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.

Tom Gentile of Optionetics

VOLATILITY

How do I figure out which strategies are best to implement when the volatility of the market changes so drastically from one season to the next?

Fortunately for option traders, volatility is your friend, provided you understand just what strategies to use. Though the duration of each trend can be difficult to predict, periods of high or low volatility can be assessed by looking at a chart of the VIX (the volatility index from the Chicago Board Options Exchange) at any given time on most charting programs. The VIX has traded in an average range between 20 and 35 since 1997. Prior to that, the range was much lower, characteristic of the economic conditions of the underlying markets. (The VIX will have undergone changes after this column goes to press that better reflect market sentiment. The true range of 20/35 may vary slightly relative to the new formulas used to calculate the VIX.)

To put it simply, when the overall market volatility is high, you should consider strategies involving time spreads, in which you would profit from a trade in the shortest amount of time decay possible (as in credit, calendar, and butterfly spreads). Since implied volatility is a component of time value in an option, when it is high, the time values of options increase. When it's low, there's very little time value to consider, in which case you would probably want to consider purchasing options either as calls and puts or debit spreads, straddles, and strangles. It might be helpful to construct a matrix of strategies to refer to as you begin the learning curve of the various options strategies. Using Figure 1 as an example, you could expand the list as you learn new strategies and master them.

Figure 1: Options strategies. Compile a list of different strategies to use under various market conditions.

MUTUAL FUNDS AND ETFS

I have a self-directed Ira that allows me to trade options in my account, but I've been beaten up quite badly with mutual funds in the last couple of years, since I can't buy puts on them for protection. Is there a way I can protect myself with options on these types of investments?

Mutual funds work much like stock indexes, in that they both contain a varied mix of equities intended to minimize the risk through a diversified portfolio. The problem with mutual funds, as you mentioned, is that there are no options available on them. However, there are stocks known as exchange-traded funds (ETFs) that not only track indexes, as many mutual funds do, but are optionable as well. Otherwise known as tracking stocks, these equities are popular tools in today's trading environment.

The most popular ETF traded today is QQQ (also known as "the Qs"), which tracks the Nasdaq 100 at a price of exactly 1/40 of the index. This issue is one of the most liquid stocks traded in the US stock market on a daily basis, and on most days has the highest volume as well. Not only are options available, but the strikes are in $1 increments, rather than $2.5, $5, and so on, as on most stocks. The options are extremely liquid, which lends them to small bid/ask spreads, often as small as five cents.

One effective strategy you can implement with an ETF to predetermine your maximum downside risk (so as not to be surprised ever again!) is to construct what is known as a married put (also a synthetic call). Since we're on the subject of the Qs, we'll use it in a hypothetical situation. Suppose you bought 100 shares of QQQ at $30 and on September 16, 2003, you're looking at a tidy profit with the stock closing at $34.26. You have a nice profit of $426, but still think that the market has some upside potential. Instead of selling the shares, you could limit your losses simply by purchasing a put on the QQQ that expires beyond the date by which you feel the market could tank, perhaps in January 2004. On September 16, the Jan 04 $35 put is $2.55, or $255 per contract.

So what's the risk? Since the put is 74 cents in-the-money, simply subtract that amount from the cost of the put and the net is your risk; in this case, $2.55-$0.76 = $1.79. By purchasing this put, you have absolutely guaranteed that you cannot lose any more than 5% of the current stock price before Jan 04 expiration. In addition, you won't get wiggled out of the trade prematurely as you might were you just holding onto the stock.

There are plenty of ETFs available other than the Qs. Some others include DIA (the "diamonds," which track the Dow 30 industrials), iShares, and Holdrs. Many are not only available with options, but also have a European-style settlement; this allows you to sell options without the risk of unexpected early assignment.

Return to November 2003 Contents

Originally published in the November 2003 issue of Technical Analysis of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2003, Technical Analysis, Inc.