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 |
DAYTRADING OPTIONS
What is the best strategy for short-term daytrading?
In my opinion, options are not for daytraders. For short-term traders, simple call and put buying is probably the most widely used strategy. Bullish traders buy calls. Bearish traders buy puts. I trade short term at times, and I find that in-the-money? (ITM) options work best because they have a better level of disaster protection, yet work like a stock due to their high delta?. I like options with higher deltas because they see greater price changes for each point of movement in the underlying stock or index. For example, an option with a delta of 0.75 will increase 75 cents for each point move in the stock. However, an option with a delta of 0.33 will increase by only 33 cents for every point move in the stock. As a final note, calls have positive deltas and puts have negative deltas. So, when trading puts, I look for higher negative deltas -- for example, -0.8 is better than -0.4.
ASSIGNMENT RISK
I haven't placed a call ratio backspread yet. If the trade is structured by selling in-the-money calls and purchasing out-of-the-money calls, what prevents in-the-money calls from being assigned right from the start?
The call ratio backspread is a strategy that involves selling at-the-money (Atm) or near-the-money calls and simultaneously buying a greater number of out-of-the-money (Otm) calls. The label ratio stems from the fact that an uneven number of calls are simultaneously purchased and sold to establish the spread. Common ratios include 1:2 and 2:3. For example, a trader might sell one Atm call and buy two Otm calls. In this case, the ratio is 0.5 (1/2 = 0.5). Most traders prefer to use ratios of 0.67 or less.
Unlike naked options selling, this strategy has limited risk because the short calls are covered by the long calls. The strategy will make money if the stock makes a large move higher. The long calls, which outnumber the short calls, begin making money faster than the short calls.
So, if the stock moves higher, what prevents the ITM calls from being
assigned? The simple answer is time value. When an option has time value
remaining, there is no legitimate reason to exercise that option. If it
was exercised, the option holder would lose the time value of the option.
Instead, the holder could sell the call and buy the stock in the market.
However, as expiration approaches and/or the option become deep-in-the-money,
then the risk of assignment begins to increase. As a rule of thumb, if
your option has less than one-quarter point of time value and you don't
want to face the risk of assignment, exit the backspread.
TRADING THE DOGS
You have mentioned the dogs of the Dow, but how or where can you find them and what are the rules for trading them?
The dogs of the Dow is a subset of the Dow Jones Industrial Average (DJIA). To be specific, they are the 10 stocks within the Dow 30 that have the highest dividend yields. Dividend yield is calculated as the stock's annual dividend divided by the stock price. Oftentimes, the stocks that make up the dogs of the Dow have been lagging the market, the share prices have fallen, and therefore the dividend yield is relatively high. For that reason, they are called the dogs of the Dow.
The philosophy behind the investment strategy is that those stocks that have been performing poorly and now have high yields are likely to outperform in the future. It is a contrarian bet. In addition, since these stocks are members of the mighty DJIA, they are leading companies in their industries today. If not, then why were they picked to be part of the Dow? So, investors using this approach will take bullish positions in the dogs of the Dow in anticipation that the group will move higher.
The list of the dogs of the Dow is updated annually. As of this writing,
the 2005 list is likely to include Merck (MRK), General Motors (GM), Altria
(MO), Sbc Communications (SBC), Verizon (VZ), Citigroup (C), JPMorgan Chase
(JPM) and a few others. The website DogsoftheDow.com provides the most
recent list and a detailed discussion of the strategy.
BOLLINGER BANDS
You have talked about Bollinger Bands, stocks coming back to their means, and using the bands as an indication of volatility. I see some stocks where the stock price never comes close to the upper band for more than a year. If the bands move with the mean price, how can this be? How do I read this situation? Thank you.
Bollinger Bands are what I call probability bands. That's what they really reflect: They give us the probability of a stock moving one way or another. Most of the time, the stock will bounce between the two bands. However, when it breaks outside of the band, we look for a reversal back into the bands. Most software allows you to adjust your settings for Bollinger Bands, which is extremely important to get good trading signals. The most common time frame is 14 or 21 days with two standard deviations. This will put 95% of the price data within the bands, or channeling. The probability of price breaking out of the bands is less than 5%.
Originally published in the February 2005 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2005, Technical Analysis, Inc.
Return to February 2005 Contents