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.
Buy low, sell high?
I’ve seen more than a few situations where longer-dated options trade at a significantly lower implied volatility relative to the shorter-term contracts. If a trader bought the cheaper contract and sold the more expensive one, like with a calendar spread, it seems to me as though there should be some type of profit opportunity. Could you please shed some light on this topic?
Great question. You’re correct in treating what seems like one of Wall Street’s proverbial free lunches with some care. The reality? If all that was required to turn a profit on a calendar spread was the simple lining up of “buying low” and “selling high” implied volatility (IV), there’d be no one to take the other side of the position. That’s not the case here, though.
Remember, in this day of access to sophisticated pricing models, everyone is seeing the same “attractive” skew, and quickly at that. That said, why IV prices are establishing this enticing relationship needs to be understood before making an informed decision.
After further analysis, the trader may still feel compelled to place the trade. But looking elsewhere may prove to be the better opportunity as we uncover a less secure trading edge with the calendar in question.
What might cause this seemingly good IV situation to look less compelling? One example that occurs with regularity in many stocks is when an earnings announcement is approaching. When the report occurs during the life of the near- or short-term contract, there is often a skew that builds up in the front month and where the back or longer maturity option might trade at a substantial IV discount.
Trying to capitalize on the IV spread between months can be riskier than initially determined because traders are expecting an earnings-related price move and a drop in the IV. If those expectations turn out to be correct, the spread’s market price/value could drop in the aftermath of the report.
The long calendar, while limited in risk and often an inexpensive strategy as far as the initial debit or cost per spread is concerned, is short gamma or curvature and long implied volatility. If a large-enough stock move occurs, which the disparity in pricing between the two contract months suggests is being anticipated by traders, the calendar will collapse in value.
In addition, stock movement compounded by a drop in the implieds of the longer-term contract can result in a near total loss of the debit paid, as both options trade with little to no value (out-of-money) or are now so deep in-the-money that only intrinsic value is left.
If it seems too good to be true, it might be available for trading, but you should know why the pricing is like it is before you dive in. Determining “the why” rather than blindly acting on a favorable skew situation will go a long way toward a better estimate of the real risk and reward involved.
To exercise or not to exercise?
Recently, I owned some calls in front of a stock’s ex-dividend date but didn’t really understand the impact of what holding the call meant. Seeing the stock was due for a pullback, I opted to sell the call position and take profits. Could you explain what am I looking for in order to make a more informed decision other than the technical variety for the next time this situation comes up?
You can never go broke taking profits, so first let me commend you on making that decision when it appeared a good time to do so. As for making an informed decision on whether to exercise a call in front of a stock’s ex-date, the theoretically correct answer is easy. Long call holders will exercise their option position when the price of the dividend being paid is greater than the buy-write market or associated put value of the strike in question.
The reason behind this is that the call owner doesn’t receive the dividend, but the call’s value will drop by the amount of “dividend times delta,” all else being equal the next trading day. Say Xyz is at $22 on the eve of its ex-date and pays a hefty $0.50 dividend. At the same time, you own 10 front-month deep in-the-money 20 strike calls trading for $2.05.
On the ex-date, shares have the dividend factored out and Xyz opens down -$0.50 at $21.50. For stockholders, they’ve lost on the new share price but they receive the $0.50 payout a month later. It’s a wash on the surface, but really a forced savings program for long-term shareholders.
As for the trader still long the 20 call, the deep option will have lost $0.50 and trade for $1.50 to $1.60 with shares at $21.50 and a matching 20 put still quoted for $0.05 to $0.10. In saying that, wouldn’t you rather have long stock in front of the ex-date in this situation versus holding the long call? But the more complicated and less discussed part is that the trader who exercises now has a much more open risk position of long stock at 21.50 versus holding the calls. If shares technically act weaker all else being equal and you aren’t able to exit efficiently, having missed out on the dividend could turn out to be looking like a very small sacrifice in the real world.
Contributing analysis by senior Optionetics strategist Chris Tyler.