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 |
WHAT WENT WRONG?
I am wondering if someone can please explain what happened during this paper trade: Sell two Yhoo January 2006 35 calls at 3.8 and buy two Yhoo January 2006 27.5 calls at 6.8. The maximum risk equals $300, maximum reward is $450, and the breakeven equals 30.5. I closed out both sides of the trade when the stock was above 35. My gain was only around $200 total. Since my maximum reward was $450 and I had a quantity of two, shouldn't it have been around $900, considering the stock price was above the short call?
The trade you outlined is a bull call spread. In this trade, you are buying a call with a lower strike price and selling a call with a higher strike price. So in your example, the cost of the trade is $300 per spread, or 6.8 - 3.8 = 3 * 100. As you noted, the cost of the trade is also the maximum risk and the most you stand to lose in a bull call spread. The breakeven price is equal to the lower strike price plus the debit, or 30.50 (27.50 + 3.0). The potential reward is computed as the difference between the two strike prices minus the cost of the trade, or 35 - 27.5 - 3 = 4.5. So, you are correct that the maximum possible reward equals $450 per spread or, using your example, $900 for two spreads.
You are also correct that the maximum reward occurs if the stock price
climbs above $35 a share, but there is an important reason why you didn't
reap the maximum reward when you closed the position: The options still
had time value. The maximum reward will occur if the stock price is above
the higher strike price at expiration when the options have no time value
remaining. As long as there is time value remaining in the option, the
spread will not widen far enough for you to close the trade and reap the
maximum profit from the bull call spread. In addition, since you were using
January 2006 options, these options have a considerable amount of time
value remaining.
TWO BASIC OPTIONS QUESTIONS
I recently graduated from college and took a class on options. I want to apply my knowledge in the "real world," but have no idea how to start. Maybe someone can answer a few questions for me: 1) If there is an option I want to buy, how do I know there is someone who will sell it to me? 2) How hard is it to exercise an option... how does it work when you buy a put from a broker and then decide you want to exercise it?
First, if the option contract has bids and offers, you will be able to buy and sell the contract. If you want to buy an option, and there is no natural seller -- that is, someone in the market looking to place the opposite trade -- the market maker will take the other side of the trade. So you never have to find someone to take the other side of your position. That is the market maker's job.
Second, exercising an option is easy to do. The option holder simply
instructs the broker to exercise the put or call. It is important to note,
however, that exercise is not the only way to exit an options position.
In many cases, the option holder will close the position through an offsetting
transaction, which means selling a contract with the same terms. For example,
if the option holder owns three XYZ 50 puts and wants to close the trade,
he or she can sell three XYZ 50 puts.
MEASURING VOLATILITY
What are the best ways to measure the volatility of the underlying to determine whether volatility is at a high, low, or mean to the historical? Are there specific indicators that can be used to chart volatility based on end-of-day data and shown along with regular indicators?
One of the best ways to measure volatility is to look at each specific stock and the implied volatility (IV) of its options contract. For example, in order to determine if IV is high or low, I look at the 12-month IV graph. Understanding where the current implied volatility is in relationship to its past highs and lows also tells me what type of option strategy to use. If IV is high, the options are expensive and I am more inclined to be a seller -- maybe look at credit spreads. However, if IV is low, the options are cheap and I'm more likely to be a buyer, which might involve trades like long straddles or strangles, depending on my outlook for the stock.
Another way you can look at volatility is to compare statistical volatility (SV), which I sometimes call "stock volatility," to the IV. Statistical volatility is computed using past prices. Implied volatility is computed using options prices. So while SV is like a rearview-mirror look at a stock's volatility, IV is forward-looking.
Now, if SV is significantly higher or lower than IV (or vice versa), this could provide a trading opportunity. One or both are likely to change, because volatility reverts to the mean (it tends to return to its average). As an example, if the implied volatility of a stock is much higher than the statistical volatility, that probably won't last. One of two things is likely to happen: 1) statistical volatility will jump higher -- that is, the stock will make a big move -- or 2) the IV will begin to fall.
Optionetics.com offers a free ranker that allows traders to rank options
based on implied volatility. If you use the ranker, you can find the highest
and lowest IV stocks based on the previous day's data. Our premium site
provides rankings, historical implied volatility information, and the ability
to create volatility charts.
Originally published in the January 2005 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2004, Technical Analysis, Inc.
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