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.
INTRINSICALLY BETTER?
Which is considered better to own, intrinsic or extrinsic premium?
That’s a broad question with no absolute answer, though some may suggest that traders refrain from owning extrinsic premium. As option traders, we should recognize that all extrinsic or time value eventually drops to zero. At expiration, all that’s left is real intrinsic value or the option has no worth whatsoever.
More important, having contract value left in the form of intrinsic premium at expiration isn’t the same as making a guaranteed profit. The reality is, you can buy 100% intrinsic value of, say, $5.00 in a deep call or put contract and end up with intrinsic value of $1.00 at expiration, or maybe nothing at all if the contract goes completely out-of-the money.
A trader’s individual style will play a role in determining whether to go deeper in-the-money with more intrinsic value at risk. Those seeking pure directional bets, where the delta approaches 99 and mimics stock, make up this stratum of positioning. But the further out in time one goes, the more difficult it is to secure a deep option with liquidity and the more it makes sense to buy, versus simple stock ownership.
Conversely, a trader can use at-the-money or out-of-the-money contracts risking 100% in time decay or maybe an option that maintains a ratio of both intrinsic and extrinsic value. The upside of using extrinsic premium is that for the same dollars at risk, the trader can obtain more contracts than with deeper intrinsic positioning. If conditions prove beneficial, returns can eclipse those produced from a smaller contract size in deeper options if the move in shares is strong enough.
In making a more informed choice about purchasing options, traders should know their greeks and recognize which of those risks he or she feels most confident with at any given time. Are you really a stock (directional) trader and comfortable with delta being your profit & loss bottom line? What’s your time commitment? Intermediate-term traders have more of a reason to use out-of-the-money contracts with confidence, as time decay (theta) is less an issue. However, those same traders should be secure in the attached and larger volatility risk (vega) per point that’s integral in shaping the extrinsic value of those contracts.
Ultimately, we can’t tell you which is right for the individual trader. But based on market conditions and your preferences for the greeks at any given time, learning to shift gears between intrinsic and extrinsic positioning and making use of spreads makes sense to us and possibly more dollars to your bottom line.
SYNTHETICALLY THE SAME
If a straddle trades for more than a strangle surrounding it, why doesn’t the math of selling the straddle and buying the strangle produce a guaranteed profit with limited risk?
The combination of a short straddle and long strangle is an iron butterfly. This lesser-known strategy is simply the synthetic equivalent of a long butterfly. The long butterfly reflects a spread composed of a 1x(2)x1 ratio of contracts whose strikes are equidistant and of the same expiration month.
In the long butterfly, the outer calls or puts are purchased and act as protection while the middle (calls or puts) strike is sold. Above or below the outer strikes at expiration, the trader loses the premium paid. Profit maximization occurs at the middle shorted strike and is equal to the distance between strikes minus the initial debit.
The iron butterfly situation you’ve presented shares the same characteristics of a 1x(2)x1 structure on equidistant strikes. Here, however, we are using a long out-of-the-money put, short call, and put on the same strike and long an out-of-the-money call. This combination will result in a credit versus the regular butterfly’s initial debit as the sold straddle will maintain more premium than the purchased strangle.
This credit, and for that matter any credit strategy, is far from a guarantee of profit. In this instance, we know this to be true, as the risk and reward profile of the two strategies are one and the same. Thus, if the regular butterfly is risking its debit, the iron butterfly also holds the equivalent risk. In order to come up with that same dollar risk, the trader subtracts the credit from the distance between the strikes.
This should make sense, as the iron butterfly can also be thought of as representing an at- or out-of-the-money bear call spread and similarly positioned bull put spread. The only time both spreads approach zero is at the shared strike of the short straddle at expiration. That’s when the initial credit will be collected in full without factoring in minor real-world costs of slippage and commissions in closing out the position.
At every other price level in the underlying instrument, one of the two spreads is moving toward capturing its maximum worth. That amount, the difference between the strikes, occurs if shares move through either the protective call or put at expiration. That’s much to the detriment of the iron butterfly, as the credit received would be smaller than the debit required to buy back the in-the-money vertical. Ultimately, though, that’s no different than what his or her counterpart in the regular butterfly is facing; it’s just packaged slightly differently.