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.
“SPLITTING” HEADACHE
Can you please explain how a 3-for-2 stock split affects the pricing of options? I saw a split of this type and couldn’t get my head around the math.
Great question. Before we jump into this complicated kind of split, though, let’s begin with the typical 2-for-1 so readers not familiar with the basic mechanics can get up to speed. The 2-for-1 split involves adjusting the old strike price and presplit option premium in half. Also critical, the amount of contracts held long or short will be doubled.
This adjustment process allows the aggregate market value or cost basis of the position to be maintained relative to the value of the position prior to the split. We need to multiply the adjusted contracts by the new premium, which has been reduced by 50% (with shares flat) to compare and confirm the risk and cost basis of the pre- and postsplit positions are the same.
In dealing with a 3-for-2 split or any split where “1” isn’t the denominator, traders need to approach the option differently in order to confirm the cost basis is still the same. In these situations, we need to use a nonstandard “hidden” multiplier other than the typical $1.00 per contract = $100.
The reason for this new step is that with an odd split, the new contract count could involve a nonwhole number. For instance, three contracts prior to a 3-for-2 split would result in a position of 4.50 contracts ((3/2) x 3) postsplit. That dilemma is why the multiplier comes into play.
In this instance and dividing 3 by 2, the nonstandard (and hidden) multiplier is 1.50 or $150 per $1.00 in option premium, while the amount of contracts held remains the same. Thus, to arrive at our cost basis for the 3-for-2 split the formula, contracts held (unchanged) x new premium (old price/1.50) x 1.50 multiplier can be used to get rid of that “splitting” headache.
WEIGHING IN ON VOLATILITY
Which is more important when determining an option’s attractiveness, statistical volatility or implied volatility?
Instead of determining whether statistical or implied volatility is the stronger consideration in valuing an option, I think it’s a good policy to look at both volatility types individually and their past relationship to one another to assess the situation with more authority.
Statistical volatility or “SV,” also called historical volatility, measures the movements of the underlying stock or instrument over different time frames. It’s expressed in percentage terms based on a confidence level of one standard deviation. Traders can look at a current reading such as the popular longer-term 100-day SV and compare it to how it’s moved in the past by pulling up a price history chart. Are prices — that is, SV low — relative to what’s occurred in the past? Is SV trading high or are current levels mostly fair based on the historical evidence we’re examining?
Implied volatility, or “IV,” is the going market price for an option and is also expressed in percentage terms. The prices being paid are a reflection of traders’ expectations for future volatility over the remaining life of the contract. Again and with most any option platform, traders can pull up a past history of how calls and puts have been priced and where current levels are in relation to that range. Doing so allows us to ask the same sort of questions posed regarding statistical volatility.
There is also the relationship of how implieds might trade relative to statistical volatility. Option prices, much like a stock, can maintain a personality. For instance, trader expectations in some stocks seem to consistently keep a bid in the implieds above statistical readings in anticipation of stronger future volatility and overall demand for protective long premium strategies.
A rare occurrence in this type of stock would be a situation where the options are priced below theoretical fair value and possibly add some extra hidden value. Net to perform a more confident analysis of an option’s pricing, giving both statistical and implied volatility their dues, is a good policy rather than choosing one over the other.
SPREAD COMPARISON
I’m fairly new to options and noticed the risk graph of a longtime spread versus a long butterfly look very similar. It seems like I should establish the spread with the stronger risk/reward profile, but if that were the case, who would want to take the other side of this trade?
You’re correct in that the risk graph of the long butterfly and longtime or long calendar spread both have the “pointy hat” look to them. The maximum profit of each strategy is realized at expiration if the stock is at the strike containing the short or sold contracts. However, the strategies are two different animals in design, and here’s why “the other side” exists and is willing to take the perceived less attractive spread.
What isn’t accounted for in the risk graph is the calendar spread involves two expirations, which makes its greeks different from the butterfly. The risk profile reflects the position based on the expiring short front-month contract. But in working across contract months, the long calendar spread involves long vega or volatility risk. Thus, if implieds increase by the time the first short contract expires, the position’s maximum profit potential can be larger than determined initially and vice versa if implieds drop.
Alternatively, the risk profile for the butterfly isn’t subject to vega risk at expiration. If shares are at the sold strike, the trader will be looking at profits that will match the initial risk graph, minus any associated slippage that might occur when closing the spread. Finally, there is the other longer-dated contract to consider with the calendar. As the front month expires or is closed, the long call can still be maintained and/or adjusted.
Contributing analysis by senior Optionetics strategist Chris Tyler.