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.
WHERE’S MY HEDGE?
If I put on a bull vertical spread, what can I do to hedge the position?
By either purchasing a bull call vertical or selling a bull put spread, you are starting out with a hedged position. Compared to an outright long call using the same strike for the purchased vertical or selling the same strike put, the trader is dramatically cutting down vega (volatility) and theta (time decay) risk. At the same time, desired directional risk is reduced but remains the crux of the spread’s ability to turn a profit.
Once you are in this type of position and you are showing a paper profit, further hedging using adjustments are possible. The most straightforward way of cutting risk down further and possibly ensuring a guaranteed profit would be to close down a portion of the existing spread if more than one contract were initiated. If a trader’s outlook on shares remains intact and there’s still room for the spread to expand nicely before hitting its maximum profit potential, this type of adjustment is certainly appropriate to consider.
By purchasing a bull call vertical or selling a bull put spread, you are starting out with a hedged position.Other options that might be considered as hedges to a bull vertical are the tightening and/or rolling of strikes. If most of the original spread’s profit potential has been made and one or more strikes exist between the purchased and sold options, such an adjustment makes sense. By tightening into a narrower vertical as with the partial closing of a position, the trader reduces risk and maintains delta exposure but retains a bullish bias based on the position’s location and width relative to the shares.
Long butterflies and long condors using all calls or puts to hedge are two other popular adjustments. The sale of a bear call vertical, or the purchase of a bear put vertical to establish either of these spread types, is an attractive alternative if the trader wishes to reduce his or her risk substantially but is also willing to make a possible profit sacrifice if shares rally strongly. The potential downside with these adjustments is that profit maximization goes from being capped above the sold strike to one in which smaller profits and possibly losses will occur, given a large-enough upside move in the stock.
OPEN AND INTERESTED
How does open interest as a trading statistic compare in its usefulness versus contract volume of an option?
Option open interest can be useful in a couple of ways as a subordinate tool in reaching a trade decision that may not be gleaned from volume alone. One improvement for traders who pay attention to open interest versus those who do not is having a better read on general liquidity provision in a product.
A stock or index’s options may be busy-looking or very quiet on any given day and reflect more of a distortion than what we might find typically. But if traders take care to see what’s been traded and still open in past activity — that is, existing open interest — a more complete picture of the product should be provided. As a byproduct, better position selection that doesn’t fall prey to liquidity inefficiencies at a later date might be possible.
While far from infallible, the more open interest that’s present across the board, the stronger the odds are that the product trades with the participation of a large and diverse group of investors. That kind of interest manifests itself into stronger liquidity provision as various traders look to take on different positions. That’s a desirable quality to have at our disposal when trading.
Open interest can also be used to form or complement a technical opinion on the underlying security. Large pools of open interest, which amount to 15% to 20% or more of a stock’s average daily volume, are viewed by some traders as obvious support and resistance level until broken. For instance, if shares are rallying toward large open interest in a call that has been out of the money for some time, resistance might be encountered.
Much like investors looking to break even on shares of stock after being underwater, naked long call holders may jump at the opportunity to sell. If we assume that the other side buying the calls are professional traders hedging deltas to flatten out the directional risk, stock will need to be sold or shorted. In turn, this can cause a loss of upside momentum at the strike and work the way technical resistance might on a price chart.
In a low, implied-volatility environment where premiums are having additional difficulty gaining in value and/or it’s been established that naked long call positions compose the bulk of open interest, this sort of situation may have further confirmation as one that will be difficult for the stock to overcome.
On the other hand, using this same line of thought, low open interest can be interpreted as a positive sign, as no obvious overhead, from an option perspective, is facing shares.