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 |
COLLAR QUESTIONS
I need help understanding collars. I know you sell the call to finance the put, and the put options act as insurance on your stock. But what happens if your stock takes off and you are assigned the call? Would you forfeit profits on the stock if it takes a run up? Is there a way around this?
As you stated, the collar is a position created with long stock, a short call, and a protective put. By "long stock," I mean holding shares. It could be a new purchase of stock or an existing position. The collar also includes a put, which will protect the stock from a move to the downside. A long stock, long put position is sometimes called a "protective put." One put option is purchased for every 100 shares of stock. However, the collar is different from the protective put because it includes a short call. Selling a call will bring in premium, which helps pay for the put. One call is sold for every 100 shares of stock. So the collar is a low-cost way of protecting a stock position.
But as you noted, the short call will limit the possible gains from the stock if the stock moves higher. Why? Because if the stock moves above the strike price of the call, the option will probably be exercised and the stock called away. If the stock is purchased for $51.50 and the short call has a strike of $55, the stock will probably be called away from the owner if the stock rises above $55 a share at or near expiration. Unless the call is bought before it is assigned, there is no way around this with a regular collar.
However, a variety of collar strategies can help. For example, selling out-of-the-money? (OTM) calls to pay for at-the-money? (ATM) puts will lessen the probability of the stock being called away. In the previous example, buying the 50 puts and selling the 60 calls will decrease the odds of having the stock called away. The trick is to find OTM calls that have high-enough premiums to pay for ATM puts. They are out there, usually with longer-term options.
CLOSING A CALL RATIO BACKSPREAD
I have a question about exiting the trade. Say I bought two contracts and sold one for credit or even. The stock price movement is then in my favor and close to expiration date. If I want to exit the trade, do I sell only one of the two contracts and let the sold contract expire? Or do I close the trade by selling what I bought and buying what I sold?
A call ratio backspread is a strategy used when the strategist expects a bullish move, but wants to limit losses in case the stock moves south. The trade is created by selling ATM or near-the-money calls and buying a greater number of OTM calls. The ratio is generally two calls bought for every one sold or three calls bought for every two sold. Ratios will also vary based on the trader's objectives and time frames. However, 1 x 2 and 2 x 3 are common ratios.
The trade delivers profits if the stock moves higher and the long calls appreciate in value. However, the short calls help pay for the cost of the long calls. In many cases, the premium from the short calls may be greater than the cost of the long calls. If so, the trade is created for a credit-that is, the strategist receives premium for establishing the trade. If the stock tanks, all of the calls expire worthless and the trader keeps the credit, which results in a profit.
However, greater profits are possible if the stock moves higher and the calls in the backspread gain value. At that point, the trader will exit the trade, which is done by reversing the position. Buying back what you sold and selling what you bought will close the trade. Selling only one of the two long call options changes the trade from a call ratio backspread (bullish) to a bear call spread (bearish). This can be done if the outlook for the stock has changed, but it does not close out the position. To exit the trade, the two long calls are sold and the one short call bought back.
VOLATILITY QUESTION
How do we know if an option is low or high volatility? If the volatility is low, what is the arbitrary number we should look for?
Each options contract will have a unique level of implied volatility [IV]. This level of volatility is really a measure of volatility that is priced into the options premium. It is computed using an options pricing formula like the Black-Scholes? model. However, most options traders today don't do the math or use the formula. Instead, IV information is available through data services and brokerage firms.
Basically, what IV reflects are expectations about the level of volatility of the stock, future, or index. It is sometimes called expected volatility. If, for instance, the implied volatility of XYZ options is high, it indicates the market, or the majority of investors, expects XYZ to exhibit high levels of volatility. In that case, implied volatility and the option premiums will be higher. However, if ZYX options have low implied volatility, it suggests that ZYX is expected to exhibit low volatility levels. When IV is low, option premiums are also lower.
So how do we know if implied volatility is high or low? Each individual stock, index, or futures contract must be considered separately. The implied volatility of options on the Dow Jones Utility Index ($DUX) will be lower than the IV on options on a biotechnology stock like IMCLone Systems (IMCL) because the former is less likely to exhibit volatility.
Options traders want to consider implied volatility of each individual contract and compare current levels to the past. To determine if IMCL options have high or low implied volatility, it makes sense to compare the current IV levels to those during the past three, six, or 12 months. Some data services allow investors to create implied volatility charts, which may be the easiest way to determine if the current level of implied volatility is high, low, or average.
Originally published in the September 2005 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2005, Technical Analysis, Inc.
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