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.
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