June 13th, 2014
Online Trading Academy Article of the Week
by Russ Allen, Online Trading Academy Instructor
One of the unique qualities of options is their versatility. A great part of this lies in the possibility of combining multiple options into a position to suit a particular purpose. It’s almost like combining two elements into a new molecule that is different from its components. Combine an atom of Sodium with one of Chlorine and voila – a molecule of table salt. We can use options to do similar things.
In any option position, one (or sometimes more) of the component options is the “anchor” of the position. This is the one that we’re counting on to make money for us. The anchor is one of the four “cardinal” positions, so to speak, of the option world: Long calls (bullish), short calls (bearish), long puts (bearish) or short puts (bullish).
If we are bullish on the price of the underlying stock (we believe it will go up), then we do a bullish trade – long calls or short puts. If we are bearish, we do the opposite – long puts or short calls. If we are neither bullish nor bearish, then we can bet on the stock to stay in a range, in which case we will have both an anti-bullish anchor and an anti-bearish anchor.
Whatever option we choose for our anchor, it may have some undesirable characteristics, based on current market conditions. These can be tamed by adding additional options to offset them.
We know that option prices are always careening from a state of being under priced to a state of being overpriced and back again. In options lingo, the “implied volatility” of the stock is constantly swinging back and forth between low and high values. This is separate from the changes in option prices caused by the current price movement of the stock; it represents a change in expectations among option traders about future movement of the stock.
When little movement is expected, then implied volatility (IV) is low, options are cheap, and they can be a good value. When they are expensive, we are better off selling them. In either case, the common option mood swings can be used to advantage.
For example: Say we are bullish on a stock, and would like to buy call options. We reckon that these will increase in price if the stock rises, and will give us a leveraged payoff if we are right. But currently the stock’s options are only moderately cheap. The crowd’s mood could shift either way.
In this case the calls that we are considering buying have one undesirable characteristic: they give us a large exposure to unfavorable changes in implied volatility. It is moderately low, but not extremely low. If it rises, that will help us, inflating the value of our calls. But if implied volatility falls (just another way of saying that people decide that they’re not so excited about the options after all and aren’t willing to pay as much for them,) then our calls could deflate further. This will partly, or maybe even completely, offset any gains from the upward price movement of the stock. Nothing causes a new option trader more consternation than to buy an option, see the stock go his way, and then discover that he has lost money on the option.
We can make this less likely by changing our position so that it will be affected less by an unfavorable change in IV. With the impact of volatility muted, we will then have a “purer” play on the price of the stock itself, which is our goal.
We could accomplish this by selling another call option, at a higher strike price. This call would counteract, to some degree, all of the effects of the original one. By choosing the combination properly, we can get the result we want.
Here is an example. On June 5, BHP Billiton (BHP) was at a demand zone (support level) around $67. Its implied volatility at that time was 21.37%. The range of volatility over the past 52 weeks had been from 13.23% to 34.31%. Here is the chart. The indicator at the bottom is an Online Trading Academy proprietary study that evaluates the current level of IV as low, medium or high:
The current IV reading of 21.37% was on the low side, but not at the bottom of the range. The options were Penney’s-cheap, but not Costco-cheap. If we just bought, say the 65 calls as our anchor unit, and BHP went higher, we would probably make money. But if that price increase was accompanied by a drop in IV, then the $65 calls would increase less.
We could improve our chances by simultaneously selling another call at a higher strike. There was a supply level at around $72. If we sold a call above that with a strike price at $75 as our offset unit, then that short call would counteract some of the impact of volatility changes.
But would we not just be betting against ourselves? Not really. If BHP increased in price and hit our $72 target, our long $65 calls would increase in value far more than our short $75 calls, and we would have a big profit. And whatever happened to BHP, our cost in this trade would be less.
Below is a section of the November option chain for BHP:
Note that the 65 calls could be bought for $4.90 or less (probably around $4.75, roughly halfway between the $4.65 Bid and the $4.90 Ask). The 75 calls could be sold for around $.95. Since the short 75 calls would be covered by the long 65 calls, no additional buying power (margin) would be required. Our net out-of-pocket cost would be $475-95 = $385 per contract. That $95 reduction in cost would go right to the bottom line.
Also note the column labeled Vega. This has a reading of .1645 for the 65 calls that we are buying. This means that if Implied Volatility decreased by one percentage point, the value of the 65 call would drop by $.1645 per share, or $16.45 per contract. This is what we would like to avoid.
The 75 call has a Vega reading of .1367. By selling that contract, the Vega of our position as a whole has been decreased to .1645 – .1367, or just .0278. A drop in IV now impacts us much less.
This reduction in volatility exposure is not free. Not only Vega, but all effects are partly offset by the short option. Notice that the Delta of our long option is .6804. It will gain $.68 for the next $1 increase in BHP. The Delta of the 75 option is .2212. It will gain $.22 for that next $1 gain in BHP, and that $.22 comes out of our pocket, since we are short that option. This reduces our net gain to $.68 minus $ .22 = $.43. But this 43-cent gain is on an investment that is less as well. On the whole, it is most likely that the spread will be the better bet.
That’s all we have space for today. Next time we’ll talk more about anchors and offsets.