Q&A
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.
SHORT STOCK RISK IN CALL CALENDAR
Sears Holding (Shld) was brought to my attention after Barron’s profiled the shares as being overvalued. Looking at the premiums, I noticed a distinct skew between the calls and puts. On the surface, the pricing makes the call calendar appear artificially cheap versus its put counterpart. I’m skeptical, but I’m having problems figuring out if some other factor is at work. Can you help?
Great question and a hat tip for seeing potential trouble rather than establishing a position that could be riskier than it appears. I checked the option premiums in Shld and what’s being priced into the attractive-looking call calendar is a potential hard-to-borrow or threshold situation in the underlying shares.
When a security becomes threatened or is in the midst of being difficult or impossible to short due to existing and heavy short interest, call prices will have a strong tendency to trade at a theoretical discount to the same strike put.
To understand this, think about the nondirectional conversion. That position is the combination of a synthetic short (short call plus long put) and a long stock. In a hard-to-borrow situation, this three-way arbitrage becomes more attractive because the market maker has long stock in inventory.
Why is that important? By maintaining a long stock inventory, an active trader or market maker won’t need to worry about being bought in on Shld. Shares can be sold against positive delta order flow without the trader having to worry about becoming net short stock.
On the other hand, a person holding short stock inventory runs the risk of being bought in if the situation escalates. Most often, the trader will be given advance notice of a buy-in but the necessitated purchase of shares can still wreak havoc. Something as simple as a hedged long call option position against short stock would require the trader to find an exit strategy for the existing long delta call position or an alternative hedge. Either way, the trader could be facing unexpected directional risks.
This potentially difficult situation brings us back to why the call calendars trade cheaper than normal situations not involving short stock difficulties. Ultimately, a spread like the long call calendar could find the trader receiving an earlier-than-expected assignment notice on the near-term call. Were that to occur, the short call would be converted into the short stock, which might face forced liquidation. Traders should check with their brokers regarding buy-ins and make sure they understand how they work before entering into a position that could be subject to this type of risk.
REPAIRING A LONG CALL?
I’ve heard option traders talk about repairing option positions when there’s an open loss. How does this kind of adjustment work?
Most often, traders use a repair adjustment when a directional bet doesn’t go as intended but the trader in question is unwilling to exit.
The most common situation for a repair strategy is when an investor holds a long call that’s lost substantial value. The “repair” is buying a lower strike call and selling enough contracts on the existing and higher strike to establish a bull call spread. Typically, this is done as close to even money as possible and generally involves selling two (one to close and one to open) contracts against buying to open a lower strike.
For instance, let’s say Ibm is near 119 and a bullish investor buys the October 125 call for $2.10 on the prospect of a breakout. Several sessions later, shares fail to confirm the trader’s original outlook by moving lower. The pressure in the stock has been largely responsible for the call losing half its value to a price of just $1.05 per contract.
At the same time, let’s say the October 120 call is trading at $2.35. While this situation to repair isn’t for even money, the net additional debit of just $0.20 ($2.35 – 2 ($1.05)) is small enough relative to the initial purchase price as to warrant consideration. The net impact of the adjustment is to essentially maintain the same dollar risk while reducing the breakeven of the new position.
The old position cost $2.10 and would require shares to rise to $127.10 to break even at expiration. The adjusted bull vertical would need Ibm to clear $122.35 (120 strike + $2.10 + $0.20 for repair). The appeal of breaking even at a lower price level can’t be overlooked. But there are negatives to the repaired position, which more often than not outweigh the potential benefits.
First, while the new position may cost little or nothing to establish, the full debit is still at risk versus exiting now for a slighter loss. In Ibm, the price to walk away is $1.05 versus staying involved for $2.35. Yes, the ability to break even is lowered considerably, but traders are by no means limiting their losses with this type of adjustment.
By the time the repair is considered to be an attractive alternative, it’s most often after shares or an index have technically soured. With the repaired position still typically in need of a countermove in order to break even — or worse, to not realize the maximum loss — traders need to be careful of what their real motivation is. Most often, containing the initial and smaller loss is the better policy.
Contributing analysis by senior Optionetics strategist Chris Tyler.