I can't merely wait and hope for the option to expire worthless. Overnight action Thursday night could result in a big change in the underlying at Friday's open on expiration day, and I'd have no chance to cover a position. I'd appreciate any insight on strategies that might apply to these options. -- Bill (bstrayer)
Like many of the sector indexes, the PHLX Bank Sector Index ($BKX) has never developed an active following among options traders. As a result, the options lack a certain amount of liquidity and, consequently, there are often wide spreads between the bids and offers. In short, lack of volume equals wide spreads.
However, in an effort to make the BKX more appealing to investors, the Philadelphia Stock Exchange (PHLX) recently modified its index. On March 22, 2004, the exchange instituted a 10:1 split on the banking index and, instead of trading near the 1000 level, the BKX dropped by a factor of 10 to approximately 100. The modification provides a larger number of strike prices and smaller options premiums, and therefore makes the index more appealing to a broader range of investors. As a result, trading volumes have improved somewhat and the spreads are beginning to narrow. If this trend continues, the BKX may become a more viable trading vehicle.
So, in response to your first question, traders will want to focus on the most liquid contracts when trading European-style indexes. Examples include the Standard & Poor's 500 index ($SPX), the Dow Jones Industrial Index ($DJX), the mini-Nasdaq 100 Index ($MNX), and the S&P 100 Euro-style Index ($XEO). When looking for sector plays, traders might also consider the PHLX Semiconductor Index ($SOX), the PHLX Gold and Silver Mining Index ($XAU), or some exchange-traded funds like the Nasdaq 100 QQQ (QQQ), the Semiconductor HOLDRs (SMH), or the Select Sector SPDRs. However, SOX, XAU, and all exchange-traded fund contracts settle American style. In my mind, it is more important to look for liquidity in the options contract than to worry about whether the options settle American or European style.
To answer the second part of your question, if you want to avoid assignment on BKX options on expiration Friday, the only way to do it with 100% certainty is to close the position on Thursday. As you note, if bank stocks make a large move higher or lower at the open Friday, your at-the-money options may become in-the-money and you could face assignment. You will have no chance to cover the position because, although the settlement value is based on Friday's opening prices, the last day to trade BKX options is on the Thursday before the third Friday of the expiration month.
HISTORICAL VOLATITLITY
I understand that to decide which option strategy to use, I need to compare the implied volatility with the historical volatility of an option. How do I view historical volatility? Is it simply a moving average of the implied? Or is it calculated from the stock movement? Or is it something else? Do you know of any websites that chart historical volatility so that I can see how the current implied compares? Thanks for your help. -- Logan
Historical volatility is a measure of volatility associated with past prices. In a nutshell, when stocks, futures, or indexes have been trading erratically and with large price changes from one day to the next, they will have high historical volatility. On the other hand, when they trade quietly and within a trading range, they will have low historical volatility. It is important to note, however, this reflects only the action in the past -- not necessarily what will happen in the future.
Most often, the term historical volatility refers to statistical volatility (SV), which is expressed as a percentage. Mathematically, SV is computed as the annualized standard deviation of closing prices over a period of time (10, 20, 30 days, and so on). Various online software will allow you to create historical volatility charts. Some software will also allow you to create charts that compare SV to implied volatility, which can be an important step in some strategies.
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Originally published in the July 2004 issue of Technical Analysis
of STOCKS & COMMODITIES magazine.
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