Q&A

Since You Asked

Confused about some aspect of trading? Professional trader Don Bright of Bright Trading (www.stocktrading.com), an equity trading corporation, answers a few of your questions.

Don Bright of Bright Trading



RATIO WRITE

I've been trading options for about 10 years. One strategy I enjoy but seldom use is a "ratio write" -- for example, buy 100 shares of a stock, sell a covered call (near the market), and sell a second call near the market: 2-to-1 ratio write. (Assume call premiums are at $6.) This gives good downside protection of $12 and an upside profit range. Occasionally, I go long on a parity call (deep-in-the-money) in place of the stock. My question applies to either strategy. I've had good success in a falling market or a flat market. Sometimes I will buy a "protective put" at the foot of the protective range ($12 below market) -- if the price is right. My thinking is unclear when it comes to adjusting for a rising market. Certainly, if the option closing is near and the market has reached the call strike price, I can buy another 100 shares of stock and have two safe covered calls. How's that sound to you? --Jim TaV

First off, a ratio covered-call write can be pretty risky, but let's take a step back before getting into your specific trades. Option pricing is determined by historical volatility, interest rates, and days until expiration. Before deciding on which calls to sell, whether or not in a ratio, most decent data vendors will give you the ability to see valuations based on these criteria. You can adjust interest based on whether you are long cash (trying to get a better return vs. simply bank interest), or if you are using short cash (margin or paying interest to borrow money). Adjust the interest rate used accordingly. Now you can adjust the volatility used to see what the implied volatility is based on the actual pricing of the calls and puts. You can compare this implied volatility to actual historical volatility to see if there seems to be some major discrepancy. When all is said and done, option pricing and profitability boils down to who is making the best guess on upcoming actual stock movement (volatility).

Each option is then assigned a delta (where 100 shares = 100 delta) based again on these factors. I have always looked to be pretty close to delta neutral. This could be done with 100 shares long with one call short, or 100 shares long with many calls short (out-of-the-money calls, of course). So first determine your net delta at the time of putting on the trade. As time goes by, you adjust your net delta. For example, long 100 shares at $32, short two near-term $35 strike price calls might be delta neutral now, but as the stock rises to $34 (depending on when it moves that far), your net delta may burn to short 50 or more.



MARKET'S EARLY RISING: AN EMAIL CONVERSATION

When the market is rising early in the trade, what is a good response? 1) Should I buy the second 100 shares of stock to convert into two covered calls? (Although I risk a whipsaw.) If I do, at what point is it best to convert?

Reference what you've written about determining the "best" put to sell or if there is a call further out to buy what might bring your delta's back in line. By "best," I mean the option that is "overvalued" based on identical criteria. Be careful not to overadjust, as this can be costly. Run your projections dated a few days or a week ahead to see what the net delta will be at various strike prices. Remember, time decay is your friend in this example.

2) If I decide to close the naked call, when is the best time? What about a dynamic buy-stop at breakeven?

Again, this is where you can think about adjusting delta based on which call appears to be the best value for your buy (in this case). If a call further out at a similar strike price appears to be undervalued when compared to your calls, consider buying those instead. In some cases, the calls you sold as overvalued may now be at a fair value; if that is the case, then simply close them.

3) If I decide to roll up the naked call, when is the best time? Is it generally advisable to roll up both calls? For example, is it the best time when the market is one strike above the call strike price?

Don't rely on the market to do what you wish it would do; if it did, we wouldn't be having this discussion! Just remember to set parameters ahead of time to adjust, run values up a week or so, and run projections based on varying stock prices at expiration.

I realize this is a case-by-case decision, but in general, do you have any advice about balancing the time remaining before expiration and the rising value of the call options?

Price (or premium) does not reflect value; valuations are based on the criteria. Use the best valuations for your option buying and selling decisions. To repeat, run sheets and projections based on upcoming time frames and stock prices. I strongly suggest you learn about conversion pricing (long stock, short call, long put) after you get a good understanding of determining valuations based on the criteria given here and basic Black-Scholes modeling.


E-mail your questions for Bright to Editor@Traders.com, with the subject line direct to "Don Bright Question."

Originally published in the November 2008 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2008, Technical Analysis, Inc.



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