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.
COLLAR VARIATION
If I own shares for a growth stock that still looks to have upside potential but I am also concerned about protecting existing gains from corrective action, what can I do in regards to positioning?
If the stock has relatively liquid options listed, you have at least a couple good ones to consider. The simplest means to protect gains while still allowing for further upside in the stock is to purchase a put one-for-one against shares owned. This is called a married put strategy or long synthetic call.
Depending on which strike the trader chooses will determine how much protection is in place and how much the purchased put will eat into potential profit should the stock increase in value. The closer the chosen put is to shares, the more protection the trader has in place to guard against downside exposure.
The downside of using a purchased put? The cost can be prohibitive. On the most basic level, using a married put month after month can become expensive if shares move higher or remain flat and the put goes out worthless. Each put that is bought ultimately eats into the potential return and could wipe out profits altogether if the associated cost is greater than the increase in share price.
A slightly more advanced strategy used to reduce this kind of negative impact associated with portfolio protection is to sell a call at the same time the long put is purchased. This combination of long stock, long put, and short call is called a collar and has the same risk profile as a bull vertical spread.
Finally, if you’re concerned about capping the upside potential of shares and/or your ability to make a timely adjustment to roll up the short call to increase your profit profile as shares move higher, an alternative position might be to use a bear vertical spread in conjunction with the long put.
Shown in Figure 1 is a comparison of a collar versus the married put/bear vertical combination with stock using Nasdaq 100 component Apple (Aapl), which also happens to be a favorite growth stock amid large-cap investors. In both strategies we’ve bought 200 shares just above $300, purchased +2 November 290 puts for protection and sold -2 slightly out-of-the money November 310 calls to finance the position.
Figure 1: aapl Collar vs. Uncapped
Our variation, an “Apple twist” on the collar, is to buy +2 November 320 calls simultaneously in order to “uncap” the maximum profit potential of the regular collar. Whereas an unadjusted collar would underperform if shares continued to rally, we see that once the bear spread’s loss potential maxes out above the highest strike, the position begins to realize additional profits as it maintains the married put — that is, a synthetic long call position to gain additional upside profit exposure.
SHORT CALENDAR
What kind of strategies can I apply with options that can profit through an earnings report when implieds appear expensive but whose underlying shares have a track record of moving strongly in reaction to the news?
If premiums appear inflated in front of a company’s earnings but you believe the stock is likely to make a dramatic move, a bull or bear vertical spread is one solid choice if you maintain a directional bias. Typically, when the tradable is placed near-the-money and/or adjacent strikes are used, the trader removes the bulk of the vega or implied volatility risk — inflated premium, associated with an outright long call or long put position.
Alternatively and under the same circumstances, if a trader is unwilling to commit to a direction in shares, purchasing both a bear and bull vertical to form a long iron condor might be considered. Ideally, if shares move significantly, the trader would find one of the two verticals maxing out by expiration as both legs go in-the-money, while the other spread collapses toward zero but whose associated loss (along with the other vertical) is less than the profit generated from the in-the-money spread.
A third possibility might be a short calendar spread if you’re cleared to trade this position type, market conditions permitting. This reverse calendar maintains positive gamma and short vega, which is an ideal Greek profile for an elevated premium situation in which the stock is expected to move.
The crux with using the short calendar is the relationship between the actual earnings cycle contract that the trader has purchased and the nearby but further-out contract that’s shorted.
This spread will appear on paper to have sold implied volatility at a lower absolute level than the purchased premium. And sometimes, particularly when the front month is facing expiration close to the earnings event, you can expect an exaggerated spread between the implied volatility of the two months. Google (Goog) is a great example of this phenomenon during most earnings cycles like those of October 2010.
To determine whether the designed long gamma/short vega position will produce profits if our expectations for a large move in shares are met, the trader can work with the associated short calendar risk graph and estimate various shifts in the post-report implied volatility skew. This process is the same as it would be for a regular long calendar, but the trader’s objectives are different.
As much as it’s important the trader have a good feel for what the post–earnings implied volatility relationship will look like, it can be drastically different than the one in front of the report. If you’re looking at an earnings report in which soon-to-expire options are involved, make sure to account for the impact of theta or time decay; often enough, its impact in one or two days can dwarf any potential losses tied to vega when factoring in the risk of the long front-month contract.
Contributing analysis by senior Optionetics strategist Chris Tyler.