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.
A SMARTER CALL TO SELL?
With a long call, what would be the best time to sell? I know that directionally, the higher a stock goes up the more the call stands to profit as it goes further in-the-money. But if a call went from out-of-the money toward being at-the-money, doesn’t it put the option at more risk because of time decay?
Knowing when the best time to sell is something all option traders strive for. Unfortunately, there is no one universal rule that we can work as simply as a light switch in order to capture the best guaranteed results. Traders look to understand the greeks of a position and work with them as effectively as they can while taking unique risk tolerance levels into consideration.
In holding a long call, the trader is working with the risks (and rewards) associated with a long delta, negative theta, positive vega, long gamma, and then a distant rho factor. Where an option is in its life cycle is going to influence your concern with potential time decay — that is, the negative theta component of the position. The closer you are to expiration while holding an at-the-money contract, the greater the exposure to this risk. The longer out we go, concern regarding time decay will be a distant third to delta and vega risks.
As a rule, with 30 calendar days left in a call’s or put’s life is when traders holding this type of premium should give consideration to decay and hedging the option. Some traders may challenge that if there’s sufficient technical evidence for accepting the increased theta risk. While Optionetics stresses not underestimating theta’s impact on a long option during this stage and the importance of hedging, gamma and delta can be increasingly productive greeks over this same period.
If the underlying stock cooperates with the trader’s expectations of a bullish move (for a long call), the at-risk extrinsic value of an at-the-money call is replaced by intrinsic value that isn’t affected by time decay. As stated, decay is heaviest during the last trading month, but it also takes smaller upward movement in the underlying for profits to grow. The fact is, decay risk can be quickly replaced by larger profits as gamma and delta work together to make the option react like a long stock equivalent as expiration approaches if shares move favorably.
A VIX’ING QUESTION
How can calls in the volatility index (Vix) sometimes trade at an intrinsic discount to the underlying instrument? My stomach tells me there’s no free lunch on Wall Street, but is this the sort of thing that might be sampled profitably with a long call position?
Let’s start off by saying the Cboe Volatility Index reflects a composite weighting of implied volatility using Standard & Poor’s 500 front and near-term contracts in order to yield a 30-day measure of expected volatility in the broader market.
The options on the Vix are actually derivatives of derivatives or second derivatives and maintain European-style exercise — that is, you can’t exercise prior to expiration, cash based and priced off futures contracts, not the “Vix” you see on the financial news or the ticker you might pull up on your trading platform.
While keeping all that in mind, also appreciate that the Vix is a mean-reverting instrument. This simply means that while the instrument can, under severe circumstances, stretch to historical highs such as in late 2008 and 2009, it won’t continue to trend higher. That’s different from a favored stock or sector that might trend unabated for an incredibly long period.
By the same token but under opposite market conditions, the Vix won’t go to zero. As long as there is trading in the broader market, some type of volatility will exist. Prices can get incredibly cheap on a historical basis such as the sub-10% levels reached in 2005 and 2006 due to much lesser underlying volatility in the market. Again, that type of trend can last only so long before some unforeseen catalyst jars the market and the Vix in the other direction.
If you see a Vix option that appears to be trading for less than intrinsic value, it’s not; there’s no arbitrage opportunity. Bottom line: Know which futures contract is tied to the contract. To use an analogy that makes a lot of sense, realize that just because a (rare) snowstorm might hit Georgia in January, don’t think buying a February ski package to Atlanta is going to be worth the price.
AN UNSURE HEDGE
Recently, I was considering a bull call spread in front of an earnings report. I wanted to have a hedged position but was concerned about assignment. What would have been the consequences if this had happened?
Do you mean, “What would your ‘options’ have been”? Seriously, though, assignment in such a situation is nothing to be afraid of. A trader assigned on a bull call spread prior to expiration enjoys the benefit of maximizing the spread’s profit potential earlier than they would otherwise be able to while holding the bonus teaser of a synthetic long put.
Remember, an assignment like this obligates you to sell stock at a strike above your purchased lower strike call. If you decided to exercise that call, your profit would be the difference between the strikes minus the initial debit paid for the vertical. As that amount is guaranteed, traders lucky enough to find themselves in this position will look at the long call market to see if a sale above intrinsic value is possible.
Alternatively, the trader may opt to hold the new hedged, synthetic long put position if they have the margin to do so. If shares were to collapse below the held strike, the result could be much larger profits than the one guaranteed due to the assignment.
Contributing analysis by senior Optionetics strategist Chris Tyler