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.
MANAGED RISK
If I’m trying to manage option position risk to reduce my maximum loss exposure, is it better to tie a stop-loss to the market price of the options or the underlying stock?
Managed stops can be a good tool as they act as an extra layer of portfolio protection beyond our initial and known risk assumption if we’re dealing with a limited risk strategy. The question of exiting with a tighter managed loss based on the underlying share price versus the prevailing option market isn’t as clear-cut. This is largely up to the individual trader and his or her risk acceptance, as well as the strategy being employed.
To illustrate with a simple situation that many traders can appreciate, say you’re bullish on shares technically and initiate an at-the-money long call strategy with less than 30 days until the contract’s expiration. In this position type, you have clearly defined risk based on the number of contracts purchased multiplied by the purchase price.
Going forward and despite shares moving up in price and further confirming your outlook on the stock, you find the passage of time has eroded the value of the option. Unfortunately, the rate and speed of change in the underlying hasn’t countered the option’s theta or time decay risk. In this instance, the trader may find the need to change their stop-loss from being tied to a technical bias to one that commits to the option’s going market price if he or she is committed to managing position risk to something other than the known maximum loss.
A trader who pursues a similar at-the-money long call strategy but decides to position with a longer-term option in an effort to dodge decay risk may nonetheless be faced with a comparable open-loss dilemma. Here, vega or implied volatility risk could reduce the call option’s value beyond the benefit of its delta component.
What if the trader decides to use an at-the-money bull vertical in lieu of a long call in this situation? If we make the assumption of the spread reducing theta and vega risk by a measurable amount compared to the long call strategies, we can see how a technical stop would continue to be effective, whereas either of the long call strategies might fail.
The construction of a vertical spread does present its own challenges. Primarily, traders need to accept that gains and profits are limited and slower to come by if the trader’s technical prognosis is validated, compared to a long call strategy. Finally, traders should check with their brokerage’s rules to find out whether there are limitations on how positions can be closed and/or managed prior to entering.
“INTERESTING” STRATEGY
With interest rates at historic lows and hard-pressed to drop further, what type of option strategy could take advantage of an increase in rates?
Call options, which have positive rho or interest rate risk, are one good way to capture an anticipated increase in rates. A long call acts as a lower-cost means (dollar basis per contract) to holding an equivalent amount of shares. As borrowing costs — that is, interest rates — rise and the cost to hold the larger capital-intensive stock position increases, a long call strategy becomes more attractive.
Because of this relationship, the call price, all else being equal, will increase to reflect its increased worth as an equivalent strategy for holding long stock. In order to take advantage of rho risk in this capacity, a trader needs to position properly. To do this effectively, the time necessary to capture a lift in rates means going out to longer-dated options, quite possibly a Leaps contract. This is due to a call’s rho factor growing larger per point shift in interest rates as one goes out in time.
When it comes to the actual positioning, traders wanting positive rho risk will look to hedge the call with short stock. This has the effect of neutralizing the call’s delta or directional risk while maintaining the required rho risk component.
One potentially large and maybe unintended risk that the trader maintains with this position is long vega risk and negative exposure to lower implied volatility. More important, as an option’s vega component will invariably be larger than its rho factor, capturing rho risk remains secondary to being confident in maintaining a long vega position.
One alternative option, if you’ll pardon the pun, are interest rate–related products that have listed options. One popular vehicle that falls under this category is the iShares Barclays 20-Year Treasury Bond Fund (Tlt).
The Tlt seeks to track the price and yield performance of the Barclays Capital US 20+ Year Treasury Bond Index by investing at least 90% of its assets in the bonds of the underlying and up to 5% of its assets in repos, cash, and cash equivalents.
As the Tlt’s underlying drops in price as rates increase, a trader wishing to position for an increase in rates would look at purchasing a put contract as the purest play. Other positions such as verticals or calendars may deserve consideration if one also has a view on vega risk.
Contributing analysis by senior Optionetics strategist Chris Tyler