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 |
DIVIDENDS AND OPTIONS PRICES
How does a company's dividend affect the option price? - Newman
The dividend can be an important influence on a stock option's price. Obviously, if the company pays no dividend, it makes no difference. However, all else being equal, a dividend will lower the value of a call option and make a put option more expensive. Why? Because after the dividend is paid, the share price will fall to reflect the dividend payment. Further, the fact that the stock falls after the dividend is paid makes calls less valuable and puts more expensive.
Not all dividends will affect option prices the same way. The larger the dividend, the greater the impact on current options prices. Small dividends will make relatively little difference to options prices. In addition, the effect of dividend payments will be greater on short-term options than long-term options. The dividend effect on the option premiums will be more noticeable with options that are closer to expiration when compared to longer-term options and long-term equity anticipation securities (LEAPS).
INDEX OPTIONS AND LIQUIDITY
I started trading [Standard & Poor's 100] OEX options last December and quickly found out that for me, the best way to trade these was using the swings in the OEX. It seems that it is better to pick options with high open interest, which are generally out-of-the-money and have smaller spreads, making it easier to get filled and apply trailing stops. - iamamillionaire
At-the-money and out-of-the-money options that have the highest open interest will often have the smaller spreads. As you point out, this makes getting good fills and applying stops easier. Basically, these options tend to be more liquid than options with little or no open interest. So, to answer part of your question, yes, it makes sense to focus on contracts with high open interest.
However, the S&P 100 index, or OEX, is an inferior index when compared to many other index options today. This includes cash indexes and exchange-traded funds. To understand why, it is important to understand the history of index options trading. The S&P 100 index was the first index to have options linked to its performance. The Chicago Board Options Exchange (CBOE) started trading OEX options in 1983. Prior to that, only stock options traded in the US. Furthermore, since the OEX was the first tradable index options contract, it quickly became popular. Not only did speculators buy puts and calls to place bets on the market, but portfolio managers used the fund to hedge portfolios of stocks. The index's relative popularity continued throughout the 1980s and into the mid-1990s.
Over time, competing index options have emerged on the financial scene, and trading volumes have gravitated away from the OEX. For example, options have become available on a host of other cash indexes. Today, traders can trade puts and calls on the S&P 500 index ($SPX), the Dow Jones Industrial index ($DJX), and the mini-NASDAQ 100 index ($MNX).
In addition, the OEX is one of the few index options that settles options American-style, which means that exercise and assignment can occur at any time prior to expiration. Some index traders view this American-style exercise settlement feature as a disadvantage because it adds an early-assignment risk to option selling. However, many other cash index products settle European-style, which removes the risk of early exercise and assignment. In response to the interest in European-style index options, the CBOE launched the European-style S&P 100 index ($XEO). The XEO is almost identical to the OEX (with an inverted ticker symbol), but these options settle European-style.
Many traders today also prefer exchange-traded funds. Since the inception of the Nasdaq 100 QQQ (QQQ) options in the late 1990s, these funds have become enormously popular. In fact, options on the QQQ, which is a fund that holds the top 100 Nasdaq stocks, are among the most actively traded contracts today. Other exchange-traded funds, including the Dow Jones DIAmonds Trust Series (DIA), the Fidelity Nasdaq Composite Fund (ONEQ), and the S&P 100 Fund (OEF), are also attracting interest from index traders. These funds can be bought and sold like stocks, but represent specific indexes.
In sum, while the OEX was the first index product, it is no longer the most popular. For a variety of reasons, trading volumes have shifted to other index products. So if high open interest and liquidity are important considerations, you may want to look outside of the OEX options altogether. The SPX, DJX, DIA, and OEF are viable alternatives. Traders interested in Nasdaq stocks may want to look at the mini-Nasdaq 100 Index, the Nasdaq 100 QQQ, or the Fidelity Nasdaq Composite Fund.
- See Editorial Resource Index
Return to August 2004 Contents
Originally published in the August 2004 issue of Technical Analysis
of STOCKS & COMMODITIES magazine.
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Inc.