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 |
FIGHTING INFLATION
Commodity prices are surging. With the Federal Reserve lowering rates aggressively, I am now more worried than ever about the risk of inflation. Is there a way to trade inflation directly, like an inflation index?
Interesting question. I don't know of any index that has been created to trade inflation directly. Indirectly, gold has historically served as a good hedge against the risk of inflation. During times of inflation, gold prices tend to rise, and during periods of falling prices or deflation, gold prices tend to fall.
If you don't have a futures account, another option is to trade the Street Tracks Gold Fund (GLD), which is an exchange traded fund that holds the yellow metal. No options are listed on the GLD, but could be listed in the near future. Alternatively, you can take bullish positions in gold mining companies or on the PHLX Gold and Silver Mining Index ($XAU), which is an index that tracks the performance of 12 gold mining stocks. Newmont Mining (NEM) and Barrick Gold (ABX) are examples of individual gold mining stocks with actively traded options contracts. Shares of the major mining companies and the XAU tend to track the long-term moves in gold, though the correlation isn't perfect. Nevertheless, if you really fear skyrocketing inflation, some bullish plays on the gold sector might make some sense.
MAKING SENSE OF MARGIN
I primarily trade stocks, but I have been watching the option market and have some interest in buying puts during market downturns. However, I am unclear how margins are assessed on put options. Is the margin on options the same as with stocks or futures contracts?
Brokerage firms require margin on stocks and options. These requirements are different from margins on futures, which is a whole other ball of wax. For stocks and stock options, some firms offer a new type of margin account, known as portfolio margin, to high net worth individuals and institutional traders. The portfolio margin accounts assess margin requirements based on the true risk of the total portfolio. For example, owning stock and a put option on the same stock will require less margin than simply owning the stock. In general, brokerage firms only allow this type of margin to accounts over a certain size, like $100,000.
Most other margin accounts have traditional strategy-based requirements. For a stock, the margin is 50%. Options must be paid for in full or have a 100% margin requirement. So if you buy 1,000 shares of XYZ at $50 and 10 XYZ 50 puts to protect the 1,000 shares, the margin requirement is 50% for the stock and 100% for the options. It makes no difference the puts are protecting the shares. The margin requirements are still high.
The margin for other options strategies will vary. For example, a broker will typically require high margin amounts for aggressive strategies like writing or selling index options. However, for a bull call spread, which involves buying and selling a call with a higher strike price, the margin is equal to the difference between the cost of selling the call and the premium received from selling, or the net debit. Your brokerage firm should have a list of current margin requirements for various options strategies available.
CLOSING OUT A CALENDAR SPREAD
I have a question about a calendar spread where the short side of the trade is in danger of assignment. Suppose I set up a calendar spread by buying an October 25 call and selling the June 25 call. June expiration is approaching, and the stock is now $25.40. I get an assignment notice. I am now short 100 shares at $25. What do I do? Should I just buy the share back or exercise the Oct 25 call to close the trade?
The calendar spread is sometimes referred to as the time spread because it takes advantage of the fact that options are wasting assets. In addition, the short-term options will lose value versus the longer-term options due to the nonlinear nature of time decay. Ideally, with the calendar spread, the stock stays in a range or makes a gradual move higher during the life of the short option. The goal is for the short option to expire worthless and for the long-term option to retain most of its value or maybe even appreciate modestly. However, if the stock moves through the strike price before the first option expiration (in this case, June), the short option might get assigned, which is what happened in the example. The first thing to do is not panic. This is not a major issue.
Once you receive the assignment notice, which is given normally the morning after the assignment has taken place, you will want to take action as soon as possible. You will be short the stock after the call is assigned and also hold the October 25 calls. In most circumstances, you want to avoid exercising the October 25 call to cover the assignment of the June 25 call because the October call will have significant time value remaining, which is lost if the option is exercised.
A better solution is simply to close out the trade altogether by selling the October 25 call and buying back the shares. On the other hand, if you still like the trade and expect the stock to drift lower, you might close the short stock position and then sell another call, maybe the July or August 25 call, to bring in additional premium. You can also adjust the position by rolling it to a higher strike price. For example, you might close out the entire trade and then create a July/October time spread using the 27.5 instead of the 25 strike price.
Originally published in the June 2008 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2008, Technical Analysis, Inc.
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