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 |
IMPACT OF DIVIDENDS ON BEAR CALL SPREAD
If I place a bear call spread and the company announces a dividend payment to be paid within the time frame of my trade, how will this affect my trade?
A dividend can affect the bear call spread or any other position that has a short call option. The bear call spread consists of a long call and a short call where the long call will have a higher strike price than the short. If the short call is in-the-money (the stock price is greater than the strike price of the option) on the day before the ex-dividend date, it might be assigned. If so, it leaves the strategist with a short stock position on the ex-dividend date, which the strategist is responsible for. So the dividend can result in early assignment of the short call, which will obviously change the position. It is a very good idea to know if the short call is at risk of assignment due to the dividend. In many cases, it is better to close out the position rather than face assignment.
VOLATILITY PLAY IN ENERGY SECTOR
I have recently started trading options, but have been trading energy stocks relatively successfully for a couple years. I have noticed that the weekly oil reports and, to a lesser extent, the natural gas reports often cause immediate, rapid movements in energy stocks. This made me think of a quick, in-and-out way to make money, and I wanted to run it by a strategist. The strategy involves entering the market with a straddle on a volatile energy stock before the Energy Information Association [EIA] report comes out at 10:30 am ET. Would this work?
The options market is very efficient when it comes to forthcoming events and the possibility of future volatility in a stock or market. For instance, a stock will often see an increase in option premiums prior to an earnings report. The increase in premiums is due to the component that reflects expectations about future volatility, or what options traders call implied volatility (IV). IV tends to rise ahead of important events and when traders expect volatility to increase going forward. IV will often fall when that event has passed.
Recent price action in crude oil has led to high volatility in the energy sector during the last few years. As a result, the option premiums of many energy stocks are high and, since the straddle involves the purchase of both a put and a call, this makes it a more challenging strategy for short-term moves. The high premiums make the trade more expensive and require a much larger move in the underlying stock in order to achieve profits.
Let's consider a recent example to illustrate. Halliburton (HAL) shares tumbled following the release of the October 5, 2005, EIA weekly statistics. Spot crude oil prices fell $1.11 to $62.79 on that day and, as expected, oil service stocks followed the price of crude lower. Hal dropped from $65.93 to $62.24, or 5.6%. Now, suppose the strategist had purchased an October 65 straddle the day before. The cost of one straddle would be $2.45 for the call and $1.40 for the put, or $385.00 total [($2.45 + $1.40) x 100]. The following day, after Halliburton shares plunged nearly 6%, the call was bid for $0.75 and the put for $3.30. Therefore, the trade could be closed out for $405.00 [($0.75 + $3.30) x 100]. Since the straddle was purchased for $385.00 and sold for $405.00, the result is a modest profit of $20.00 per straddle. That's not bad for a one-day trade, but keep in mind, commissions will also eat away at this small profit.
So, although the strategist was correct about the EIA report triggering volatility, and Hal did indeed make a large move, the profit from the straddle did not amount to much. There are two primary reasons for this. First, the calls cost more than the puts and therefore the trade had an upward bias. If HAL had rallied 5.6%, the results would have been much better, but the strike price of 65 was the closest to the underlying stock price at the time. The stock price is not always going to be equal to the strike price of the straddle. When it is not, the position will have a bias one way or the other. The second reason for the straddle's mediocre profit is because the IV in the options contract is relatively high due to the volatility in Halliburton and the oil service sector. Therefore, this very short-term trade was expensive to put on and required a very large move. Although the large move did happen, the profit was small. So, although energy stocks will move higher or lower following the EIA reports, it takes a very significant move in the stock price in order to generate profits from a short-term straddle in the sector right now.
VOLATILITY AND DEBIT SPREADS
Does volatility matter at all if we do a debit spread trade where we buy and sell options at the same time? It appears that we eliminate the effect of volatility!
Yes, you're right. In a debit spread, like a bull call spread, the strategist buys one option contract and sells another on the same underlying stock in the same expiration month. The only difference is between the strike prices of the option that is purchased and the option that is sold. Nevertheless, since the strategist buys one contract and sells another, they are essentially hedging low or high volatility. Using the spread, volatility basically negates itself.
Originally published in the March 2006 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved.
© Copyright 2006, Technical Analysis, Inc.
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