Explore Your Options

with Tom Gentile

Tom Gentile Portrait

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.

Can you explain what extra risks I would assume with a long butterfly position if assigned on any or all of my short contracts?

Great question. First, realize a forced assignment in a long butterfly position won’t open up the trader to more dollar risk. The assumed debit and maximum dollars at stake when the position was opened remains the same, no matter how many of your short calls or puts are assigned. This is because you are hedged and contract neutral. Understanding you are essentially in a covered position, as far as dollars at risk are concerned, might be easier if you break down the long butterfly into its component spreads of one bull vertical and one bear vertical and look at different assignment scenarios.

To illustrate, assume you have a one-lot XYZ 30/35/40 (1 x −2 x 1) long call butterfly established for $1.50. With shares at 37, you receive assignment on one of your two short 35 calls. Now short 100 shares as part of your overall position, you can exercise the long 30 call to flatten the stock inventory. The exercise, which is your right to buy 100 shares at 30, maximizes the value of the 30/35 bull vertical as you were already forced to sell or short shares at 35.

But maximizing your gain on one side of the fly isn’t the same as a guaranteed overall profit, but your risk remains fixed at $1.50. Now, into expiration or until you exit, you still maintain five points of risk on the open 35/40 bear call spread. In effect, this counters the closed bull vertical until and if you do better for yourself by buying to close the spread for less than $5. That’s possible, but with the worst-case scenario being a profit wash after closing out the two spreads, you remain on the hook or at risk for up to the initial debit paid of $1.50.

The real risk with early assignment is tied to the extra margin, which would be required to be in place due to the shorted or long stock or if your account isn’t qualified to hold short stock, such as with IRAs. In either situation, you would be forced to close down the position prematurely. If the closing of the position is transacted through the exercise process, the result would be a quicker-than-expected realization of your maximum loss potential.

However, if your broker’s rules allow you to close out the position in the open market and the capture of time premium is possible when exiting, your long contracts being closed would stand to benefit. This could result in a smaller net loss than experienced with exercising. And some profitability but less than the maximum associated with the stock landing at the short strike at expiration is possible.

I’m fairly new to options but not to stock trading. How concerned do I need to be about gamma on my directional plays using a long call or long put for positioning?

You’re in luck to some degree, as gamma is a positional ally. In trading price direction of a stock or index with straight long call or put positions, your primary motivation is assumed limited risk and desired delta exposure. Delta is the greek, which theoretically shifts a contract’s premium by the assumed variable’s risk exposure.

For instance, a one-lot, at-the-money long call position with +50 deltas can be expected to increase in value by $0.50 if the underlying moves favorably higher by one point. Similarly, a one-lot, in-the-money long put, where the delta of −99 moves almost identically to stock, can be expected to benefit by nearly $1.00 per contract or $100 if the underlying dropped by one point.

With the long call or long put position, you also maintain favorable exposure to the greek gamma. Gamma is the variable that acts to shift your directional/delta risk by this factor over a one-point move. Back to our first example, an at-the-money +50 delta long call might maintain gamma of +30. Thus, if the underlying goes up a point, the delta would increase to +80 over the course of that move. In turn, we can estimate based on an average delta of +65 the call’s premium increased by $0.65 rather than $0.50 and what amounts to as good news for the trader.

Gamma exposure will be at its largest when the contract is at-the-money and expiration is fast approaching. This should make intuitive sense, as it would take little in the way of stock movement to force the option into its permanent home of being in-the-money and a stock-equivalent 100 delta position ready for exercise or, conversely, out-of-the-money with no value or delta. At the same time, already in- and out-of-the-money options of the same contract month will have virtually no gamma value and normal-sized movement will fall well short of affecting either “money” status and attached, steady deltas.

Favor from gamma does come with a cost in the name of decay risk and represented by theta. Long contracts maintain negative theta risk, as the potential for that premium to collapse to zero is a possible hazard of this type of limited risk strategy.

Also a consideration but typically second to decay is long vega or implied volatility risk. When gamma is coming into its own — that is, near expiration and with at-the-money positioning — it increases if implied volatility drops. Lower implieds translate into more stable pricing. Thus, a one-point move away from at-the-money positioning means a stronger delta shift from near 50 and toward 100 or zero is required. This is accomplished through a larger gamma factor, but at the expense of lower implied volatility, albeit a factor with rapidly declining influence into expiration.

Originally published in the July 2012 issue of Technical Analysis of Stocks & Commodities magazine. All rights reserved. © Copyright 2012, Technical Analysis, Inc.

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