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.
WEEKLY OPTIONS
I’ve noticed the more active large-cap stocks are offering options that expire weekly. Can you give some background on how these contracts work and how they might differ from standard listed calls and puts on equities?
Good question. What you’re seeing listed in names like Apple (Aapl), General Electric (GE), Google (Goog), and other highly liquid, large-cap stocks are weekly options. The exchanges and your broker can provide you with an up-to-date listing. This product will continue to grow, given the strong response from option traders for this new offering.
With these contracts, there are similarities, as “weeklys” are standardized contracts in most ways. For one, the models used to generate prices for regular contracts are the same as for the weeklys.
The weekly is simply a means by which to allow traders to place positions on a very short-term contract when none would otherwise be available if the front-month contract still had two to about five weeks of life remaining. This also means the risks (and rewards) surrounding the theta and gamma are heightened, as they would be with regular contracts.
Another similarity is the multiplier for calls and puts. Each contract represents 100 shares of the underlying instrument. American-style exercise is another shared characteristic. The right to exercise early if you’re the contract holder and the obligation to take assignment, if you’re short, are factors.
Finally, weeklys also expire on Fridays. If there’s an exchange holiday for an “expiration Friday,” the weekly’s life will be cut short by one day and expire at the close of business that Thursday.
As for the differences, weeklys are listed on the Thursday or Friday preceding expiration, so the maximum time in the contract’s life will be six or seven trading sessions. Weeklys aren’t listed when the regular cycle is setting up with the front month entering its final week of life. That makes sense, as putting a fresh weekly contract on the board would be redundant as the two contracts would be the same other than open interest.
INTEREST-ING CALL
If interest rates are climbing, is it true that call prices go up? I thought the market acts adversely to rate increases, so if share prices went lower, why would calls increase?
I believe you’re mixing information, which while related are separate and not necessarily correlated matters. If traders believe monetary tightening will threaten corporate profits, then market prices are apt to go lower. On the other hand, if investors see that same policy action as curtailing potential inflationary pressures and/or because economic demand warrants such measures, then the market could react bullishly.
How the market reacts aside, call prices will increase in value when interest rates increase. This is because a long call has positive rho, the greek associated with interest rates. A positive rho factor will increase the premium of the option by that amount per one-point shift up in interest rates.
Why? It comes down to theoretical pricing. When the long call is fully hedged directionally on a risk-neutral basis, the trader’s natural offset is short stock. When rates increase, the added interest taken in from the short stock inventory means the call will be more valuable and therefore priced at a premium to the same call in a lower rate environment.
SIXTH CENTS
Of the factors that affect an option such as time to expiration, stock and strike price and supply/demand characteristics, which do you see as most critical?
Let’s start by outlining the six characteristics that form the basis for option prices. A trader needs to know the stock price, strike price, time to expiration, dividends (if any), interest rates, and implied volatility.
All are important in how an option is priced, but interest rates is the least important and only becomes challenging for longer-term contracts. The same could be said about dividends. Only if your contract were priced for several of these cycles should a trader need to consider its impact more thoroughly.
Stock and strike price and time to expiration are easily defined variables with no “what-if” unknowns, but are very critical. The first two form the basis for whether the option has intrinsic and/or extrinsic value, while the latter influences just how much extrinsic or time value might exist at any given time. The more time left in a contract’s life, the greater the chance for some extrinsic value to exist.
Then there’s implied volatility. Implied volatility (IV) is traders’ collective vote on current and forecasted conditions for the contract based off the underlying volatility (statistical or historical). IV is the most consistently challenging variable, as it can truly be a wild card as far as pricing is concerned.
Turns in investor sentiment and shifts in IV such as increased fear resulting in higher IV levels shouldn’t be underestimated. If you have an understanding of those six factors, you’ll have a more solid sense of how all those “cents” combine for the total premium of an option contract at any point in time.
Contributing analysis by senior Optionetics strategist Chris Tyler