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 |
TIME TO GO?
Tom, I've heard you saying, "When volatility is high, it's time to buy, but when it's low, it's time to go." I think it was in the context that volatility is increasing when stocks are falling and that's a good time to buy. Conversely, when volatility is low, it may be time to take profits and avoid a correction. Do I have this right? Thanks. -- Rock
The sayings "VIX is high, it's time to buy" or "VIX is low, it's time to go" are often used with reference to the CBOE Volatility Index ($Vix). The index tracks the expected volatility of the Standard & Poor's 500 Index ($SPX), which is updated in real time using the prices of SPX options. In addition, VIX is often used as a contrary sentiment indicator.
When VIX is high, investors are driving up the prices of SPX options, which is a sign that they expect increasing levels of market volatility going forward. Therefore, VIX will rise to high levels during market panics or crashes. Historically, these times are also the best times to buy stocks because investors overreact and drive down stock prices too far. So when VIX is high, it's time to buy.
On the other hand, when VIX is low, investors may be showing too much complacency or bullishness. Most market tops occur when sentiment has become too one-sided and too much optimism is priced into the stock market. So when VIX is low, it's time to go, or move out of the market.
Recently, however, market volatility has been falling. Some people think that the rise in the number of hedge funds that use volatility strategies is why the overall levels of volatility drop. Regardless of the reason, volatility has been falling and VIX is moving into a lower trading range. It set a series of new multiyear lows in 2004 and the market has been heading higher nonetheless. So until a new range is established, if VIX is low, it might not necessarily be time to go.
ANOTHER ASSIGNMENT QUESTION
If, for example, I hold a calendar spread with a short January 2005 50 call and long January 2006 50 call, what can I do if I am worried about assignment near expiration? For example, say the stock is near $60.00 and the option is in-the-money by $10.00. What are you going to do when you're approaching expiration day of January 2005? Let's say today is Monday and Friday is expiration day; are you going to buy the short option back on Monday, or are you going to wait for few days, until Thursday or Friday?
The risk of assignment becomes a real possibility when the option is deep-in-the-money and is close to expiration. In your example, the January 2005 50 contract is both in-the-money and near expiration when the stock is at $60.00 a share during the third week of January. As a rule of thumb, anytime that the time value of an option drops to less than a quarter point, the strategist should be prepared for the possibility of assignment. It doesn't matter if there are one, two, five, or 10 days remaining until expiration. Simply put (no pun intended), early assignment of the short option is quite high when the time value of the option falls toward zero. It becomes very high during the few days prior to expiration.
So if you are in a position and you might get assigned on a short contract, and you don't want to face assignment, then some sort of follow-up action is in order. In the calendar spread, the next move might be to close out the position completely. Or the short option can be bought back and then another option can be sold to continue to reduce the cost of the spread.
STOCK SPLIT EFFECT ON OPTIONS
This may seem like a very foolish question, but I am a bit unsure on the topic. What is the effect of stock splits on options? Based on brief reading here and there, it seems that there are positive effects on the underlying shares, which positively affects the option. But, to be honest, I don't see why. Help?
A stock split is nothing more than an adjustment to the company's shares. It adds no real value and is cosmetic in nature. For example, if I own a company and it has 500,000 shares outstanding and each share trades for $100.00, I might decide to split the shares two for one and bring the price down. Bringing the price down might bring more buyers because the stock seems more affordable at $50.00 rather than $100.00.
The market value before the split is $50 million (or 500,000 shares times $100.00 a share). The market value of the company remains $50 million after the stock split. However, rather than having 500,000 shares outstanding, the company has one million shares trading for $50.00 a piece.
The options contracts are also adjusted following a stock split. In most cases, the strike price is adjusted down, but the option owner holds a greater number of contracts. In the previous example, a holder of 10 at-the-money options (or options with a strike price of 100) will become the owner of 20 contracts with a strike price of 50. The adjustments to the options contract following a split can be found in the informational memos at the Options Clearing Corp. (OCC) website, www.optionsclearing.com.
Why do some traders like stock splits if there is no meaningful change to the market value of the company, the shares, or the options contracts? While the reasons vary, many investors and traders believe that stock splits signal favorable trends for the company. For one, the stock price has been trading higher and is climbing in price, so it is in a bullish trend. In addition, management must be confident that the stock price will continue to move higher. After all, management would not split shares of a company when they expect the stock price to decline. Therefore, although stock splits are merely cosmetic in nature, some investors view the split as a positive corporate event that signals good things for the company going forward.
Originally published in the March 2005 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2005, Technical Analysis, Inc.
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