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 |
BULL CALL SPREAD HELP
If you place an order to buy a September 95 call for $1.50 and sell the September 100 call for $0.75, the total debit is $0.75. If the option now has gone to zero, do you need to reverse the order to get out of the trade? Or do you hold until the expiration and do nothing? In addition, can I buy to close the September 100 call without selling to close the September 95 call?
It sounds like you entered a bull call spread and the market turned south on you. Also, your spread was probably on options that were either deep out of the money or very close to expiration or both. You were paying just 75 cents for the spread and had the potential of making $4.25 (the difference between the strike prices of the options minus the cost of the spread). The reward-to-risk ratio is almost 6-to-1! This is a very aggressive strategy. As it turns out, it sounds like the underlying security did not make the explosive move you were looking for and the value of the options has fallen to zero.
In this case, if the options have just a few days or a week of life remaining, the outlook isn't bullish and chances are the contracts will expire worthless. You don't have to do anything. The contracts will expire worthless and you will be out of the trade. The initial debit of 75 cents per spread is lost.
However, if there is still sufficient time remaining, there is a possibility that the price of the underlying security will move higher and you might be able to salvage some of the value of the long call with the 95 strike. If this seems like a possibility, then to answer your second question, you can close out the short call and simply hold the long side of the trade. If the call with the 100 strike is now well out of the money (the strike price well above the market price of the underlying security), you can probably buy it back for a nickel or a dime. By doing so, you bank a profit on the short call and then cross your fingers, hoping for the security to rally back above the strike price of the long call, or $95.00.
As a rule, we look for bull call spreads that have a reward-to-risk ratio of 2-to-1 or 3-to-1. In addition, we set stop-losses based on time in the trade or percentage losses. For example, we might buy a call spread with six months of life remaining and if the underlying security doesn't start moving higher after one or two months, we exit the trade and look for other opportunities.
FUTURES AND OPTIONS RISK
Although it is a low-probability event, I know being long a Standard & Poor's 500 (ES) contract could rack up huge losses if the market melts down and bypasses any protective stop. This is always on my mind, although it does not prevent me from trading futures. Could a protective put (or something else) be bought at the same time for longer-term futures trades that would protect as a wide stop? Could you give an example of how to search for the most cost-effective protection? Of course, I like the futures for the leverage. Could I buy a deep-in-the-money call option instead?
Good questions. It can be difficult to sleep at night if you are holding long futures and the market is set to gap down the next day, possibly busting lower without triggering your stop-loss. It does happen and certainly poses a risk to holding ES or other futures contracts without a hedge.
Puts can certainly help offset that risk. For example, if I hold the S&P 500 September 2008 (ESU8) futures contract at 1,300 and want to hedge risk, I can set a stop at 1,270 and also buy a September 1,250 put. If ES gaps through my stop, the puts will increase in value and help to offset the losses from the decline in the S&P 500. If it continues falling, I am protected by the put because I can exercise it at 1,250. My risk becomes the cost of the put plus the price of the futures minus the strike price of the put. While the risk is still substantial, it is far less than the risk associated with holding a long futures contract without a hedge.
The higher the strike price of the put, the greater the protection and also the greater the cost. For example, if the 1,250 puts are trading for $10, I pay $500 for one contract ($10 x 50) plus commissions. I might pay twice that for the 1280s. Then, if the ES rallies, the puts start to lose money. Even if S&P 500 holds steady, I can lose because of time decay. The put options will lose value over time.
Why not buy a call option instead? A straight call purchase will have the same risk profile as long futures and puts. It will also suffer from time decay, but has limited risk and good upside return potential if the S&P 500 moves higher.
To answer your last question, deep in the money calls are certainly a possibility, but you want to also consider how trading expensive options will affect buying power. In the previous example, if you want to trade the September 1,200 puts for $125 a contract, you'll see a profit/loss curve very similar to trading the futures contract. However, your broker will probably require the necessary buying power in your account (or $125 per contract x 50 = $6,250 per contact), which is considerably more than the current margin on ES futures themselves. In short, buying deep in the calls might reduce the leverage you enjoy trading the straight futures contract.
Originally published in the October 2008 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2008, Technical Analysis, Inc.
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