Q&A
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 |
TRADING OIL
Is there a way to trade oil without trading the commodity itself?
I have heard of using stocks like ExxonMobil, but are there any indexes
that track oil?
Shares of energy-related companies will move higher and lower along
with the price of crude oil most of the time. Stocks and oil move together
because rising crude oil prices will boost the profits of energy-related
companies. As a result, investors are willing to pay higher prices for
the shares of these companies when crude oil prices are high. The relationship
is not perfect, of course, but trading stocks like ExxonMobil or Halliburton
is one way to play oil.
Some indexes track groups of stocks in the sector. For example, the
AMEX Oil Index ($XOI) is an index of major oil companies. XOI includes
the big companies like Exxon, Chevron Texaco, and ConocoPhillips. The PHLX
Oil Service Index ($OSX) is an index that includes a group of oil drillers
including Baker Hughes, Schlumberger, and Diamond Offshore. Both the XOI
and the OSX have listed options and can be used to profit from moves in
energy.
Exchange-traded funds (ETFs) are another vehicle for playing trends
in the oil industry and are arguably the best for a few reasons. Like indexes,
ETFs hold groups or baskets of stocks; therefore, they can offer exposure
to an entire sector and not just one industry. In addition, shares of exchange-traded
funds can be bought and sold like shares of stocks, which is not possible
with indexes. So ETFs open the door to more strategies that include both
shares and options. Finally, from a liquidity standpoint, exchange-traded
funds are often superior, with higher trading volume and narrower spreads.
This is not always true for sector indexes, which lack volume and so suffer
from wide spreads between the bids and offers.
In the energy sector, two exchange-traded funds you may want to consider
are the Select Sector Energy Fund (XLE), which holds all of the energy-related
companies from the Standard & Poor's 500, and the Oil Service HOLDRS,
which is an ETF that holds the shares of oil drilling companies. Shares
and options of both are actively traded and are among the best tools for
stock and options traders to participate in the next move in energy.
OPTIONS ON THE VIX
Now that options have started trading on the VIX, how can I use them
to hedge against a market crash?
The CBOE Volatility Index ($VIX) is a measure of market volatility that
is derived from S&P 500 ($SPX) options. It is computed using a formula
and updated throughout the trading day. At the same time, VIX reflects
expectations about future market volatility. Basically, SPX options become
more expensive when investors become nervous and start hedging their portfolios.
The increase in demand for portfolio protection causes volatility expectations
and the VIX to rise. For that reason, the index is often called the market's
"fear gauge." It rises when investors become anxious and spikes to extremes
during market crashes.
The Chicago Board Options Exchange (CBOE) started trading options on
the volatility index on February 24 of this year. The contract has been
well received and already sees steady trading activity. In a very short
time, it has become a viable tool for placing trades based on our outlook
for market volatility. The options trade under the same symbol (VIX) and
have unique features that should be considered before trading. We have
several articles on our website, www.optionetics.com, devoted to the new
contract. The complete product specifications can be found at www.cboe.com.
There are several ways to use the tool. For example, if an investor
is concerned about a market crash, he or she might buy VIX call options
or establish other bullish trades. The position will increase in value
if the volatility index moves higher, which occurs during significant market
declines. If the VIX spikes higher and the strategist expects volatility
to ease going forward, he or she might buy VIX puts or establish bearish
trades on the index. Finally, if the expectation is that volatility will
remain tame, credit or income strategies like butterflies or credit spreads
might make sense.
CLOSING A CALL OPTION
I have some confusion about call options. Say I buy a contract for
$200 at $2 a contract. Suppose the strike price is $40. If I decide to
buy that stock, do I have to come up with the $4,000 to buy it, or am I
able to just sell the option?
You can sell the option at any time to close out the position. If the
position is closed, there is nothing left to do. However, if you decide
to exercise your call option, you can call or buy the stock for the strike
price of $40 a share. Each call option gives the owner the right to buy
100 shares at the strike price. So in this case, you will have to pay the
$40 a share, or $4,000 for every call contract exercised.
Originally published in the May 2006 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved.
© Copyright 2006, Technical Analysis, Inc.
Return to May 2006 Contents
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