Q&A
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.
DOUBLE DOWN OR UP?
If a trader is long stock that goes against him and he’s unwilling to sell, are there any option strategies to recoup those paper losses without laying out more capital?
Hypothetically, anything is possible. But it’s also true when a trader opens up his portfolio to options, there are more opportunities to produce a larger profit or reclaim open losses faster. For a longer-term investor intent on holding shares despite an existing loss, one such strategy is called a double long position.
In an unprofitable long stock scenario, a double long consists of executing a ratio front spread as close to free or a credit as possible. That’s easier done than said. The front spread looks to purchase a lower strike call, typically at-the-money call, while selling higher strike calls of the same contract month. The most popular ratio is 1 x (2). Without stock ownership, this strategy is net short calls above the higher strike, but that’s not necessarily a bad situation to be in, at first at least, as the maximum profit is also at the strike. The breakeven on a 1 x (2) is this profit added to the shorted strike call.
For instance, if the front spread was put on for even money using the March 40/45 calls, the trader would have a maximum profit of $5 at 45 at expiration. Both short calls go out worthless exactly at 45 and the long 40 strike call would be intrinsically worth $5.00. But a continued move in shares would result in a point-for-point decrease in those profits, with a breakeven at $50 and losses north of that as the trader is effectively short 100 shares above the 45 strike.
What this strategy means to an investor already long stock, other than being called a double long position, is that the upside risk is covered by shares, assuming the proper ratio of 1 x (2) for each 100 shares owned. This also means the trader has twice the bang for his buck up to the sold strike where gains are then capped, unless an adjustment is made. At the end of the day, or through the life of this position, the trader has adjusted from simply owning long stock that’s underwater to having a buy-write and bull call vertical.
To use a simple illustration in getting back to even, let’s say a trader bought 100 shares of XYZ at $30, only to find the stock at $25 shortly thereafter. Down $500 on paper and if XYZ maintained liquid options, the trader could likely price out a 25/27.5 call 1 x (2) in one of the front two months for even money without too much trouble. A few weeks and a favorable expiration later and shares having rallied 2.5 points to $27.50, the trader recoups $250 on his or her new buy-write position while making the same amount of 2.5 points, or $250 on 1x 25/27.5 bull call vertical. In total, the trader has recouped the $500 paper loss despite having originally paid $30 for stock and XYZ still at $27.50.
Getting back to even or wherever this type of bullish investor wants to go with their shares can be more difficult than our example. Ultimately, that’s going to depend on how large of a loss has already occurred. Though the spread itself can readily be executed for even money or a small credit, the positioning to come up with this type of pricing could require multiple profitable front spreads before the trader is made whole again.
Finally, and not to be taken lightly, the trader still maintains his or her original risk of being long stock without protection on the downside other than the kind showing a ticker price of $0.00. In thinking more dynamically, instead of the more popular free double long, buying a protective out-of-the-money put in conjunction with the front spread to form a collar and vertical might be evaluated first. For less upside potential but a lot less headache, that more involved but thoughtful positioning is something to consider.
WHAT VOLATILITY?
When determining the fair price for an option, how important is historical stock volatility compared to the current implied pricing set by the crowd if the two are deviating widely?
That’s a good question but one without a set answer, as far as profits handed out by the market is concerned. What we can say emphatically is historic or statistical stock volatility is important, particularly for longer-term contracts. A large discrepancy between the pricing of the option and underlying volatility won’t go unpunished, if the two types of volatility continue with that relationship.
For instance, a delta neutral buyer of 50% IV on a six-month contract compared to longer-term statistical volatility of 35% would stand to lose on that position if his or her hedging efforts to remain directionally flat were consistently executed on stock volatility nearer to the historical reading of 35%. Even if implied volatility remained well-bid at 50%, the passage of time would tear away at the higher-priced implieds in the form of added decay above and beyond the 35% statistical hedging.
Conversely, a situation involving shorter-term and bid-up implieds relative to historic volatility could suggest traders preparing for a one-time event such as earnings. This type of event might dramatically affect the stock’s statistical volatility in one quick and potentially hard-to-trade price reaction. If the crowd is correct and shares make an exaggerated move, the trader trying to capture the existing volatility spread showing high relative implieds by using a short vega position could stand to lose a good deal of money.