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 |
EXIT STRATEGY EXAMPLE
Would you explain the process of exit strategies? Thanks. -- Elom
The appropriate exit strategy will depend on your outlook for whatever you are trading. In most cases, it's best to have a stop-loss that will trigger your exit from the trade if it begins to move in the wrong direction. The stop-loss might be based on a technical level, a dollar amount, or a percentage. For example, you might set a stop around an important technical support area in the market. Or, you might stop out of the trade if it moves 5% in the wrong direction.
We also recommend setting an exit strategy based on a profit objective. For example, if you set up a straddle or a bullish spread using options, you might exit part or all of the trade when you have achieved a 25% or 50% profit. Most important, when you develop an exit strategy, whatever it is, stick to it. This sometimes means cutting a loss even if it's painful in the short term.
My approach to exit strategies is more technical than mechanical. My #1 rule is to get out of a trade when the market tells me to. In other words, if the market moves against me and triggers my technical stop-loss, I will exit the trade and get rid of the position. I don't second-guess myself; I have no trouble getting out if this happens.
Recently, I had an experience with Merck (MRK) that provides a good case study. I took a bullish trade in Merck based on one of the systems that I teach. The stock triggered a long position, and I put a stop-loss in at 32.50. Well, on October 6 the stock broke below 32.50 on news that one of the company's important products would be recalled. My options position was exited at a loss. A short while later, the stock fell to below 30, which is 2.50 below where I stopped out. So I was happy that I had taken the loss and moved on to other trades.
DELTA OF THE DELTA
I'm learning option trading and have a question that you may be able to answer. I know that gamma will show how much your delta will change. My question is: Is the gamma showing the percentage of the move or the actual amount of the move based on the underlying moving up one point? For instance, if your delta is 0.70 and your gamma is 0.16, does this mean the delta will change by 16% or 16 cents if the underlying moves up one dollar? Thank you. -- Steve
Gamma is sometimes called the delta of the delta. Basically, it projects how much your delta should move versus a price move in the underlying asset. As you state, gamma can be expressed as a percentage. However, the increase or decrease in gamma applies to the delta. For example, let's assume you have a call option that has a delta of 0.50 and a gamma of 0.05. The underlying asset moves up one point. The position increases in value by 50 cents and the delta increases by 5% of the stock move. In this case, it increases by 0.05 to 0.55.
STEPPING IN TO CALENDAR SPREADS
I have been doing call and put spreads and I am now interested in doing calendar spreads ... but I am unsure what happens when you buy a long-term put and want to sell a short-term put, but there are no options available for the month you want to sell the short-term put. Thanks. -- Jeanette
A calendar spread, like any trade, requires a system to find profitable trades. In this type of trade, we are buying a longer-term and selling a short-term option. This trade can generate profits from time decay and also appreciation in the longer-term option. Thus, it is sometimes called a horizontal or time spread.
The first thing I look for in a calendar spread is a stock that has a sideways or gyrating chart pattern. These are generally stocks that are moving within a trading range, because if we pick a stock that makes a volatile move, the calendar spread will not make money. So the fact that we want a gyrating or quiet stock makes the calendar spread very different from the more widely used vertical (bull call or bear put) spreads.
Second, volatility skews can help increase the odds of success with a calendar spread. A skew occurs when the premium of the short-term option is much higher than that of the longer-term option. This often occurs ahead of important events like earnings announcements, FDA news, or other pending news. Trading skews is popular because it can work most of the time. However, occasionally the stock makes a dramatic move due to a pending news announcement. I like big skews, but tend to stay away from any that are bigger than 40%. If they are that big, there is probably some significant news pending on the stock that could make it break out one way or another -- which will result in a loss for the calendar spread.
The third thing to consider is volatility. My calendar spreads focus on stocks with below-average volatility. For example, I will look for stocks in the bottom average of the one-year volatility chart.
As far as expiration months go, you are correct: options are not always available for the months you want. However, if you choose an actively traded contract that includes long-term equity anticipation securities (LEAPS), you will find the contracts with the most months of expiration. Keep in mind that new expiration months are continually being added to any options contract. Thus, there are always short-term options (one to two months) to sell when the short option in your calendar spread expires.
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Originally published in the December 2004 issue of Technical Analysis
of STOCKS & COMMODITIES magazine.
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