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. Contributing analysis is by senior Optionetics strategist Chris Tyler.
BULL AT A DISCOUNT?
I’ve noticed some bull call spreads trade for less than intrinsic value prior to expiration. Why is that, since it would seem like a good opportunity to buy at a discount compared to an outright call?
What you’re seeing is a function of larger extrinsic or time value in the short, higher strike call compared to the deeper long call. This causes some verticals, in particular those with one strike deep-in-the-money and the other slightly in- or out-of-the-money, appear to be trading at a discount to its intrinsic worth at expiration.
This relationship between the two makes profits harder to come by relative to an outright deep long call position as shares move up. But as expiration grows closer or if shares rally swiftly enough, the reduction in the extrinsic value of your short call will result in the spread expanding toward its maximum profit potential.
As with any spread, verticals can represent a stronger opportunity relative to an outright position. However, the determination of this value is a combination of implied and statistical volatility, market conditions, and a trader’s expectations.
At Optionetics, we would favor a vertical over a long call due to its reduction risks associated with the greeks. But we also stress the value in performing this kind of due diligence when a trader considers a position to reach an informed decision.
GOING NAKED OR COVERED?
If I’m moderately bullish to neutral on a stock, should I sell a call against shares or short a put? The strategy risk profiles look the same if I compare the two positions using the same strike and expiration.
Selling or shorting a put naked — that is, no underlying hedge with short stock versus selling a call against long stock on a 1:1 ratio with the same strike and expiration — maintain the same risk graphs because they are equivalent strategies. Another name for the covered-call sale is the buy-write.
With the risks of these positions equal, barring dividend risk during the life of these strategies, the choice comes down to whether you’re interested in holding or are already holding shares as part of a longer-term strategy that may hold a tax advantage. That’s something you’ll need to consult with a tax professional about.
That said, there are situations when a stock is on a threshold list or hard to borrow for shorting that might affect option prices and favor selling the naked put rather than executing the covered call or buy-write. When a stock is difficult to borrow for shorting purposes, call prices can trade at a discount to the puts.
This can be seen in the form of an implied volatility skew between the two option types, affecting put/call parity. This is because the natural hedge of having stock available to reduce the directional risk is jeopardized for the long call position that would require short stock.
On the other hand, the trader who is long a put and wishes to hedge off that position’s short deltas is free to buy stock without restrictions. In turn, this ability makes the put more attractive and forces a bid or higher implieds into the contract due to the increased investor demand.
For a trader who would be on the other side of this situation when considering a buy-write or naked put sale, the advantage would be to sell the put rather than its synthetic equivalent. By doing so, you’d generate extra income for each contract sold in a profitable scenario than would otherwise be the case.
GETTING STARTED
Being fairly new to options, I want to get proficient in trading spreads so I can position for factors other than just direction. Which strategies might be a good starting point?
Verticals and straddles are good strategies to begin with, as they involve only two legs, both contracts are in the same expiration month, and traders can familiarize themselves with greeks.
The vertical is either bullish or bearish using all calls or puts. With the vertical you can compare how a capped reward strategy trades in relation to an outright position when you’re looking for an alternative to holding a long contract.
The straddle is also important to understand when starting out. The position involves the purchase or sale of a call and put on the same strike. This allows the trader to learn about a nondirectional strategy categorized as a volatility spread or long curve position.
By understanding the straddle as both a buyer and seller of option premium, you’ll gain confidence regarding the impact of time decay (theta), directional curvature (gamma), and the implied volatility component in option pricing (vega).
After building that foundation on spreads, butterflies and iron condors that involve two verticals combined into one position can be approached more easily and offer new and different ways to position. At this point, a trader can also look at calendars.
Despite its simple design, the calendar or time spread is complicated by implied volatility skew across trading months. This skew can be much more varied than with single-month spreads or if other key catalysts are involved. There can be some interplay involved, how profits and losses are realized, and why it can make sense to understand other spreads first.