Option Characteristics (5)

In the option world, a seller of an option is considered to be short the option.  This based on the criteria that an investor is short if he started a transaction by selling, rather than buying an option.  An option buyer is considered to be long the option purchased.  This tracks the same terminology used with respect to being short and long a particular stock in equities.

You may now be wondering what happens at expiration to the option buyer or seller.

Assignment occurs when an option holder who has decided he wants to own the underlying, exercises his option by notifying his broker accordingly.  That broker then advises the Options Clearing Corporation or OCC of their customer’s instruction to exercise.  The OCC then randomly selects a clearing firm member having at least one customer who was short the same option contract against whom exercise will be made. The OCC then notifies the firm. The firm then carries out its clearinghouse obligation by also randomly selecting a customer, on an equitable basis, who was short the option, for assignment.  The selected customer is assigned the exercise requiring him to fulfill the obligation agreed to when he wrote the option, that is, the obligation to deliver the appropriate number of shares.

In some instances, a call or put you wrote will not be assigned via the above stated process when an option holder expressly decides to exercise even though the option is slightly in-the-money.  For example, at market close on expiration Friday last week, a call option I wrote was 11¢ in-the-money.  In the past, such options would expire automatically because there were less holders who wanted to exercise from amongst all the call options that had been written or sold on the strike price and expiration date.  Under current exchange rules, since the broker and exchange can still profit even though the in-the-money options are only narrowly on the plus side, these non-exercised options are  “automatically” assigned when they are a certain amount in the money at expiration.

That difference was once 5¢.  It’s now down to 1¢.  While each firm may have their own threshold, the Option Clearing Corporation’s (OCC) automatic exercise threshold is 1¢.  Option sellers should check with their broker to determine the broker’s policy regarding exercise thresholds to avoid surprises.  It’s likely your broker will follow the OCC’s automatic exercise threshold.

Keep in mind that an option holder has the right to exercise their option regardless of the price of the underlying security. It might be a good practice for all option holders to express their exercise - or non-exercise - instructions to their broker. Is there a magic number that ensures that option writers will not be assigned?  The answer is “No, not any longer.” Although unlikely, an investor may choose to exercise a slightly out of the money option or choose not to exercise an option that is in the money by greater than 1 cent (.01).

Some investors follow the option trading proverb, “when in doubt, close them out.”  This means that if they buy back any short options they are no longer at risk of being assigned.  Since you pay a commission (small) to close out a position and don’t pay when the option is left to expire, it seems counter-intuitive to close out a position.  However, closing out an option that is very close to the strike price, say a week or even a few days prior to expiration means you can sell those options again and capture a slightly increased time value.  If the option I sold is at risk of being assigned, I simply wait to expiration, as do most other option sellers.

For example, assume I sold an option on the Feb 95 IBM calls.  It was clear to me with about a week to go until expiration that even though the stock was not likely to reach 95 and there was little risk of being assigned if I didn’t close out my position by buying back the now very cheaply priced call option (almost no time value and fairly far out-of-the money) I had sold.  This allows me to sell another call option and capture an additional 5 or 10 days of time value in the price of the premium I’ll receive.  The considerations are the same and this approach works the same way for puts.

In the next option education installment, I’ll cover option symbols, some basic option tools and option brokers.  After that, the discussion will shift the mechanics of how options are bought and sold online, some basic option tools (a little technical analysis here) and strategies, covered calls, how options can best be used by conservative investors, a few miscellaneous items and my own approach to fun, games and profits in the world of options.

And remember, you are free to ask questions at any time.

Saul…

Hi Mike,

Thanks for your question.  I have a couple of observations and references for you to read that may help with respect to your question. I personally don't know the answer to your question although it seems to be lurking in the Forbes article cited below.

This is all brought out and then some in the Forbes April 2008 article found at

http://www.forbes.com/2008/04/07/black-scholes-options-oped-cx_ptp_0408black.html

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 "For instance, deep out-of-the-money puts are priced with a higher implied volatility (say, 40%) than at-the-money puts, which may show an implied volatility of, say, 23%.

The whole idea is to obtain a dearer price for puts with extreme strikes (since market crises happen quite often), and to do that, you have to manipulate Black-Scholes. If I want a more expensive option, all I have to do is to very conveniently increase its volatility number--for instance, from 23% (which may be the real volatility expectation) to 40%."

Here's another quote from the same article that describes the manner in which options are priced in the trenches and not in academia. "There are two main reasons why Black-Scholes is, frankly, not used. First, option prices (at least for liquid contracts) may be simply the result of supply-demand interaction, with no model involved at all. As Taleb and Haug show, options often are priced via other options, through a simple conduit known as put-call parity, which allows a trader or investor to derive the price of a call from a put and vice versa. No fancy mathematical modeling, no partial differential equations required."

You may also be interested in another article on Black-Sholes by Michael Lewis.  He is the author of several successful non-fiction books including Liar's Poker, Moneyball: The Art of Winning an Unfair Game and The Blind Side: Evolution of a Game.  The article can be found at






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http://www.portfolio.com/news-markets/national-news/portfolio/2008/02/19/Black-Scholes-Pricing-Model?print=true 

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Hi Karen.

Glad to read that you're enjoying the workshop.

Your question about the difference in open interest for PFE calls and puts is well taken and shows you're thinking about what the option chain shows rather than just accepting what is put in front of you.

I think you're correct about the meaning of an inbalance between the number of calls and puts, that more calls signifies investors are bullish and more puts show a bearish tilt. However, note that what is an inbalance at one strike price may go in the opposite direction at another strike price.  For example, see the attached chain for LOW's July options where puts at a 20 strike price outnumber calls while calls at the 22.50 strike price far outnumber puts at this price level.  In other words, option traders are more confident LOW will hit or exceed 20 by July 17th and much less confident the price will get to 22.50 by expiration.  Inexplicably, at least to me, this reverses again at the 25 strike price.  Thus, I don't believe you can extrapolate what investors think about the overall prospects of PFE or LOW based on calls and puts at a given strike price.

Open interest does have some believers for other purposes.  Many think a change in open interest, usually a significant shift in calls or puts, signals a change in trend of the underlying or that a lack of change in open interest signals no trend change.  I don't pay much attention to open interest myself in the type of option trading I do except to note for purposes of gauging liquidity if it's large or small.  

Investopedia has a good article on the subject of open interest; see






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http://www.investopedia.com/articles/optioninvestor/04/060904.asp?viewed=1

Saul...

Option Characteristics (7)

You will recall I previously mentioned several factors that affect an option’s premium.  For either a call or put, we’re interested in the underlying stock’s price, the strike price of the option, the time until expiration, the volatility of the underlying stock, the risk free rate of interest and dividends payable.  Since these factors affect option pricing, we need a way to get a handle on how changes in one factor can effect changes in another factor and how quickly that happens.

This is the province of the famous option “Greeks.”  The Greeks are simply the names of measurements of relative movements in option prices with respect to changes in the several factors set forth above.  An understanding of what the Greeks tell us will create insights with respect to options that will definitely help you when you trade options.

There are several relationships among option factors that are defined by the Greeks.  Many option traders place a fair amount of emphasis on the Greeks and while such focus is worthwhile, there are as many, if not more, option traders who concentrate on other option characteristics.  For the conservative options trader point of view, I think it best to confine ourselves to the big four; delta, gamma, theta and vega.  Let’s take a look at what these Greeks tell us.

Delta measures the change in option price relative to a change in the price of the underlying.  It gives us the probability of an option finishing in-the-money.  Call option deltas range from a value of 1.0 to -1.00.  An at-the-money option has approximately a 50 delta and therefore a 50% possibility of becoming in-the-money at expiration.  For a call, this means a delta of 0.5; for a put, the delta is -0.5.   Thus, we would seek call options with higher deltas, closer to 1.0, and put options with lower deltas, closer to -1.0.  Note that these are probabilities, not certainties and that you can be profitable, although it may be less likely, buying and selling options with deltas that are below 0.5 and -0.5.

Gamma measures the change in delta relative to a change in the underlying’s price.  In other words, it measures the change in delta for every 1 point change in the price of the underlying stock.  Gammas for options that are further out in time (to expiration) will have a lower value than gammas for options that are closer to expiration because deltas for options with shorter maturities are more certain in terms of whether a closer in option will expire in or out-of-the money.

Theta measures the sensitivity of the option premium or price with respect to the time remaining to expiration.  Alternatively stated, theta measures time decay or the reduction in daily premium value as an option gets closer to expiration.  Time decay is fastest in the last 30 or so days prior to expiration and when an option is at-the-money. 

If your strategy moves you to buy an option, it is to your advantage to purchase longer-term contracts with their lower thetas.  Of course, the premium for such options will be higher although initially more cost effective when time decay is slower.  If you adopt a strategy that profits from time decay, then you will want to sell or write shorter-term options, when time decay is relatively rapid.  Thus, if I’m selling calls, I would tend to seek out call options that are within a month or so of expiration because that’s how I can maximize the advantage I’ll get from time decay. 

And then we come to vega which reflects historical volatility and measures the sensitivity of option price to changes in volatility of the underlying asset.  In general, the further an option is from expiration, the higher its value of vega will be.   The greater the volatility, the greater the risk and the higher premiums will be because of the volatility factor.  When vega is positive for an option, it suggests that increasing volatility is in our favor.  When vega is negative, it suggests the opposite, that volatility is not favorable for us as an option holder. 

 An excellent article that explains the Greeks can be found at Investopedia; see http://www.investopedia....tor/04/121604.asp.  As this article points out, you need to appreciate that the numbers given for each of the Greeks are theoretical.  They are projected from mathematical models and change over time.  Moreover, the Greeks cannot simply be looked up in a table such as an option chain.  They need to be calculated on a current basis.  To get up-to-date values for the Greeks, you’ll need access to a software package with data feed that calculates them for you.  All of the best commercial options-analysis packages will do this, but it’s not cheap.  Alternatively, your options broker will have such a tool available on its web site for your use as a customer.

Now, after you’ve struggled through this material on the Greeks, please be comforted by the fact that many option traders don’t get very involved with the Greeks and definitely don’t obsess over them.   I use the Greeks, but in moderation and more often than not to help me make a choice of which option I want to buy or sell from among two or more candidates.  The Greeks can definitely be your friend, but as with all meaningful friendships, the relationship is probably best developed over time.

Next, an easy to use broker’s tool for calculating the Greeks.

Saul…

Selling Call Options

Assume you are convinced that a specific company’s stock is about to sag or even drop significantly. You don’t want to short the stock itself, so what can you do to act on your bearish conviction?  You can simply sell a call option, which is also called writing a call. 

When you sell or short the call option, you take on an obligation to buy 100 shares of the underlying at the strike price from the call owner before the option expires should the owner exercise.  You are paid the option premium when you sell a call and you get to keep the premium whether or not the call you sold ends up in the money or expires worthless.  If your conclusion is correct, you’re home free, the option will expire worthless and exercise will not occur. 

However, if the call you sold expires in the money, usually by being more than 1¢ above the strike price per your broker’s rules, the call will be exercised and as the call seller you must deliver 100 shares of the underlying to the exercising party through your broker.  If the call was sold by an options trader who doesn’t own any shares in the underlying or owns less than what he’s obligated to deliver, the option seller has to go into the marketplace and buy enough shares to cover his total obligation.  If the shares have significantly appreciated in value above the strike price, this will be a very expensive obligation to satisfy.  Selling a call without owning shares in the underlying is called selling or writing a naked call since you are not covered or lack ownership of the underlying shares.

A short call theoretically gives the seller virtually unlimited risk in exchange for the premium.  If that’s the case, why would a seller want to engage in this practice.  For one thing, selling a call often looks like easy money to many option traders.  They don’t buy the underlying because they want to conserve capital, are willing to take the risk that the underlying shares will drop in value or assume they can close out their option trade by buying back the call they sold before it gets too expensive to do so. 

Keep in mind that the call seller’s broker will require sufficient funds in the seller’s account to cover the risk and cost of being exercised on a naked call so it’s hard for the call seller to hide.  Margin calls are usually a fact of life for naked call sellers who, therefore, have to be very nimble and very right with their assumptions about the prospects of the underlying company.

As is the case for a call buyer, the call seller has to be correct on both the drop in value of the underlying and the time in which that drop will be achieved.  Unlike the call buyer, however, the call seller can lose much more than the premium involved so selling naked calls is not for the option newcomer or the conservative investor.  In fact, I believe that there’s little justification for any investor to sell naked calls.   For me, the risk reward ratio of a naked call simply doesn’t compute. 

But some investors will want to sell calls, on a naked basis or as part of a more complex option scenario.  Let’s address the call selling part of that possibility by taking a look at a couple of  examples for two stocks that we believe will drop in value over the next several months.  There’s no shortage of candidates for this dubious honor, but considering the downside risk of selling naked calls I did try to focus on two companies that are still priced relatively high and have poor future prospects by my standards.  Here are my two examples with prices based on yesterday’s close.

Let’s say I think that Cognizant Technology Solutions (CTSH) and FactSet Research Systems (FDS), who respectively provide services in the information technologies and financial communities, will drop in price as demand by their customers sags over the next several months, if not longer.  The reported loss of almost 700,000 U.S. jobs in February strongly suggest that recovery is not close so selling these calls doesn’t seem to be all that much of a risk.  The use of CTSH and FDS, as examples in this workshop, are for educational purposes only and are not recommendations to buy, hold or sell these stocks or options on these stocks.

CTSH closed yesterday at $17.98.  The July 20 calls will provide a premium of around $1.85 or $185 per option contract for a holding period of just over 140 days total.  While I may need funds in my account to satisfy any future obligation to deliver the 100 shares of CTSG, I can let the money draw interest while it sits in my account or buy shares in other companies that I think have better prospects.  All I need do is collect the premium and wait until expiration for the option to expire if I’m correct in my prognosis for CTSH.  Further, if this stock significantly drops in value before July 17th, I can buy back the option I sold at a now much reduced option premium to close out the trade and look for opportunities to sell other calls.  There is value in selling naked call options on CTSH despite the obvious risk, although I don’t choose to do so or recommend the practice.

How will FDS fare under a like scenario?  Well, FDS closed yesterday at $36.23.  The June 40 call options on FDS sold at around $3.60 or $360 per option contract for a holding period of just over 110 days total.  Again, I’ll need funds in my account to accommodate a future exercise, but as an options speculator I’m prepared for that and willing to accept the risk of a rise in price above $40 a share.  That’s a comfortable safety margin and I’m prepared to take the chance that FDS will not rocket above the strike price.

As with the purchase of call options in Monday’s workshop posting, I’ll enter orders to sell these call options at limit prices, but not before 10:30 or 11:00 a.m.  I wait until after what’s called amateur hour so can get a look at how things are going and see if the market moved up or down.  Since the market is likely to have moved, my premiums will be higher or lower and I may decide, based on how much the share price of these two stocks changed, to withhold my order, change it to a different strike price or move to a different expiration date.  If I entered my order too early, I can be filled before I get a chance to evaluate the market and the underlying stocks this morning and I don’t want to have that happen. 

As with stocks, most option educators recommend spreading risk among several rather than just one or two opportunities.  In this example, I spoke about two stocks and I’ll likely decide to write 2 calls on each stock rather than 4 calls on either CTSH or FDS.  I’m aware that the FDS calls pay a better premium and that selling 4 of these calls would be better on an income basis than selling calls on CTSH.  However, diversification works for the investor in the options market as it does in the equity market and it’s a good approach to keep in mind.  Better yet, it applies to just about all options strategies and situations and in this case permits me to spread the risk in case I decide to write all my options in this instance on a single stock that then moves against me.

Next, the covered call.

Saul…

The Covered Call (2)

As previously discussed, the covered call is a straightforward strategy that seeks to generate income and simultaneously limit risk below that of a naked call option.  Since the naked call can result in a sizeable loss should the underlying experience a rapid rise in price, owning the underlying stock avoids the need to buy shares at inflted levels.  In turn, by writing a covered call, you give up all profits beyond the strike price in exchange for taking a lot of risk out of the trade.  However, a covered call is not risk free.  The risk remaining in a covered call is that the underlying will fall in price, below your break-even level.  While the covered call option will expire worthless, and you do get to keep the premium, you’ll be left holding the now price depressed underlying stock.

Of course, you’re not locked in and can simply sell the stock at a loss and move on or try to repair the position by taking other steps to get back some of the loss, which strategy will be touched on in a later installment of this workshop.  However, when you're going for income, even modest losses can severely damage performance, so it’s a good thing to limit any loss in every reasonable way.  It is important to note that you can avoid or minimize the liklihood of being chained to a swooning stock by insisting on an acceptible level of quality which will hopefully guard against a bad trade. 

I also like to write shorter term covered calls to improve premium flow.   

Thus, I try for near term expiration dates of from one to four months at best, not for 9 months or even longer as I can do with LEAPS.  In other words, the shorter my holding period, the less time I hold the position and the greater my opportunity to write another covered call.  Once an option in a covered call position I have expires worthless I will reassess the underlyingand write another covered call on it or pick another stock for this purpose if the original stock has dropped in quality.

If you look at an options chain for any underlying stock, you will notice that the call premium for an option that is three months away is not three times the premium for an option that is only one month or less away.  The same is true for puts. The rates of time decay are not linear and decay accelerates as the time to expiraton gets shorter.

Let’s examine FDS for an example of this premium characteristic.  FDS was trading at $36.79 when I first typed this message.  This morning, the March 40 call premium for FDS was at $1.33.  The June 40 call premium was $3.13 at the same time.  If I could sell an FDS call three times between now and June, I’d make $4.32 in premiums (3 x 1.33) while I’d only make $3.13 for selling the June 40 call right now.  Yes, I’d have about three times the commissions and I’m not sure I would be able to get the same or a better premium between now and June for the FDS calls I’d be trying to sell, but I think that I’ll come out better in the long run selling call option positions of shorter duration. 

In the final analysis, however, keep in mind what your expected return is and select your option accordingly.  You won’t always be able to get the 4% or 5% you’re seeking, but it’s better to accept a lesser return than to select a lower quality stock or go out too far to expiration.

By the way, the tendency to get better premium results from selling a few shorter options as opposed to a single longer option has to do with the fact, previously noted, that time decay occurs at a faster rate, in fact it deteriorates exponentially, as expiration gets closer, especially in the last month of an option.  This time decay factor is reflected in the often heard advice given to call buyers to sell slightly in, at or out of the money options they have bought once they get within 30 days of expiration.

Another tactic I use in selling covered calls is to pick the strike price closest to the share price of the underlying.  I like to do this because the premium will be higher and I’m content to make less on stock price appreciation in that situation.  Keep in mind that selling a call option near the strike price is a much different tactic than selling a call on an option with the highest premium lacking any concern for the quality of the underlying. The former has merit, the latter is foolhardy.

If the share price of the call you want to sell is in the money, that overage amount will be reflected in the premium you get so there’s no issue about losing money if you’re called at what would be a strike price lower than your purchase price.  Again, since my interest in selling covered calls is to generate income and if I can  avoid longer holding periods and sell more covered calls, I’m happy.  The commission costs are pretty low these days so I try not to let that influence me too often.  At TradeKing, my broker, buying or selling shares is carries a $4.95 commission and options cost me $4.95 plus 65¢ per option contract.  The bottom line is that a possible $12 to $15 in additional commissions should not be a factor if you can add $200 or more to your account each month.

I don’t sell covered calls where the underlying stock is selling below $10.  This is not unique to me and is a recommendation often made by many option traders.  It’s basically a quality based rule since it’s pretty difficult to find a quality stock selling at or below $10.  I also tend not to sell covered calls where the underlying stock is over $50 a share because that sucks up too much capital and limits diversification.  To my way of thinking, 6 covered call positions using $25 stocks is better than 3 positions implemented using $50 stocks.  You get more premiums with $25 stocks and better diversification at the same time.  Lastly, I don’t put more than 17% or so into any one position in my options portfolio.  One limiting factor in this respect is finding enough quality stocks selling around $25 a share under some market conditions.  If that happens, wait for things to improve.  Don’t compromise on quality.!

To recap. Consider selling covered calls

1.  only on quality stocks (as you determine quality),

2.  as close as you need to get to the strike price to maximize premiums,

3.  try to sell covered calls having shorter rather than longer durations, and

4.  on underlying stocks selling between $10 and $50 a share.

Next, some additional covered call thoughts and using covered calls in investment clubs.

Saul…

Sorry, but a work related emergency has left me short of any spare time for the next few days.  I expect to post my next message in this options workshop on Friday.  Thanks for your understanding.

Saul...

Hi Karen,

Are you using Portfolio Manager 5?  PM5 is ideal for all sorts of options transactions, and accurately adjusts cost basis for exercised, assigned, expired, etc. transactions for the underlying security or option itself.  Each option you would write would have a unique symbol, so not sure what you meant by managing your asset library.  Also, once your past options have been closed out, you can clean these old option symbols out of your current asset library by using the 'delete not held' choice.  Does that help?  If not, please let me know.  Also, the PM5 online help feature has an entire chapter devoted to option transactions, how to enter, etc.  That too might be of help for you.  If not, please let me know.

Regards,

Matt Willms, President QUANT IX SOFTWARE

- developers of BetterInvesting Portfolio Manager

Hi Matt, Yes, I am using PM 5 and have read the Options chapter.  I'm sure I'm missing something here however, I'm unable to link the option transaction to the underlying stock.  I had an option assigned - the purchase price was not adjusted, and the only place the option showed up was on the Transaction Report, so I can't use the 'delete - no longer held' as I would not have a record of the transaction.  I will email you privately with a copy of the transaction.  I'm signed up for the tax tracking class tonight - so this may help resolve the issue for me.

Thanks,

Karen OBoyle