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

BOX SPREAD

I know how to construct a box spread, but why does it work? Is there a way to tell which option(s) are under/overpriced?

The box spread is an arbitrage play that can sometimes be used to capture risk-free profits. The difficult part is finding situations ripe for the trade's application. It is actually a combination of a bull spread and a bear spread. The spreads can be either debits or credits. Consider the following situation: 

 XYZ = $47.5 a share
 September 45 call = $2.75
 September 50 call = $0.50
 September 50 put = $3.00
 September 45 put = $0.75
The strategist creates two debit spreads, a bull call and a bear put, with the following: 
  • Buy the Sept. 45 call and sell the Sept. 50   call for a debit of $2.25 (or $2.75 - 0.50)
    • 


  • Buy the Sept. 50 put and sell the Sept. 45    put for a debit of $2.25 (or $3.00 - 0.75)

    • The total cost of the spread is $4.50, which means it has locked in a profit of 50 cents at expiration. The profit is equal to the difference between the two strike prices and the cost of the trade, or $5.00 - $4.50 = 0.50. This works because, at expiration, one of three things will happen: 1) The stock is above the strike price of the Sept. 50 call option and the puts expire worthless but the bull call spread is worth $5; 2) The stock falls below 45 and both calls expire worthless, but the bear put spread can be closed for $5 a spread; 3) The stock stays above $45 and below $50. In that case, the short options expire worthless, but the strategist can exercise the right to buy (call) the stock at $45 and sell (put) it at $50, for a $5 gain.

    Finding situations where the box spread can be applied is not easy. For debit spreads, the strategist will want to answer the following question: Would the total cost be less than the difference between the two strike prices? If yes, then profit opportunities using the box spread might exist (but commissions and slippage will also be a factor).

    STRATEGIES FOR EARNINGS

    Earnings reports often seem to cause stocks to make big one-day moves. Is there a way to use options to profit from the move, even if you have no idea which way the stock is headed?

    Straddles and strangles can sometimes be used when the trader expects a big move in the stock price, but is unsure about direction. A straddle is the purchase of a put and call on the same stock with the same strike price and expiration date. A strangle is similar but includes two options with different strike prices. For example, if XYZ is trading for $47.50, I can create a straddle using the September 47.5 call and the September 47.5 put. A strangle could be created using the September 50 call and the September 45 put. Both trades will work if the XYZ makes an explosive move higher or lower and either the put or the call appreciate enough to cover the cost of the trade.

    While straddles and strangles can generate profits when the strategist expects a significant move in the underlying stock, it will not always work before or after a known event such as an earnings report. The stock doesn't always move as expected; for example, if the earnings report holds no major surprises, the stock might not move. In that case, neither the put nor the call will increase in value, and the cost of the trade (commissions and slippage) might result in a loss instead of a gain.

    In addition, the options market is efficient and option premiums will often rise ahead of an earnings report. The rise in option premiums is due to an increase in implied volatility (IV). Basically, IV will often rise as the market begins to anticipate the potential volatility related to the earnings report. This drives up the option premiums like a pump filling up a deflated soccer ball.

    However, once the report passes, IV can collapse and the premiums will deflate again. This phenomenon, known as a volatility crush, can cause the option contracts to lose value, even if the stock makes a significant move. Before buying options ahead of an earnings report or other event, check the IV history of the stock. If it is already high, the options are already priced for a big move and there is a risk of volatility crush after the earnings report has passed.

    OPTIONS PRICE VS STOCK PRICE

    How much will my option contract be worth if my stock moves $1.00 higher? Is there an easy way to see how this works?

    The change in the value of an option for changes in the value of a stock will be based on several factors including the strike price, the time left until the expiration, and the volatility of the stock. There is no standard rule or chart that can be applied to all options contracts.

    However, there is a measure that will give you an idea how changes in the stock price will affect the options contract. It is known as delta and measures the projected change in the value of the put or call based on one-point moves in the underlying asset. For example, if the XYZ 50 call has a delta of 0.60, it will increase in value by 60 cents for the next point move higher in XYZ. Put options have negative deltas. Thus, if the XYZ 45 put has a delta of -0.45, it will lose 45 cents in value for every point move higher in XYZ.

    Originally published in the September 2006 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved.
    © Copyright 2006, Technical Analysis, Inc.


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