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 |
SEASONALITY
I know seasonality is an important factor in the commodities markets. Is there any way to play seasonality in the stock market? Can you give an example?
Important seasonal patterns exist, not just in the commodities market, but in the stock market as well. One seasonal trend that you might have seen in the commodities market is natural gas. Prices move higher before the winter because colder weather creates an increase in demand for the commodity. As temperatures drop, consumers need more heat and also more natural gas.
In the stock market, there are seasonal patterns related to the weather and other events. For example, stock of natural gas companies like Williams Cos. (WMB) reacts to changes in natural gas prices. So there is sometimes a seasonal pattern in Wmb and other commodity-related stocks, which is tied to the price moves of the commodity.
Another example of seasonality in the stock market has nothing to do with the time of year, weather, or commodity prices. The Presidential cycle is a four-year cycle we have researched back to 1944. It is very accurate! The first two years of a four-year term are weaker and the last two have been stronger. This has been true for every time, except when a President has a second term. In that case, the reverse has happened, with the first two years of the second term stronger than the last two.
However, since 1944, the pattern of the last two years of a Presidential cycle has always been positive. In addition, our work shows that the best time to get long the stock market is in the last 15 months of the second term or, in this case, from October 1, 2007, to December 31, 2008.
HEDGING WITH INDEX PUTS
I recently decided to liquidate my mutual fund holdings and do my own stockpicking. My portfolio is substantial and well diversified. I have also considered minimizing my downside risk with puts on the Standard & Poor's 500. From what I understand, I should focus on longer-term options, but I am not sure why or what strike prices to choose.
The S&P 500 tracks the largest US companies. Options are active and make a good choice for hedging a diversified portfolio of stock holdings. The options are quoted in dollars, but to buy a put or a call, the investor pays the current market price multiplied by 100. For example, if the put option is quoted for $30 a contract, it actually costs $3,000 to buy one ($30 x 100). In addition, if the S&P is trading near 1,450, then it represents the equivalent of a $145,000 portfolio (or 1,450 x 100). Ten puts could cover a $1.45 million stock portfolio, and so on.
The best strike price will depend on the amount of protection the investor is seeking. For example, a put option with a strike price of 1,200 can be purchased for a few dollars. However, the protection from that put won't really kick in until the S&P 500 falls toward that strike price: from 1,450 to 1,200, or 17%. That might be more loss than an investor can stomach. A put with a higher strike price, like 1,350, will offer a lot more protection, but that put will also cost more. In addition, the greater cost will lower the return of the portfolio if the market moves higher and the put loses value.
So there is an important tradeoff to consider when looking at strike prices. Without knowing your risk tolerance and longer-term outlook, there is no way to know the best strike price for your situation. Nevertheless, the first question to ask is, do you want "disaster insurance" or are you willing to pay a higher premium to try to fully protect the portfolio?
The second important question concerns the expiration month. How long do you want the protection? Do you want to buy short-term options and continually roll them forward as they expire? Probably not. Time decay will eat away at your put option because contracts with less time to maturity will lose time value faster than those with more time left until expiration. Consequently, if you are looking for portfolio protection during the next three months, it is better to buy the puts that expire in four or five months rather than in three months. The premium will be higher, but time decay will be less of a factor.
SPREAD CONFUSION
When you open a spread trade, could the sold leg be exercised, or do I own both sides of the contract and they are not "separable"? For example, I have considered a bull call spread where I buy the XYZ May 60 call and sell the XYZ May 55 call. Will I be exercised if the underlying fell below $55?
Let's clear up a little confusion. If you buy a call and sell a call as part of a spread, you can exercise the long contract any time you want. However, you might be assigned on the short side of the spread if the call is approaching expiration and there is little time value remaining. However, if the stock is below both strike prices, these options are out-of-the-money and there would be no reason to expect assignment. In addition, if you buy a call and sell a call with a lower strike, you have entered a bear call spread and not a bull call spread.
The bear call spread is established for a credit and will make money if the stock price falls. In this case, if the stock closes below $55 a share at expiration, both calls expire worthless and you keep the credit.
Originally published in the February 2008 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2008, Technical Analysis, Inc.
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