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. |
Tom Gentile of Optionetics |
COVERED CALLS
If I write a covered call for a stock I bought at 30.50, am I allowed to place a stop-loss price, say, 27.00, to protect it from further decline? What happens if the stop-loss price is triggered?
Although one of the components of a covered call is the underlying stock, it is still a spread, since it contains a combination of both a long and a short position. Most brokers do not place stop orders on spreads. However, you can probably place what is known as a contingency order, in which the spread is sold based on the stock price alone. If, for example, you decide that you wish to sell the spread when the stock hits 27, the contingency order will automatically sell your spread at the price you specify or at the market. But again, this is up to each individual broker and is something you should ask about.
COLLARS
Could you please explain what a collar is and how it works?
Collars are strategies that anyone who owned stocks in 2000 probably wishes they had known about. A collar is a virtually risk-free hedge against a downward move in a stock. The strategy involves buying a put for every 100 shares of stock owned. The put offers near-total protection against any losses in the stock. However, because puts have time value built into them, they carry additional risk. This risk, or time value, is paid for by selling a call with the same strike (or higher) as the put, thus providing the "free" hedge. It's the equivalent of buying an insurance policy on your car, but for the same price as the policy premium, selling the right to buy the car to an interested neighbor.
Generally, to maximize the loss protection, the puts are purchased at-the-money or just in-the-money. This way, as the stock falls, the puts will protect you against a total loss. Anything out-of-the money, and your risk is the difference between the stock price and the put strike. The advantage of this is twofold: First, you need only sell enough premium in the calls to pay for the put, and second, you can therefore sell out-of-the-money calls. This way, in case you're wrong, and the stock moves higher, you can enjoy higher profits until you're called out of the stock (should you be assigned).
There are several other methods that use collars to protect against stock losses. In fact, puts were invented for this exact reason -- protection. It's worth your time to investigate this and other hedging strategies, not only for your own benefit, but so that you can help me debunk the myth believed by so many unsophisticated investors that "options are dangerous."
OUT-OF-THE-MONEY OPTONS
Why is it so difficult to make money on out-of-the money options?
No matter how difficult the pricing formulas may seem for options, calls (and puts) are basically priced according to their probability of being in-the-money at expiration. The higher the strike price, the lower the probability that it will be in-the-money and potentially profitable. That's why out-of-the money options seem so cheap. (For the most part, speculators buying these cheap options extremely far out of the money have as much chance of profiting as a $1 bill has of making you a fortune in the lottery.) These types of options don't have much chance to double in value because the probabilities are so low of such a large move.
However, a call's ability to gain value has to do with all kinds of factors, such as movement of the stock, volatility, and the time it takes for the move to occur. The more the stock price is in-the-money to the strike price, the higher the probability that you will make money. That said, if you were a market maker who had to buy the call from a buyer using a pricing formula such as Black-Scholes, you would calculate the best price for the option, taking into account all the different factors of time, price, and volatility. The trick is to price the option low enough to actually create a market that someone is willing to pay for, yet stack the probabilities in your favor, not theirs. Therefore, it's not so much that market makers want to be "fair" as that they need to provide a liquid market so they can eat, too. If they charged too much, nobody would buy, and they'd be out of business.
The fact that far out-of-the-money options have some value to them works mostly in the favor of the market makers. They figure, if someone wants to buy these options, then they need to sell them. But often if you look carefully at the price of a cheap option, say 25 cents, you'll see that there is either just five cents on the bid, or no bid at all. Be careful of this. If the smart guys don't like the probabilities, you probably shouldn't either. They'll be happy to take your money, but it's another thing to get it back. We like to call this the "Roach Motel" trade -- you can check in, but often you can't check out!
Return to May 2004 Contents
Originally published in the May 2004 issue of Technical Analysis
of STOCKS & COMMODITIES magazine.
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Inc.