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.
EVENT PRICING
I’ve often heard traders and analysts make statements along the lines of such and such move is being priced into a stock in front of a key event with regards to its options. What is this and how is it calculated?
Great question, but it’s not a “one size fits all” situation. What’s being expressed is how option traders’ collective actions can be fitted into a price estimate for the movement expected in the shares once the event driving the option premiums is announced.
For instance, in front of Food and Drug Administration (Fda announcements, a typical scenario) is to see option premiums get bid well-above theoretical fair value based on the stock’s underlying movements. Traders doing the bidding are willing to pay the stiff prices in the calls and puts because the expectation is that the news will move shares dramatically enough to compensate for the added premium risk.
Once the news is released, long premium option traders are going to lose money through either a lack of movement in the shares, an implied volatility crush as premiums revert toward more normal pricing, or a combination of the two. This isn’t the same as saying those same traders are going to wind up with losses. In fact, bulls or bears could walk away with profits, sometimes very large at that. But there’s likely to be fewer gains for the directional trader who does win, due to the negative effect a drop in implieds would have on his or her position.
Getting back to net trader expectations — by taking the at-the-money straddles and strangles and then pricing those spreads based on post-event implieds, we can see how large of a move in the stock is necessary for traders long these nondirectional strategies to break even during the next session.
Those price points thus become our basis for how the stock is being priced by participants. Where implieds ultimately settle after the news is announced isn’t foolproof. But with a bit of practice looking at historical implied and statistical volatility charts, your ability to estimate where premiums will trade is certainly approachable more often than not.
OPENING VS. CLOSING
What’s the importance of whether a trader is opening or closing a large option position in a stock I’m positioned or interested in?
Like following the actions of larger interests initiating a fresh position in a stock, an opening trade presumably carries more weight than a closing execution. Traders hold this to be true because to open is to be motivated by the desire to make a profit.
The commitment to open a position demands an outlay of capital and increased risk tolerance in order to affect the transaction. On the other hand, closing out an option position, much like with stock, can be more complex and the real motivation not as obvious as we might think.
Regardless of whether or not the trader is opening, what those actions represent can be difficult to determine. The position could involve stock or other options, which may or may not be easy to get a good fix on. The activity could even represent part of a more esoteric position like being part of a volatility basket.
Except under certain circumstances such as low open interest and obvious call buying in front of an event, it can be difficult to track what the “to-open” trader is doing. And even there, that’s not sufficient reason to commit resources without exercising due diligence.
WHEN CLOSING TRADES MATTER
Most expiration weeks’ pin risk seems to come up as a topic of conversation as one or more well-known stocks square off with the pin. I know how pin risk can affect long straddle holders, but what’s the risk for other position types?
Anyone holding a short contract and letting it expire under the assumption of the option being worthless is at risk of assignment. The risk of winding up with an unwanted short stock position due to a short call being assigned or a long stock caused by a held short put happens to be more commonplace when a stock is near the strike, but the reality is that news can affect options thought to be well out-of-the-money or deep in-the-money as well.
As for the assignment risk associated with a pin, let’s say Trader A is short the November 50 call in Xyz and shares close at 49.90. The contract is worthless based on the closing price. However, let’s also introduce Trader B, who is long the same contract but maintains short stock against the now-worthless call. If Trader B wishes to go out flat with no position, he or she may exercise the call in order to get rid of any unwanted delta or directional risk.
While Trader B’s action may seem unfathomable, in the afterhours market when even the majority of most liquid and large-cap stocks don’t maintain decent liquidity, this type of associated pin risk of a surprise assignment increases. Hence, paying up through exercise may be cheaper than trying to buy stock due to the lack of liquidity. To avoid a potential headache, “buy to close” is an option worth consideration.
Contributing analysis by senior Optionetics strategist Chris Tyler.