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 |
ONE CALL, THAT'S ALL
I bought my first call option on a stock and the trade is working out nicely. The stock is up almost 10% since I bought the option. I know I can close the trade and make a profit, but is there any way to protect some of the profits if I think the stock might rally even more?
Sounds like a good situation to be in. If the stock has moved higher as you hoped and the call option has increased in value, there are adjustments you can make to lock in some or all of the profits. The best adjustment will depend on the situation, but one possible approach is to convert the straight call purchase into a bull call spread by selling a call option with a higher strike price. Here's how that would work.
Say XYZ is trading for $50 a share and I buy the XYZ December 55 call for $2.50 a contract. Now, suppose XYZ shares rally 10% to $55. In that case, the strategist has a profit of at least $2.50 a contract, which is equal to the current stock price ($55) minus the strike price (50) minus the cost of the trade $2.50. At that point, the strategist might choose to close out the trade for a 100% profit (or more if time value is remaining.)
However, if the strategist wants to lock in some profit and create a position in anticipation of further gains in XYZ, the call might be converted. In this case, the strategist might decide to sell the XYZ 57.50 call and establish a trade known as a bull call spread, which is long the XYZ 50 and short the XYZ 57.50 call. If the XYZ 57.50 call can be sold for $3 when XYZ is at $55 a share, the strategist then pockets a 50-cent profit from the total spread ($2.50 for buying the XYZ 50 call minus $3 for selling the XYZ 57.50 call).
If the stock then falls below $50 a share, the strategist does nothing, allowing both calls to expire worthless and keep the 50-cent net premium. This would be the new worst-case scenario for the adjusted trade.
On the other hand, the spread can continue to make money if XYZ moves higher. If XYZ rallies above $57.50 at expiration, the trade makes its maximum profit. At that point, the short call will be assigned at $57.50 and the strategist can exercise the long call for $50. XYZ is bought for $50 and sold for $57.50 for a $7.50-per-contract profit. Add 50 cents for selling the spread and the trade nets $8, or 220%. Of course, the spread can also be closed out at any time if the strategist wants to bank a profit and avoid assignment.
The key is that making adjustments can add flexibility to your options trading. The adjustments will often depend on expectations for the stock price as well as the strategist's risk tolerance. There is no right or wrong way to make adjustments in options trading. In this case, we adjusted a long call to a bull call spread, but there are other ways to change positions to lock in profits, limit losses, or take other steps to change the risk-reward in your favor. The key is remaining open to new ideas and also understanding that trades will not always work out as you might have planned.
TRADING THE S&P 500
I understand there are two ways to trade the mini-Standard & Poor's 500: the $XSP and the SPY. Both have similar prices. What are the differences?
The S&P 500 ($SPX) is one of the most actively traded index products. Both the options and the futures see a lot of action. Some smaller traders don't like trading options on the $SPX because the index has a high value (currently 1,300) and the premiums are expensive. One at-the-money option with only one month of life remaining will sometimes cost $2,000 or $3,000 a contract.
To make the SPX more affordable to smaller investors, the Chicago Board Options Exchange (CBOE) launched the mini?S&P 500 ($XSP) in November 2005. (This is not the same as the emini S&P 500 futures.) The XSP is equal to a tenth of the $SPX. If the S&P 500 is near 1,300, the mini index is equal to 130. The lower value also makes the option premiums much smaller.
The S&P Depositary Receipts (SPY) is another investment vehicle designed to equal a tenth of the S&P 500. However, the SPY ("spiders") is not an index, but rather an exchange-traded fund. This means that shares can be bought or sold, which is not possible with the $SPX and $XSP. In any event, with the S&P 500 near 1,300, spiders can be bought for approximately $130 a share. That it can be bought or sold makes it more interesting to some strategists because it is possible to make more adjustments to positions by using options and shares. It also means that, while options on the S&P 500 and the mini index settle for cash, SPY options settle for shares.
WHERE DO OPTIONS TRADE?
I read that the NASDAQ Stock Market would begin trading options. I thought options already traded on the NASDAQ.
Six different exchanges make markets in stock and stock index put and call options. The CBOE and the International Securities Exchange currently account for approximately two-thirds of the total volume. The American Stock Exchange and the NYSE (through its purchase of Archipelago) also offer option trading. The Philadelphia Stock Exchange is a leader in sector index option trading. Most recently, the Boston Options Exchange offers all electronic trading of puts and calls. When NASDAQ enters the fray in 2007, it will represent the seventh US options exchange.
Originally published in the November 2006 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved.
© Copyright 2006, Technical Analysis, Inc.
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