Recent Options Q and A
I sure hope all my readers made some good money last week on expiration Friday. Judging by the emails I received, a number of you paper traded based on my article and reported decent results. My opinion of paper trading is that it's better than not trading at all, but it's not nearly as good as putting on small, minimal risk positions. Somehow when real money is on the line, no matter how little, people tend to watch their positions very closely. It might even be more of an ego thing than the money, I'm not sure.
Well it's been exactly 3 months since I did a Q and A article. As usual, the questions run the gamut from basic to more advanced. If something in the options world is bothering you, feel free to ask.
Q) Do you honestly believe that the specialist or market makers are pricing their options inventory on the basis of volatility, the Greeks, or any other standardized model??? These guys are professional bandits and they price their options at will!
A) As a former Market Maker (MM) and Floor Official on the American Stock Exchange, I can unequivocally state that options pricing is originally set on the basis of a predicted future volatility and an options pricing model. The model could be a modified Black-Scholes or Cox, Ross, Rubinstein, or any number of other well known, or not so well known proprietary models. It's after the initial pricing when supply and demand factors come into play that the prices start to vary. For example, suppose the market on an option is 1.20 x 1.30, 200 up (that means that the MMs are willing to buy 200 contracts @1.20 and are willing to sell 200 contracts @1.30).
With those quotes being shown, an advisory service advocates buying these options at any price up to 1.60. Orders start coming in and the MMs sell 200 contracts at 1.30. Depending on how fast and how many orders are coming in and also on how much stock is available to hedge the trade, they may offer 100 or 200@1.35 or they might go to 100@1.40, or something else. Remember, it's a competitive auction market, the MMs don't have to sell at your price just because you want to buy.
On the other hand, if you're trading an option that "trades by appointment" with hardly any open interest and low daily volume, I would not suggest putting in stop loss orders. MMs have great latitude in being able to lower their bids or increase their offers. So while they shouldn't move a market just to trigger an order, play it smart, just in case. Use mental stops, or stops based on the stock instead of stop loss orders. Like any business, you will find the majority of MMs are honest and play by the rules (you may not like the rules, but that's a different story.) They want the public customers to stay in the game.
Q) Regarding the put/call skew, what is the purpose of buying the Put if you are going to buy the stock?
A) I assume your question relates to putting on a conversion. In other words, at a given strike price let's assume that the Call is trading with a higher implied volatility (IV) than the Put. I suggested that you sell the Call, buy the Put and then buy the stock; this combination is called a conversion. The combination of the long Put and short Call is synthetically equal to short stock. By selling the actual stock you are creating a position that has captured the difference in IVs between the Put and Call. I suggest you review the details in the article. The truth of the matter is that you probably won't see too many of them come along anymore (the big boys with the sophisticated computers catch them pretty quickly) but it is important to understand the mechanics of how they work and what could potentially go wrong.
Q) If I have a delta neutral position, but I'm long a lot of gamma, how do I neutralize the gamma?
A) I assume that you have delta neutral position, because you want to neutralize the impact of directional changes on your position. Delta neutral will do that over a small range of stock prices, while gamma neutral will keep the position neutral over a larger range of prices. The usual reason why a position is made gamma neutral is to isolate the volatility component.
All long options, both Puts and Calls have positive gamma. Near term, close to the strike options have greater gamma than those that are longer term or further from the strike price. Normally when putting on a gamma neutral, delta neutral position, the first thing is to determine the proper ratio of the options you're using. In other words suppose you were using the XYZ Aug 50 Calls and Sep 50 Calls. If the gammas of the options were 7.1 and 5.3, then you need to trade the options in a ratio of 7.1/5.3 = 1.34. So you would need to trade 4 of the Sep options for every 3 of the Aug options. As far as which do I buy and which do I sell, it doesn't matter as far as the gamma aspect is concerned. Either way the position will be gamma neutral. The key depends on why you're putting it on. If volatility is high and you're expecting it to decrease, put it on so that the position vega is short. If volatility is low and you're anticipating an increase, then put it on so that the vega is positive. Either way, you now have a gamma neutral position.
The next step is easy. Determine the delta of the position and neutralize it by either buying or selling stock. Of course, you know how I think; when I'm referring to stock I mean synthetic stock. Either long Call, short Put for synthetic long stock, or short Call, long Put for synthetic short stock. It shouldn't matter which expiration month you use.
Q) I have a question about your article on covered Calls. You say that selling the May 55 Put is the same as buying the stock and selling the May 55 Calls. But if I sell the May 55 Put, which is deep in the money since the stock is trading at $51, wouldn't I risk getting assigned the stock?
A) Your point is well taken and yes, whenever you're short an option there is the possibility of being assigned. However, the option in the article is ITM, but not DEEP ITM. For a put option to be deep ITM means that its delta is close to -1. I ran some scenarios and the delta of a May 55P with a volatility of 25 is about -.80. The real issue though is that if you are assigned and the delta is significantly greater than -1 that may be a positive event for you. You have now captured the remaining time premium sooner than you should have. In other words, a dollar today is worth more than a dollar tomorrow. Regardless of what the delta was when you were assigned, you would sell the stock the next morning.
If being assigned is a cash flow issue, then roll out to a later month or down to a lower strike when the delta gets close to -1.
As always, if you have any questions about my articles, have suggestions for future topics, or want more information about our options mentoring program, feel free to email me at: sfreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.
11. Know Thy Options!
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Stan Freifeld comes to us from the Floor of the American Stock Exchange where he traded options for his own account from 1994-2001. He was a Market Maker for the options on several popular equities including Dupont, Schering Plough, Walgreen's, CBS, U.S. Surgical and Biovail.When he is not trading or thinking about trading, Stan relieves his stress by playing competitive squash, competing in local road rallies with his Ferrari Cabriolet and tutoring local high school students for the SAT's. The bottom line is that Stan, a long time MENSA member, is an engaging teacher with an extraordinary background in options trading and risk management. He is helpful and patient by nature and equally at ease with all levels of traders, from complete novices to advanced pros and academics. He'll be happy to teach you to trade!