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

CURBING LOSSES

I understand that options can provide less risk than stocks since the capital outlay is much smaller, but when the underlying moves against you, options tend to lose money more quickly. Is there any way to curb the rate of these losses so as not to get stopped out so quickly?

This question is actually a two-parter. First, let's address the assumption that the losses occur more quickly. This is actually a fallacy, in part because of the leveraged nature of options. Since the purchase of one option contract that controls 100 shares of the underlying can cost far less than the stock itself, inexperienced traders assume this simply frees up more capital to purchase many more option contracts. (The typical train of thought goes something like this: Stock XYZ is trading at $60, but a 50 call is trading at $5. Why spend $6,000 on 100 shares when you can spend the same amount on 12 of the 50 contracts and control 1,200 shares?) The problem with this philosophy is that it doesn't truly represent the conservative nature of options as a means of emulating the same profit curve as their stock equivalent. This can lead to devastating losses very quickly.

If a trader wishes to buy 100 shares of a $25 stock, that purchase will cost $2,500. However, an at-the-money 25 call may cost $2 (or a net investment of $200). On average, two at-the-money calls will have a combined delta of 100, or the same as 100 shares of stock (delta is the dollar amount that an option will increase in value for each $1 move in the stock). So the question is whether the two calls at $400, with the same profitability as the stock at the onset of the trade, are riskier than the $2,500 invested in the stock itself. If the stock were to drop to $20 overnight, you would lose $500 in the stock position; however, you only stand to lose the $400 invested in the option position. Granted, you will lose 100% of your options investment and only 20% of the stock position, but we need to compare apples to apples here.

That brings me to the second part of the question -- how to slow down those losses. As far as curbing the losses goes, you can make some simple adjustments to keep from losing your entire debit in a long position and still maintain less risk than the original stock position. With options, if your long position moves against you, the first question you should ask yourself is whether there is something you can sell against your position to take back some of the original debit and thus reduce the cost of the trade.

In most cases, if losses begin to occur, a trader could simply hedge his long position by selling another call with a higher strike with the same expiration month. This reduces the cost of the original debit safely, with no additional risk whatsoever. That's one idea. However, if you experience an overnight drop like our previous example, provided your analysis is now bearish and there's nothing left to sell above the strike you bought, you may be able to sell a call with a lower strike price than the long as well. By selling a lower strike (most likely with the same expiration, but it doesn't have to be), you can take in much more premium than the long option is now worth. However, you will now be at risk for the margin requirements of the new position. The margin would be the difference between the option bought and the option sold, plus the remaining amount of premium in the long position less the premium taken in for the short sale.

Continuing with the same example, suppose the short strike is 22.50, which we sell for $1.00. All that we have left to sell in each long position is 25 cents. Our net risk at this point is 2.50 - 1 + 0.25 = 1.75 per spread ($350 total for our example). So, in addition to the $400 in the original trade, we could lose another $350 for a total of $750. Though we've added risk to this position, this adjustment is still a lot less risky than possibly losing more than that amount from a stock purchase. However, should the stock stay under 22.50 at expiration, you keep that 75 cents and lose only $250 on the trade.

TAXES AND PROFITS

I have a long position on a stock with a large gain that I'd like to defer paying taxes on until next year. Is there anything I can do with options that will allow me to hang onto the stock until then while simultaneously locking in the profits?

Absolutely. The easiest thing to do would be to buy a deep in-the-money put on the stock that expires in January. The put should have very little time value so as to preserve virtually all of the gains on the stock. Using CSCO as an example, on December 10, 2003, the stock was trading at $23.80. Suppose you wanted to lock in your gains at that point and defer. You could go out and purchase a January (2004) 27.50 put for 3.90. Since the put is 3.70 in-the-money, only 20 cents of time value remains in the position. CSCO can oscillate back and forth all it wants until January, and you could never lose any more than the additional 20 cents invested in the time premium. Should CSCO fall $2, your put gains the same $2.


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Originally published in the February 2004 issue of Technical Analysis of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2004, Technical Analysis, Inc.