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APRIL 2005 Volume 1, No.


Cap risk and lock in profits


and currency options

Pricing, volatility, and strategy fundamentals


and more


Contributors . . . . . . . . . . . . . . . . . . . . . . . .4 Editors Note . . . . . . . . . . . . . . . . . . . . . . .6 Options News

By Carlise Peterson CME launches new stock index and currency options . . . . . . . . . . . . . . . . . .8 The Chicago Mercantile Exchange expands its offerings of stock index and currency options with Russell 2000, Euro FX, and yen contracts. Fraud down under . . . . . . . . . . . . . . . . . . . . .9 An Australian bank head pleads guilty to fraudulent foreign exchange option trades that caused $282 million in losses to customers.

Software review . . . . . . . . . . . . . . . . . .10

OptionVue 5 (Standard version) By David Bukey

Options and sentiment analysis . . . . . . . .26 Learn how sentiment indicators reveal the mood of the market and improve the odds of successful options trading. By Bernie Schaeffer and Jon Lewis

Options Strategies
Hedging risk with collar trades . . . . . . . . .14 Learn how to create collar trades, which provide protection and flexibility to long positions without adding to costs. By Jim Graham Event-driven straddle trades . . . . . . . . . . .18 Larry McMillan lays out the criteria for long straddle trades that can successfully capitalize on market events. By Lawrence G. McMillan

Options Basics
Options 101 . . . . . . . . . . . . . . . . . . . . . . . . .30 Learn the basics about option pricing, trading, and volatility. By Options Trader staff

Options Resources . . . . . . . . . . . . . . . .38

Software, Web sites, and new products.

Key concepts and definitions . . . . .40 Options Calendar/Events . . . . . . . . . .41

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For all subscriber services:
Editor-in-chief: Mark Etzkorn Managing editor: Molly Flynn Associate editor: Carlise Peterson Associate editor: David Bukey Contributing editor: Jeff Ponczak Editorial assistant and Webmaster: Kesha Green Art director: Laura Coyle President: Phil Dorman Publisher, Ad sales East Coast and Midwest: Bob Dorman Ad sales West Coast and Southwest only: Allison Ellis Classified ad sales: Mark Seger

Jim Graham is the product manager of OptionVue Systems, where he works to develop and enhance the companys OptionVue 5 options analysis software. Previously, he worked in the securities and commodities division of First Chicago Capital Markets, helping broker-dealers, hedge funds, and other securities firms meet their financing and settlement needs. Graham spent four years in the United States Marine Corps, with a specialty in computer operations, and earned his B.A. in economics from Lake Forest College. Lawrence McMillan is the author of the best-selling books Options as a Strategic Investment and McMillan On Options. He is publisher of the Daily Volume Alert service and The Option Strategist newsletters, as well as all market commentaries found at his site, Bernie Schaeffer, author of The Option Advisor: Wealth-Building Techniques Using Equity & Index Options, founded the Option Advisor newsletter in 1981. Timer Digest has ranked Schaeffer as a top market timer since 1984 and the Market Technicians Association presented him with the 1997 Best of the Best award for his work in the field of sentiment analysis. His Web site,, has been recognized as a Forbes Favorite and by Barrons as a first stop for options traders. Jon Lewis is managing editor for Schaeffers Investment Research and directs the activities of the companys editorial department. He is responsible for most of the written work supporting Schaeffers newsletters, alert services and He is the editor of the Option Advisor and is the senior editor of the firms primary education product, 10 Days to Successful Options Trading. In addition, Lewis has written numerous articles on options and sentiment analysis for Schaeffers clients, the print media and

Volume 1, Issue 1. Options Trader is published monthly by TechInfo, Inc., 150 S. Wacker Drive, Suite 880, Chicago, IL 60606. Copyright 2005 TechInfo, Inc. All rights reserved. Information in this publication may not be stored or reproduced in any form without written permission from the publisher. The information in Options Trader magazine is intended for educational purposes only. It is not meant to recommend, promote or in any way imply the effectiveness of any trading system, strategy or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Trading and investing carry a high level of risk. Past performance does not guarantee future results.



Exploring trading options

elcome to the inaugural issue of Options Trader, the first monthly magazine for options traders in the stock and futures markets. Options can be a daunting subject for a few reasons arcane terminology and some occassionally complex math, to name a couple. But mostly, confusion about options stems from a lack of plain-language, commonsense sources of information about these instruments. We want Options Trader to help remedy that situation. Each issue will include market and industry news along with different trading strategies and analysis articles that demystify options and allow you to experiment and learn before you risk money in the market. Also, because even many relatively experienced stock and futures traders have only a passing familiarity with options, well feature articles for new options traders every month, along with coverage of Web sites, software and other resources. In addition to an extended article by Larry McMillan (adapted from two articles he wrote for Active Trader maga-

Options can be a daunting subject for a few reasons arcane terminology and complex mathematical pricing models, to name a couple.

zine) about trading straddles in conjunction with market news, this issue also includes an excellent primer on options in the Options Basics section, as well as a new article by Jim Graham on the collar trade. And our news section reviews a few recently launched futures options contracts that might interest you. Over the next several months, Options Trader will introduce additional features (including analysis of options systems) and expand its range of new articles. We hope you will stay with us as we grow. In the meantime, let us know what kind of topics interest you most so we can provide the kind of magazine working traders can actually use from month to month.

Mark Etzkorn, Editor-in-chief



CME launches new stock index

and currency options

he Chicago Mercantile Exchange (CME) launched options on E-mini Russell 2000 futures contracts, the smaller-sized, electronically traded version of the CMEs Russell 2000 contract. E-mini Russell 2000 options were listed for trading at 5 p.m. CT on Sunday, Feb. 13, 2005. As the E-mini Russell 2000 is one of our most successful E-mini products, with average daily volume up 344 percent in 2004, offering options on the Emini was the next logical step, says Craig Donohue, CMEs Chief Executive Officer. With this upcoming product launch, CME now offers options on three of our most actively traded futures contracts: E-mini S&P 500, E-mini NASDAQ-100 and E-mini Russell 2000. To help ensure liquidity in this new market, CME will select seven firms to commit to provide continuous, transparent and competitive markets for the exchanges E-mini Russell 2000 equity options traded on CME Globex. The current CME Globex electronic fee waiver for the CMEs E-mini S&P 500 and E-mini NASDAQ-100 options on futures contracts will also be extended to E-mini Russell 2000 options. CMEs E-mini Russell 2000 options are based on the Russell 2000 Index, a capitalization-weighted index of approximately 2,000 actively traded, small-capitalization U.S. stocks. For the fourth quarter 2004, average daily volume for E-mini Russell 2000 futures was approximately 67,000 contracts with total 2004 volume at 17,121,233 contracts. The E-mini Russell 2000 futures have become one of the most active stock index contracts in the world.

E-mini Russell 2000 options contract specifications

Contract size: One E-mini Russell 2000 Index futures contract. Contract months: Two quarterly expiration months and two serial expiration months. Globex trading hours: 5 p.m. 3:15 p.m. and 3:30 p.m. 4:30 p.m. CT, Monday Friday; start up on Sunday at 5 p.m. Minimum tick: .10 index points ($10.00); a half tick is .05 index points ($5.00). Last trading day: Third Friday of contract month; 8:30 a.m. for quarterly expirations; 3:15 p.m. for serial expirations. Exercise price interval: 5 index points. FX (EUR) and Japanese yen (JPY) options contracts, with European-style expiration, on its electronic CME Globex platform in April. The CME already offers these contracts with American-style expiration through open outcry and during a limited CME Globex trading period. European-style options can be exercised only on expiration day, while American-style options can be exercised any time up to expiration. The new electronically traded FX options contracts will be available nearly 24 hours a day and will trade alongside the open-outcry markets. Similar to its FX futures, CME will offer connectivity to a select group of automated market makers for the options. The European-style options on these two futures contracts will be listed on April 3 at 5 p.m. CT on CME Globex and in the open outcry market on

Euro FX option contract specifications

Contract size: One Euro FX futures contract for 125,000 Euro. Contract months: Four quarterly expiration months and two serial expiration months. Globex trading hours: 5 p.m. 4 p.m. CT the following day. Trading floor hours: 7:20 a.m. 2 p.m., Monday Friday. Minimum tick: $.0001 per Euro ($12.50); $.00005 ($6.25) for option prices of $.00045 or less. Last trading day: March quarterly and serial options: The second Thursday preceding the third Wednesday of the contract month at the normal Regular Trading Hours (RTH) closing time of 2 p.m. (CT). Weekly options: At the normal RTH closing time of 2 p.m. (CT) on any Thursday of the contract month that is not the termination of a quarterly or serial European-style option. Exercise price interval: $.005 (e.g., $1.305, $1.310, etc.)

Euro and yen options set for April launch

The Merc will also launch new Euro


April 4 at 7:20 a.m. CT. CME FX futures and options, which last year traded $6.2 trillion in notional value, are a rapidly growing part of the overall FX market, says Rick Sears, Managing Director of CME Foreign Exchange. Last year, our total FX volume grew more than 50 percent, and our electronic volume was up 128 percent from the prior year. Offering the choice of European-style expiration, as well as American-style expiration, allows our investors flexibility in determining investment strategies and also provides alternative tools that are more in line with the OTC market. CMEs Euro FX and Japanese yen futures and options contracts are among the exchanges most actively traded FX contracts. Average daily volume in Euro futures and options was 86,757 in 2004 and 31,070 in Japanese yen futures and options. Except for the termination-of-trad-

Japanese yen option contract specifications

Contract size: One Japanese yen futures contract for 12,500,000 . Contract months: Four quarterly expiration months and two serial expiration months. Globex trading hours: 5 p.m. 4 p.m. CT the following day. Trading floor hours: 7:20 a.m. 2 p.m., Monday Friday. Minimum tick: $.000001 per Japanese yen ($12.50); $.0000005 per Japanese yen ($6.25) for option prices of $.0000045 or less. Last trading day: March quarterly and serial options: The second Thursday preceding the third Wednesday of the contract month at the normal Regular Trading Hours (RTH) closing time of 2 p.m. CT. Weekly options: At the normal RTH closing time of 2 p.m. CT on any Thursday of the contract month that is not the termination of a quarterly or serial European-style option. Exercise price interval: $.00005 (e.g. $.00965, $.00970, $.00975, etc.).

ing day and exercise, all contract terms specified are the same as for CMEs American-style FX options. The CME

will continue to offer American-style options on both Euro FX and Japanese yen futures contracts.

Fraud down under

Aussie bank traders convicted of faking trades to protect their bonuses.
he former head of National Australia Bank Ltd.s currency options trading desk, Luke Duffy, pleaded guilty to three charges of making false foreign exchange trades that led to losses of A$360 million (U.S. $282 million). A total of 20 criminal charges each were set against currency options dealers David Bullen, Gianni Gray, and Vince Ficarra for unauthorized trading at the Melbourne-based bank, Australias biggest bank, between October 2003 and January 2004. According to the Australian Securities & Investments Commission, the four hid losses after incorrectly betting the U.S. dollar would rise in value against the Australian and New Zealand

currencies in the final quarter of 2003. The losses were hid to protect annual bonuses, which ranged from A$265,000 for Duffy to A$120,000 for Ficarra. Duffy pleaded guilty to charges under the Corporations Act of using his position dishonestly to make 12 false foreign exchange trades. One of the charges related to currency trades worth A$145 million. The maximum penalty for each offense is five years in jail. Bullen, Gray, and Ficarra face 19 such charges under the Corporations Act, plus one charge each under the Crimes Act of obtaining financial advantage by deception to secure personal bonuses. Duffy was required to surrender his passport and will appear in the County Court for a plea

hearing June 14. The traders first hid losses by shifting profits and losses from one day to another, which they called smoothing, according to a report by PricewaterhouseCoopers. Later, they processed false spot foreign-exchange and false currency-options transactions to hide losses. In October 2003, the traders discovered the bank had stopped checking internal options transactions. The four were fired after the losses were discovered in January 2004 by a junior trader. Their supervisor and three other executives were also dismissed. The fallout reached the banks boardroom, with Frank Cicutto resigning as chief executive and Charles Allen quitting as chairman.


OptionVue 5 (Standard version)



Program: OptionVue 5

ptionVue 5 is an options analysis package that allows option traders of most skill levels to view all options across asset types (stocks, indices, and futures), build trading strategies based on them and evaluate each scenarios profitability. The program also has several tools that identify underlying assets whose options characteristics fit a variety of trading strategies. OptionVue 5 can then recommend specific option trade combinations and track performance. The program isnt cheap, and several features, including its scanning and account-tracking ability, are sold as separate packages (see Software Summary for price details). Also, traders looking for detailed price charts might be disappointed. However, nearly every feature can be modified, which gives options experts great flexibility, while traders new to options wont be overwhelmed with unnecessary details. This review describes the standard version of OptionVue 5; the professional edition offers more detailed reports and manual volatility modeling.

What it is: Options analysis program that provides updated options data, plots an option strategys performance and suggests specific trades based on user-defined criteria. Who its for: Options traders. Skill level: Intermediate to advanced option traders. Company: OptionVue Systems International Inc. Web site: Phone: (800) 733-6610 Address: 1117 S. Milwaukee Ave., Suite C-10 Libertyville, IL 60048-9860 Price: Standard $995; Professional $1,695. Additional features sold separately $400 each: Portfolio Manager, Continuous Data Interface, BackTrader; Value Sheets (to print the Matrix $195). Background Data Base subscription for one year: weekly $650; monthly $300. OpScan per month $49; per year $500. Data: 20-min. delayed $49; EOD $27.50. Thirty-day trail $49, standard or professional. Service bundles of these features are available at various prices on the Web site. Upside: Long list of clever analysis features. Customizable tools and variables (including its volatility pricing models). Downside: Cost. No intraday stock charts and limited set of technical indicators. Minimum Windows 95, 98, NT 4.0 or later, 2000 or XP; 1 GHz processor requirements: (recommended); 128 MB RAM memory; 60 MB of hard disk space; 800x600 resolution monitor; Internet access.

OptionVues DataVue subscription service provides 20minute delayed and historical prices on more than 2,400 stocks, indices, futures (financial, commodity and currency), bonds and their options. Up to six years of historical daily price and volume data is available, and all current strike prices and expiration months (including LEAPs) can be downloaded. You can retrieve prices manually or set DataVue to update every 10 minutes. OptionVue also imports and exports ASCII price files. Real-time users must pay a one-time $400 fee to access one of six continuous data feeds: IDC eSignal, IDC Comstock satellite, PC Quote/Hyperfeed, AT Financial, Thompson One or BullSignal, which provides data from the Australian Stock Exchange. (Monthly vendor fees also apply.)

OptionVues Background Data Base (BDB), which is updated each Saturday morning, lets you search for assets with low or high volatilities relative to their historical levels, which the program uses when projecting option values. Although a BDB subscription is optional, each asset file contains current strike and expiration information, margin requirements, dividends and interest rates, and constant elasticity of volatility (CEV) factors vital statistics that OptionVue needs to project option values and perform accurately.

Quote display. OptionVues quote window can hold hundreds of underlying asset prices with more than a dozen columns of market data. Figure 1 shows relevant price information (last price, daily point and percentage change, daily high, daily low, volume, exchange traded and time) for selected indices, stocks and futures, as well as a categoApril 2005 OPTIONS TRADER

FIGURE 1 QUOTE DISPLAY All of OptionVues features are easy to format. This quote screen shows various indices, stocks and futures as well as two option-strategy candidates. ry labeled strategy candidates. Instruments can be easily added or deleted and you can also create original categories. You can change each columns width and select among 15 additional headings. Matrix. Double-clicking on an asset in the quote window brings up its Matrix a list of options at every strike price and expiration month. Each asset has its own Matrix, which consists of four main sections: actuals, or underlying assets, futures (if applicable), options and summary statistics (e.g., implied volatility, margin requirements, cash flow, current value and Greeks). In the Matrix, you can test any trade scenario involving options and their underlying Source: OptionVue 5 assets. You can paper trade the underlying asset, buy or sell a single call or put, or build ume, open interest, theoretical price, percent under- or more sophisticated combinations such as covered calls, overvalued and option Greeks. Also, if you double-click straddles, credit or debit spreads, collars, butterflies and each asset or option, nearly 30 of these statistics appear in a separate window. condors. Graphic analysis. After you propose a trade in the Figure 2 shows the Matrix of the Nasdaq 100 index-tracking stock (QQQ) and lists the underlying stock price in the Matrix, OptionVues graphic analysis window displays its top section. In-the-money (ITM), at-the-money (ATM) and profit profile according to price changes in the underlying out-of-the-money (OTM) options appear in the center sec- asset. The program shows each trades gain or loss based on tion, and the lower summary section calculates the figures todays date and several future dates (e.g., the nearest option expiration date and the date half-way to it). trade statistics. Figure 3 shows the profit profile of a QQQ short straddle The Matrix resembles a spreadsheet. It distinguishes between potential trades and existing positions and can on three dates: current (dotted line), expiration (solid brown analyze their trade details separately or combined. If you line) and the midpoint between both dates (dashed line). enter the number of shares to buy (positive) or sell (nega- Although the trade is currently below the breakeven line, it tive) in the third Trade column, OptionVue will summa- will return up to $1,220 on expiration day, depending on where QQQ trades at that point. rize trade statistics in the lower section. This short straddle will profit on expiration day if QQQs Once you execute these trades and click the convert trades button, the program tracks them here and in the closing price is between $33.80 and $36.20. The figures portfolio manager. At this point, your shares roll over into lower section lists the trades profit or loss and its Greeks at the existing positions column. If there are shares or con- certain stock price intervals (horizontal lines). These statistracts in both columns, you can choose how to analyze them. tics are based on the current date (in late September), but The options section lets you track proposed and existing change if other lines are highlighted. Most chart features can be easily edited. OptionVue can plot options positions the same way. Here, the second column shows each options market implied volatility (MIV), or as many as five performance lines based on either user-defined dates or implied volatility changes. You can modify the size of mid-point between its bid and ask prices. However, you can change the Matrixs format and dis- the trade and also view performance (y-axis) by yield, annualplay up to six columns and three rows of detailed informa- ized yield, change from initial value or option price. tion on any asset or option, such as bid and ask price, volcontinued on p. 12
OPTIONS TRADER April 2005 11


FIGURE 2 THE MATRIX The Matrix is OptionVues central feature and shows options prices (including LEAPS) and implied volatilities for each underlying asset. You can propose trades here and evaluate their characteristics. This figure shows a short straddle that consists of at-the-money October QQQ options.

Source: OptionVue 5

The Details button on the lower right is a great feature that breaks down the trade into individual components and calculates its performance (including commissions) and daily time decay. Its easy to see how trade parameters shift across different dates, underlying asset prices and volatility changes. If you are evaluating more than one trade, you can superimpose different performance charts into the current one to determine which is more profitable. Analyzing multiple scenarios is easy and extremely helpful. Price charts. OptionVues price charts arent as detailed as its performance charts, so serious technicians and intraday traders should rely on other software to plot tick-bytick price moves and create original indicators. However, given OptionVues sole focus on option strategies, its charting features are more than adequate. The program plots underlying assets in daily, weekly or monthly bars, and you can add 10 indicators including a moving average of put/call volumes. The chart windows most useful feature is its target box, which allows you to select a specific area of a price chart to predict upcoming price moves. OptionVue copies the boxs target price and date ranges into its TradeFinder scanning tool to find specific option strategies that profit when the underlying asset moves in that direction Volatility charts. OptionVues volatility charts plot six years of daily implied (IV) and statistical (historical) volatilities (SV)

for each underlying asset invaluable information for options traders. Each chart also lists average SV and IV levels over several intervals: three, six and 10 weeks, as well as 18 months, and three, four-and-ahalf, and six years. Users can also overlay asset prices in these charts. Modeling. The program can calculate options prices using two volatility models: uniform and variable. For each underlying asset, the uniform method uses an overall average of all options implied volatilities, but the variable method measures the individual IVs of each option, which can lead to more accurate results. Portfolio manager. OptionVues three portfolio manager tools (Transaction log, Status and Reports) conveniently convert trades from the Matrix, track open positions, summarize account values and evaluate account performance. There is no limit to the number of accounts you can track, and its easy to distribute individual trades among them. Once you execute a trade, it moves from the Matrix to the transaction log, where you can edit its details. In the status window, you can view account values, buying power, portfolio beta, delta and theta, margin requirements, and total gains and losses. As with all of OptionVues features, you can include slippage and commissions. OptionVues reports are quite extensive and cover five topics: a list of open positions, individual gains and losses (realized and unrealized), performance analysis, dividends, interest, and transfers and taxes. Navigation within the report tool is easy because OptionVue organizes each area into separate tabs and you can switch to a different account at any point.

Scanning tools
Background Data Base (BDB) Survey. OptionVues BDB survey searches nearly 2,000 volatility charts in its Background Data Base to find up to 50 underlying assets with unusually high or low statistical and implied volatility ideal candidates for non-directional trading strategies. You apply the following criteria to up to six years of asset data: greatest dollar volume of options traded, highest and lowest SV or IV, highest and lowest IV/SV ratio, and highest or lowest current percentile (IV or SV).

FIGURE 3 PROFIT ANALYSIS OptionVue plots each strategys projected profit or loss based on upcoming expiration dates or expected changes in implied volatility. This figure shows three lines, which represent the profitability of a QQQ short straddle today (dotted line), at expiration (solid line) and the midpoint (dashed line).

Survey results can be sorted by these categories, and OptionVue always lists each asset with its daily options volume, and current statistical and implied volatilities with relevant percentile rankings. Digging into the details of these assets is easy. Simply highlight a row and click the Matrix or chart buttons, or right-click on one or more rows to add them to any section of your quote window. TradeFinder. If you have a list of assets with options that seem attractive, the TradeFinder tool can find specific option trades with the highest expected returns or largest probability of profit. TradeFinder Source: OptionVue 5 looks for trade opportunities based on either underlying price movement or changes in implied volatility. Once you select a number of assets to explore and set the price and date targets for each, you specify one or more option strategies among 25 different types including long and short underlying positions, long or short options, vertical credit and debit spreads, straddles, strangles, collars and butterflies. OptionVue will only show trades that meet your criteria in terms of investment amount, minimum or maximum option prices, volume and open interest. The top 50 suggested trades can be sorted by predicted profit, and you can immediately analyze each trade in the Matrix or in a performance chart. OpScan. The OpScan service uses a simple formula language to explore OptionVues own servers via the Internet and find assets and options that have unique trade characteristics. Though OpScan is similar to the BDB survey, you can write custom formulas from more than 70 criteria here, which gives you more flexibility. Up to 12 of OpScans predefined formulas can be copied,
TABLE 1 OPSCAN FORMULA EXAMPLE The OpScan scanning tool retrieves attractive underlying assets and options from the companys servers. Each scan is based on formula language that isnt hard to learn. You can build original formulas or use 12 predefined ones. Title: Pick: Sort: Show: Fat call premiums on quiet stocks SV<=30 AND CIV>SV+10 AND ATVOL(5)>200 IV-SV iIV,SV,CIV

edited or created from scratch. Default formulas have titles such as breakouts to the upside, fat call premiums on quiet stocks and undervalued options based on recent market implied volatility. Table 1 shows the main sections of an OpScan formula. The pick line scans for assets that have current statistical volatility of 30 percent or less and current call implied volatility that is 10 percent above that value. Also, it requires the five-day average volume of all of that assets options to be more than 200. The results are sorted by the difference between implied and statistical volatility (i.e., assets with expensive options appear first). The final line shows each assets overall implied and statistical volatility as well as the IV of its calls alone.

Other features
OptionVue offers other valuable features such as the BackTrader, which shifts the entire program back to a specific hour or date and lets you paper trade with historical data. Also, the probability calculator tells you the likelihood of an underlying asset ending below, in between or above given prices at a future date.

OptionVue has an extensive list of analysis tools, but the programs flexibility is its best feature. The program is expensive and its stock charting features could be expanded, but these are minor complaints. Both intermediate and serious option traders should appreciate its analytical power.



Hedging risk with collar trades

Collar trades can help reduce the risk of a stock or futures position and lock in gains without wiping out additional profits.

Buying a protective put is the easiest way to prevent ver the past year, stock market volatility has been very low by historical standards, excessive losses from unexpected price drops or to protect as measured by the Chicago Board Options unrealized gains in a stock without selling it. Similar to an Exchanges volatility index (VIX). This has insurance policy, it protects you against losses for a fee led to a certain amount of complacency among investors, the puts premium. who seem to have a short memory span. After all, it was not long ago that FIGURE 1 A COSTLESS COLLAR so many people saw the value of their This collar trade, built around 100 shares of Google (GOOG) purchased at stocks plummet when the tech bubble $185, costs the same as buying the underlying shares, but it limits risk to burst. $2,000 and caps potential gains at $3,500. Individual stocks can be hurt by company or industry specific news even when the overall market is rising. Thats why it is important to consider a trading plan that incorporates hedging techniques to limit the damage from sudden price drops. The collar trade is a hedging technique that consists of buying the underlying stock or futures contract while simultaneously buying puts and selling calls with the same expiration date. This strategy allows you to either limit a trades risk or protect unrealized gains. Also, you can adjust the strategys components to unexpected moves in the underlying instrument to help maximize a trades potential profSource: OptionVue 5 Option Analysis Software ( it.

Hedging with protective puts

A hedge is a transaction that reduces the risk of an existing position. The most commonly used option hedge is the purchase of a put option to protect a long stock position.

Suppose you have 100 shares of stock valued at $50, and you buy a put option with a $45 strike price. If the stock drops, you bear the first five dollars of losses, plus the put options cost. But you cannot lose any more than that

amount no matter how far the stock price drops below $45. If the stock finishes above $45 at the options expiration date, the put expires worthless. However, if the stock is trading below $45 a share at expiration, the gain from the put will equal any loss incurred on the stock below that level. This strategys advantage is that if the stock price goes up, you keep all the gains, minus the put premium paid, no matter how high the stock price goes; but you are perfectly insured below $45. However, while protective puts reduce potential losses, they also reduce potential profits. This cost discourages many traders from buying puts on a consistent basis. When a stock goes up and the puts expire worthless, traders start to complain about the put premiums expense. Over a long bull market, most investors will simply stop buying puts. The collar trade helps you work around the expense of providing continuous downside protection. It is a very popular strategy among institutional investors.

Costless collar example

Lets look at a collar trade example in which we dont own the underlying stock, but are interested in buying it. For instance, on March 2, 2005, Google (GOOG) traded at $185. At that point, both the bid price of the January 2006 220 call and the ask price of the January 2006 165 put were $15.90. To create the collar, buy 100 shares of GOOG, sell the January 2006 220 call, and buy the same-month 165 put. Figure 1 shows the collars potential profit or loss based on Googles stock price. The strategy costs just $18,500 the same as if you simply bought 100 shares of GOOG. Here, the options cost nothing because the Jan. 2006s 220 call premium offsets the cost of buying the January 2006 165 put. Several things could happen to Google between March 2, 2005 and the options Jan. 21, 2006 expiration date. First, its price could remain between $165 and $220. In this case, both options will expire worthless, and you own 100 shares of Google. Since the options were essentially free, you end up no better or worse off than if you had simply bought the stock. (Figure 1s diagonal line $165 to $220 is identical to the potential profit or loss of owning 100 shares of the underlying stock.) If GOOG drops below $165 by the expiration date, the collar trade cant lose more than $2,000 ($185 - $165 = $20 * 100 shares) no matter how low the stock price drops. This is the floor established by the collar. However, if the stock dropped 20 percent to $148, and you only held the underlying stock, you would lose $3,700 ($185 - $148 = $37 * 100 shares). And losses would continue to mount with every additional price drop. Finally, if Google rises above $220 by expiration, you will gain $3,500 ($220 - $185 = $35 *100 shares) for those 325 days, an 18.92-percent return, and your shares will be assigned at $220 to the call option buyer no matter how high GOOG climbs.

Collar that trade

A collar is a hedge that confines your risk to a particular price range. To construct a collar around a stock position, first buy a put option for every 100 shares of stock to protect against a price drop. Then, sell one call option for every 100 shares to help pay for the puts. While you can use options from any expiration month to construct a collar, both the call and put option must have the same expiration date. You can even create a costless collar, which is a collar that requires no additional capital. To create a costless collar you need to look at the price of the various call and put options and then construct the trade so the premium you receive from selling the calls completely pays for the puts purchase. This may not be possible for every stock, but you can always use this technique to at least minimize the trades capital requirements. Collar trades lock you into a protected price band. You are insured if the stock falls below the puts strike price, but you forfeit any profits above the calls strike price. In addition to providing low-cost protection, a collar can be used to lock in unrealized profits without actually selling any shares. This can be especially useful for stocks you want to sell that have substantial gains, and it can also help you defer capital gains taxes. For example, you could construct a collar using Jan. 2006 options so that a stock sale wont occur until the next calendar year. Collars let you lock in a trades profit now, but you do not actually sell the stock until the options expire, which means you would not pay capitalgains tax until April 15, 2007.

Protecting unrealized profits

The collar strategy can also be used to protect unrealized gains. For example, oil prices have increased by about $10 a barrel since the beginning of 2005. Assume you correctly anticipated oil prices would continue to rise and bought 100 shares of Conoco Phillips (COP) at $84 on Jan. 3. On March 2, COP traded at $109, which represents an unrealized gain of $25 per share. The collar trade is perfect for protecting this type of gain without having to actually sell the stock. To lock in this gain, you could have purchased the January 2006 105 put for $7.00 and sold the same-month 125 call for $4.00 on March 2.
continued on p. 16



FIGURE 2 LOCKING IN PROFITS Collar trades guarantee youll capture unrealized gains without sacrificing too much upside potential. Although this collar trade cost $300 more than owning COP stock outright, it delivers a minimum $1,950 profit while allowing a maximum gain of $3,500 (including dividends).

Note this is not a costless collar like the previous example. We structured this trade to provide maximum downside protection (down to $105), while allowing room for COP to increase further (up to $125). This insurance cost only $300, or the net difference in price between the options ($700 - $400), plus commissions, and still allowed $16 of upside potential per share (i.e., $125 projected price - $109 current price). Figure 2 shows the resulting positions potential profit and loss based on COPs stock price. Because this is not a costless collar, if the stock price ends up between $105 and $125 at expiration, you will make $300 less than if you simply held the stock. But after placing this trade, youve locked Source: OptionVue 5 Option Analysis Software ( in a gain of at least $1,950. However, that protection caps your profit at are not necessarily forced to stay in the position. $3,950. You can always close the entire position (including the Lets break down these totals to see exactly how to calcu- stock) and take your gain or loss. But there are often adjustlate Figure 2s best- and worst-case scenarios. The long 105 ments you can make to increase the collars overall profput option guarantees a minimum selling price at its strike itability. In fact, there are several ways to trade around your price, and since you bought Conoco Phillips at $84, this core positions. equals a $2,100 profit ($105 - $84 = $21 * 100 shares). If the stock price falls dramatically, sell the long put, buy Subtracting the cost of the $300 collar leaves a profit of back the short call, and then place a new collar on the stock. $1,800. Yet this is $150 less than Figure 1s worst-possible In this case, the short call drops in value as the long put outcome of $1,950. appreciates. The difference is dividends. Conoco Phillips pays a quarThe new collar will then protect the stock against further terly dividend of $0.50 per share. Because you own the under- sell-offs at the current price while still allowing additional lying stock, you will receive a $50 dividend each quarter profit if it heads back up. This adjustment should not require ($0.50 * 100 shares). Therefore, youll get three payments much (if any) additional capital because the cost of the put between March 2004 and the options January 2006 expiration and the premium you receive from the call should again be date for a guaranteed total profit of $1,950 (barring a decrease about the same. It makes sense to make this type of adjustin the dividend). For details about how dividends affect ment anytime the stock price has dropped roughly 20 percent. options prices and strategies, see Options and dividends. What if the underlying stock takes off while you are in a If COP trades above $125 during this nine-month period, collar? Just lock in the trades unrealized profits. One your stock will be assigned to the call options owner. approach is to sell the put, buy back the call, and then put a (Selling the January 2006 125 call requires you to sell 100 new collar on using an at-the-money put and an out-of-theshares of Conoco Phillips stock at $125.) Because you money call. The result will look similar to the Conoco bought COP at $84, your gain would be $4,100 ($125 - $84 = Phillips example (Figure 2). $41 * 100 shares). Again, subtract the $300 cost of the collar Another possibility is to buy additional in-the-money and then add $150 in dividends a total profit of $3,950. puts (one for every 100 shares of stock) against the collar. This would lock in some profit while giving you more Flexibility upside potential if the stock fell back. Figures 1 and 2 show only what would happen if you placed It is also possible to increase your potential return by pura collar and then waited until expiration. But the underlying chasing the stock on margin. Margin allows you to trade stock is likely to move (up or down) substantially over the securities by putting up only part of the purchase price and next nine months. When large stock price moves occur, you borrowing the remainder from your brokerage firm. For
16 April 2005 OPTIONS TRADER

Options and dividends

ividends need to be considered when entering any trade involving a stock, stock options, or index options. If you own stock, youre entitled to receive any dividends paid, and if youre selling short, you need to pay dividends to the lender. Traders also need to understand how dividends affect option prices. When a strategy includes a long position in the underlying stock (e.g., a covered call or collar trade), the dividends you will receive over the life of the trade will affect your probable gain and loss. For example, if you dont take this step when entering trades that include a long stock position, youll substantially underestimate potential profits. The stock price will also drop by the dividend amount on its ex-dividend date, or the first day the security trades without its dividend (i.e., you must own it before this date to receive the dividend). Dividends impact a stocks price, which in turn influences option prices. While the stock drops by the dividend amount in a single adjustment, option prices anticipate dividend payments in the weeks (and months) before they are announced. High-cash dividends imply lower call premiums and higher put premiums. This also applies to trades that involve options on stock indices. The expected dividends to be paid by all the stocks in an index (adjusted for each stocks weight in the index) need to be taken into account when calculating the fair value of index options. To calculate the fair value of various types of options using several variables (including dividend yield), visit Not including dividends when analyzing a potential option trade may make an option seem up to 15 percent undervalued at times, which impacts your decisions and could cause you to enter a trade that might not have been a good idea after all.

stocks, you must typically deposit 50 percent of the trades cost (i.e., 2-to-1 leverage). In Figure 1, for example, 100 shares of Google cost $18,500 and had a maximum potential profit of $3,500 a possible return of 18.92 percent. If you choose to use margin to purchase the stock, you only need $9,250, which doubles the collars potential return (in percentage terms) to 37.84 percent if the underlying hits or exceeds the calls $220 strike price. However, using margin also means that your potential losses also double. For example, if Google trades no higher than $166 at expiration, the collars $2,000 loss actually represents 21.62 percent of capital instead of the original 10.81 percent.

Managing your positions

Current low-volatility market conditions are a great time to adjust your portfolio and improve your risk profile. If the bulk of your portfolio consists of individual stocks, look for ways to hedge your downside risk. The collar trades advantage is that it works well in all kinds of markets. It is a low-cost way to provide downside protection, protect existing gains, and its easy to adjust as market conditions change.
For information on the author see p. 4. Questions or comments? Click here.

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Related reading box

Putting volatility to work, Active Trader, April 2001 How to make practical use of volatility in your trading. Technical Tool Insight: Volatility Index (VIX), Active Trader, April 2001 VIX for beginners: an analysis of the CBOE volatility index (VIX). You can purchase and download past Active Trader articles at

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Event-driven straddle trades

Options can allow you to profit whether the market goes up or down, but the approach wont do you much good if you pick the wrong options under the wrong circumstances. Here are some ideas to help you put on trades that have a better chance of succeeding when news moves the market.
uying an option straddle is the simultaneous purchase of a call and a put with the same strike price and expiration month. Traders use this option strategy to take advantage of sudden price moves, either up or down, by the underlying instrument. This ability to profit regardless of market direction is a major reason many traders are attracted to long straddles. However, because you are purchasing both a call and a put, the premium you pay is expensive relative to just buying one or the other outright. The underlying market has to move a considerable distance and quickly to generate a profit. In some situations going long a straddle is appropriate, such as before a major event that could dramatically move the underlying instrument. Circumstances that can have a dramatic impact on the price of a stock include the results of a Food and Drug Administration (FDA) hearing, a lawsuit verdict or to a lesser degree a potentially volatile earnings announcement. The following discussion outlines a set of criteria for taking advantage of potentially significant stock moves triggered by these kinds of events and illustrates the results by walking through trade examples.

hearings or lawsuit verdicts because option traders believe the news will

make the stock gap in price. The option writer demands more for an option because of the increased level of uncertainty in these situations, while the option buyer is willing to pay more because of the potential for a price gap. Because a decision from the FDA or a

categories of market-moving events that drove the high implied volatility levels, and the number of times they occurred. It is rare for a stocks options to get extremely expensive for at least four consecutive days prior to an earnings announcement, and this category appeared only eight times per year.

Reactions to FDA rulings are generally about 2.5 times as big as those from earnings announcements.
jury cant be known in advance, no one can predict the direction the stock will move up or down. In many cases, straddle premiums seem ridiculously expensive, but the opposite side of this coin is that the underlying stock will often move a great deal, justifying the expense. To determine whether a straddle was a good opportunity, we reviewed stocks whose options were trading at extremely high implied volatility levels from Jan. 1, 1997, to Feb. 1, 1998, according to their appearance in the High Implied Volatility section of the Daily Volume Alert report ( The next step was to identify stocks that appeared on that report four or more consecutive days. There were 48 such situations. Table 1 shows the different Stock splits refers to stocks that have already announced their splits, and for which the ex-dividend date (the date at which the stock price is lowered to
TABLE 1 WHATS THE BUZZ A number of events triggered high implied volatility in options from January 1997 to February 1998. Reason for high volatility FDA hearings Earnings announcements FTC decisions Stock splits Takeover rumors Unknown reason

Number of cases 12 8 1 9 13 5

Events that drive volatility

Option premiums often rise before FDA


TABLE 3 STRADDLE PERFORMANCE The long straddles triggered by FDA/FTC announcements performed much better than those based on earnings announcements.

reflect the split) is approaching. Unknown refers to situations in which the options became expensive and then returned to a lower implied volatility without a news item to account for the temporary rise. In all likelihood, such items are takeover rumors, but at the time there was no identifiable source for the rumor.

We were interested only in those situations for which there was a publicly known date when information will be released that could drive the underlying stock. This eliminated unknown and takeover rumors. Lawsuits would normally be included, although no major ones occurred during the test period. Stock splits also were discarded because in these cases the options were expensive only because the TABLE 2 REACTING TO THE NEWS market makers raised their offers in This list of reactions to news events the face of increased demand from reveals FDA/FTC rulings have much people trading the split phenomemore impact on the market than earnnon (the supposed tendency for ings announcements. stocks to rally after stock splits); the Symbol Stock Price Net high implied volatility is not prereopening change percent dicting a volatile stock movement FDA/FTC per se. category: This narrowed the list to FDA and REGN 10.88 -8.25 -43 Federal Trade Commission (FTC) AIMM 4.31 -9.44 -69 announcements, and earnings announcements. Twenty-one cases CEPH 13.00 -7.00 -35 fit the study parameters. Table 2 LIPO 9.56 -15.25 -61 shows the actual moves that IPIC 19.25 +1.75 +10 occurred when the anticipated PLC 13.38 -12.13 -48 announcement eventually occurred. CORR 12.88 +1.38 +12* If the market is open when the GDT 60.88 +2.88 +5 announcement is due, trading is suspended, and the Stock reopenCEPH 10.44 -0.81 -7 ing column is the price at which the ATIS 13.75 +0.50 +4 stock reopened. ORG 22.06 +2.63 +14 Table 2 shows the reactions to CYTC 23.38 +3.88 +20 FDA rulings are generally about 2.5 ODP 17.13 -5.50 -24 times as big as those from earnings Average: 27% announcements. Keep in mind the stock had to have extremely expenEarnings category: sive options for at least four days prior to the known date of the QNTM 36.38 +3.25 +9 announcement. Clearly, large dayAPCC 23.63 -4.88 -17 trading profits would be available if ORCL 41.00 +4.88 +13 one were able to guess the direction TCNL 22.13 0.00 0 the stock was going to move after TSA 17.75 -3.00 -14 the announcement. However, the MACR 9.56 -2.00 -17* fact the options were so expensive indicates there was a possibility of a JBIL 59.25 -7.50 -11* large move in either direction. BJS 71.63 -3.63 -5 Finally, the option volume in these Average: 11% cases did not provide any reliable * Move continued for another day or two clues, as no one knew the news in Source: advance.


Implied volatility Before After

Gain/ loss

121 145 144 113 129 151 163 62 141 159 145 99 106

92 141 88 85 69 110 70 52 90 55 80 64 73

143% 72 26 87 -41 111 -26 -2 -15* -60 -40 -6 -4

Average: +19%

78 115 75 70 89 98 113 46

56 86 40 51 70 73 76 41 Average:

-18 -45 -11 -43 -20 12* -22* -10 -20%

* Move continued for another day or two Source:

Straddle performance
In analyzing how a straddle performed in each of these situations we will consider only the near-term, atthe-money straddles. Furthermore, we will compute the initial straddle price four days after the implied volatility registered extremely high levels. Although we have stressed it was necessary the date of a pronouncement be publicly known, there were situations for which this date was not available.
continued on p. 20




For example, everyone knew the FTC was reviewing the Office Depot (ODP) merger, but no one knew the exact day on which the ruling would be handed down only that it would be within the next few days. Table 3 shows the implied volatility of the options on the dates the straddles were initially bought (Implied Volatility Before), the general level of implied volatility after the stock made its gap move (Implied Volatility After) and the net gain or loss from buying the straddle. A quarter point was deducted for slippage and commissions. Table 3 shows the option market did a pretty good job of predicting how far

Traders should buy straddles before FDA or FTC events, and consider selling them in advance of earnings announcements
uations in which a considerable amount of time elapsed between the fourth day of high volatility and the day before the FDA announcement. In such cases, it is possible for the stock to rise or fall during this period, only to move back to where it was on the day you bought the straddle, resulting in a potentially large loss. A better approach is to wait until the day before the FDA announcement and buy an atthe-money straddle. This way, no matter what the FDA decides, the stock will move away from the straddles strike price. Here are some guidelines for trading straddles immediately before a news announcement. To buy straddles on stocks prior to FDA/FTC hearings or jury verdicts in lawsuits: 1. Wait for implied volatility to be extremely high for four days, more or less consecutively. 2. If you know why volatility is high (e.g., an FDA hearing is imminent), proceed. If you do not know why implied volatility is high, do not buy a straddle yet wait for a reason to become evident. 3. Dont buy straddles on takeover rumors, earnings situations or stock splits. They should be bought only in anticipation of FDA or FTC hearings, lawsuit verdicts or similar events. 4. Once the reason for the high volatility is validated, see if the date of the event can be determined with certainty. If the date is definite, wait until the day before the event and buy straddles.If you cant determine

these stocks would move, but in general there was still room for the long straddle to make money in the FDA/FTC category. In the earnings category, traders would actually make money by writing (selling) the straddles. Hence, it is generally apparent that traders should buy straddles before FDA or FTC events, and consider selling them in advance of earnings announcements (consider because commissions work against the straddle seller, too, and dont leave much room for profit). As far as earnings go, there is often an overly optimistic whisTABLE 4 THE WAITING GAME per number that circulates This table shows straddle performance when among aggressive traders. As a there was a considerable delay between the result, options traders often pay fourth day of high implied volatility and the too much for straddles in actual FDA/FTC announcement. advance of earnings announcements. Stock Net Results Regarding companies await(Straddle bought straddle ing the results from FDA hearon last day) buy profit ings, traders take positions FDA/FTC based on the analysts projecCategory: tions for what they expect to REGN 143% same happen, and those are often AIMM 72 same positive projections. However, CEPH 104 much the FDA often surprises everyimproved one and the stocks move (norLIPO 157 much mally, fall) far more than anticiimproved pated as traders liquidate on IPIC -41 same the disappointment. Hence, owning straddles is profitable PLC 58 worse going into an FDA ruling. CORR -26 same
GDT CEPH ATIS ORG ODP Average: 2 -15 -60 -40 34 29% slightly better same same same somewhat improved

One way to improve profits would be to wait until the day before the FDA hearing to buy the straddle. Recall that the results in Table 3 assumed the straddle was bought after implied volatility had been extremely high four consecutive days. Table 4 lists those sit-



FIGURE 1 FDA REJECTION When the FDA did not approve Liposomes drug application, the stock fell more than 60 percent. This would have produced a substantial profit for a long straddle position.
Liposome Technology (LIPO), daily 30

the date with certainty, buy the straddles on the fourth day of high volatility. 5.Exit immediately after announcement is made. the


This months article includes examples of the event-driven straddle approach, including trades that did not work out as planned.



Trade examples
Figure 1 shows Liposome Technology (LIPO) in the summer of 1997. An FDA meeting was scheduled for July of that year, and implied volatility expanded as the announcement approached. When the FDA rejected the companys drug application, the stock collapsed from 25 to 9. Prior to the announcement, the straddle had been trading at approximately 9, so the 16-point drop in the stock price resulted in a substantial profit. Its important to remember that no one knows what the FDA will decide, so do not look for guidance in a stocks price action leading up to an announcement. In this case, during the previous month, the stock had been rising, which shows that a price trend is not a reliable predictor of the outcome of this kind of event. All you can do is determine that the options have gotten very expensive, in which case the event-driven long straddle strategy is appropriate. Figure 2 shows the same stock in September 1999. As explained last month, the strategy is to buy the shortest-term straddle that makes sense in a given trade situation. In this case, Sept. 16 was the day before expiration, which means you would buy the October at-the-money straddle. If the FDA meeting drags on, trading in the stock could be halted for a day or two. Waiting until the last possible minute to buy the straddle minimizes time decay during the trade and increases
OPTIONS TRADER April 2005 10






Source: MetaStock Professional (

the odds of still holding the straddle when the news is announced. In this case, it is not efficient to buy the OCT 25 straddle several weeks ahead of time, only to find the stock trading at 20 or lower on the day of the FDA meeting. In that case, the straddle would be far too bearish, and not nearly neutral enough to profit from an up move in the stock. In this case, the OCT 17.5 straddle was trading at 6.63. The stock dropped nearly $10 after the news. The next two examples show that sometimes other events can get in the way of the one youre trying to trade. United Therapeutics (UTHR) announced it would be appearing at an important FDA hearing on Aug. 9, 2001 (Figure 3). Using the trade rules, you would buy straddles on Aug. 8. The stock was trading around 12.50, making the AUG 12.5 straddle the appropriate strike. If you had purchased the straddles in the morning, you were in for a wild ride. Late in the trading day, a research paper concerning UTHR was posted on the FDA Web site, written by one of the advisors to the committee that was going to rule the next day. The paper
continued on p. 22


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FIGURE 2 BUYING THE RIGHT STRADDLE Although Liposome again tanked after a negative encounter with the FDA, traders who bought their straddles too soon would not have reaped the full benefits of the trade.
Liposome Technology (LIPO), daily 30










Source: MetaStock Professional (

FIGURE 3 BAD NEWS BECOMES GOOD NEWSAND A BAD TRADE A negative report on the FDA Web site sent United Therapeutics tumbling. The next day, however, the companys drug was approved. What appeared to be a perfect straddle trade turned into a loser.
United Therapeutics (UTHR), daily 17.0 16.5 16.0 15.5 15.0 14.5 14.0 13.5 13.0 12.5 12.0 11.5 11.0 10.5 10.0 9.5 9.0 8.5 4 10 24 September

it doesnt guarantee a winning trade. Another example further illustrates how the current era of instantaneous and far-reaching communications can impact any trade. Matrix Pharmaceuticals (MATX) had announced an FDA hearing for Sept. 10, 2001, setting up a straddle purchase on the preceding trading day Friday, Sept. 7. At the time, the stock was trading near 7 (Figure 4), so we were preparing to buy the September 7.5 straddles. However, before the stock opened for trading on Friday, a negative opinion paper was released by an FDA researcher and posted on the FDA Web site. There was no trading in MATX that day or the next which was the day of the hearing itself. When the stock finally reopened after the trading interruption following the terrorist attacks it did so at 1! The long straddle strategy was still sound (the straddles cost less than 6.5), but the implementation became a little more difficult because of the release of information on Web sites in advance of the hearings.

Not covered
It is not a good idea to put on covered writes or other option selling strategies in advance of FDA announcements (or similar chaotic events), despite the seemingly overpriced nature of the options at such times. Many a covered writer has been buried when the underlying stock plummets after a negative FDA announcement. For example, in the MATX situation, there is no way a covered writer would have been protected down to a price of 1. Naked put sellers would have suffered the same fate. And although naked call sellers would have come out OK in the MATX situation, they will not when market-moving news is positive. Avoid selling options covered or otherwise in these situations, even



2 9 July




6 13 August



Source: MetaStock Professional (

essentially said the drug being reviewed did not work and should not be approved. UTHR stock plummeted to 8.75 in the last few minutes of trading on Aug. 8. On Aug. 9, however, the FDA committee met (trading in the stock was halted all day) and approved the appli22

cation. UTHR reopened at 14 the next day. As a result, the straddle purchase was not profitable because the stock wound up just slightly above the 12.5 strike price. Perhaps the lesson to learn here is that, even if you execute the trade correctly (waiting until the day before the announcement, in this case),

FIGURE 4 TOO MUCH INFORMATION A negative report on the FDA Web site and the terrorist attacks of Sept. 11 hammered Matrix Pharmaceuticals. The Internet has made it easier to quickly disseminate information that can affect stocks, making it more difficult to execute straddle trades.
Matrix Pharmaceuticals (MATX), daily 12 11 10 9 8 7 6 5 4 3 2 1 0 23 30 6 August 13 20 27 4 10 24 September 1 8 October 15 22 29

though such strategies seemingly appear to be mathematically attractive. The math cant accurately estimate the scope of the chaos that will follow the event.

The broad market

Because market indices are collections of stocks, any dramatic news affecting one company is unlikely to make the event-driven straddle strategy a worthwhile approach for trading index options. However, the markets potential for extreme movement is great, even though index options might be expensive. This is akin to the event-driven straddle buy setup for individual stocks. One such opportunity developed in the aftermath of the Sept. 11 attacks. Option implied volatility increased dramatically, as reflected in very high readings in the CBOE volatility index (VIX), shown in Figure 5. Implied volatility had risen in anticipation of another chaotic event taking place and stayed high during October. Everyone was concerned about the possibility of more terrorist strikes, which would very likely produce a sharp, downward gap in the stock market. On the other hand, nearly all put/call indicators at the time were giving buy signals, reflecting the markets deeply oversold state. Thus, there appeared to be potential for a sharp upside price move as well. However, the unknown variable in this scenario was the timing of the event. Moreover, during October the underlying market was behaving much as an individual stock does prior to an important event: trading in a range despite the very high VIX readings, the constant scary stories on TV about anthrax, terrorists attacks and the seemingly growing worldwide unrest over the bombing of Afghanistan. That the broader market was relatively unchanged while the

Source: MetaStock Professional (

FIGURE 5 HIGH VOLATILITY The CBOE Volatility Index (VIX) reached extremely high levels in the days following the Sept. 11 terrorist attacks. This created an opportunity to execute an event-driven straddle trade on index options.
CBOE Volatility Index (VIX), daily 60 55 50 45 40 35 30 25 20 23 30 6 13 August 20 27 4 10 24 September 1 8 October 15 22 29

Source: MetaStock Professional (

VIX was high offered the opportunity to execute an event-driven straddle buy in index options for those who expected a big movement. At this point, it was important to evaluate what the Dow Jones (DJX) straddle might be worth for the November expiration. During mid-

October, the DJX was near 94, and the NOV 94 straddle was selling for approximately 6.20. The DJX is oneone hundredth of the Dow Jones Industrial Average (Figure 6), so to profit from a long straddle, we would need a move of 620 points in the big
continued on p. 24



FIGURE 6 DOW JONES INDEX OPTIONS The price of the Dow Jones index options moved more than 8 points from October to November a substantial move that resulted in a successful trade for straddle buyers.
Dow Jones Industrials (DJX), daily

index prior to expiration. What was the probability of the Dow being able to move 620 points between mid-October and the November expiration? Any probability estimate is very dependent on what volatility we expect the Dow Jones index to have during the life of the option. This was one of the most difficult times in history to predict volatility because of the potential for chaos. For example, the 10-day historical volatility of the DJX at the time was 18 percent something fairly in-line with the long-term history of the broad market. However, the 20day historical volatility was 30 percent, because this longer time frame contained some of the chaotic trading days following the terrorist attacks. Which volatility measure should be used in trying to estimate the probability of the DJX being able to move 620 points over the course of one month? Although there is no definitive answer, the probabilities are shown in Table 5. The probabilities were derived using www.optionstrategist.coms Probability Calculator 2000, which uses a mathematical technique called Monte Carlo theory to predict the probability of a stock hitting a target (or targets) at any time during the life of the trade. Most free online calculators allow you to estimate the probability that a stock will be above or





80 10 24 September 1 8 15 October 22 29 5 12 19 November

Source: MetaStock Professional (


Volatility 18% 25% 30%

Estimate of hitting breakeven 58% 82% 92%

Source: Probability Calculator 2000 (

below a target price at the end of a study period say, at option expiration. However, its more reliable to have these probabilities relate more to a real-world environment, as the Monte Carlo simulation does. Considering the results from Table 5, if we use the lowest estimate of volatility (18 percent) there is a 58 percent chance that the Dow can move 620 points either up or down at some time prior to November expiration. However, if we used the highest volatility estimate of 30 percent (which would probably not occur unless chaotic events took place on either the upside or the downside), there is a 92percent chance the Dow will move 620 points. Both of these probabilities are quite high. The position on Oct. 18 was to buy DJX NOV 92 calls (DJVKN) at 3.10 and buy the DJX NOV 92 puts (DJVWN) at 3.40. At that time the DJX was 91.64. Figure 6 shows that the DJX rose to almost 100 by expiration a move of more than 8 points (equivalent to a move of more than 800 points by the index itself), which was more than the cost of the straddle. Hence, this was

something of an event-driven straddle buy in the broad market because as is the case with individual stocks the options were seemingly expensive but in reality failed to account for the full effect of the chaos potential of the underlying market.

A sector to watch
Because event-driven straddle trading works best in FDA- and FTC-related situations, increasing activity in the biotech sector should lead to many more opportunities for these trades. Watch for options that are overly expensive, then determine if they are trying to adjust for the outcome of a government hearing or a lawsuit. Careful analysis and conservative interpretation of the guidelines at the beginning of this article (and in last months article) will help you focus on the best trade setups. For more information on the author see p. 4. Questions or comments? Click here. A version of this article previously appeared in Active Trader magazine.


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Options and sentiment analysis

Put/call ratios, short interest, and the option open interest configuration: Find out what these sentiment tools represent and how you can trade with them.


hort-term option buying can be lucrative, but there is a reality that all option traders must face: You will have losing trades. In fact, successful options buyers almost always have more losing trades than profitable ones. However, they still achieve substantial gains because their winning trades take in far more dollars per trade than their losing trades give up. Accordingly, it is imperative that winning trades yield substantial profits for a trader to be successful. Contrary to what you might think, successful options trading does not result primarily from your knowledge of options or options strategies. While such knowledge is necessary for successful trading, the key factor is your ability to correctly forecast the direction, magnitude and speed of the underlying stock. Poor stock-pickers will never profitably trade options,

even if they are option wizards. In fact, option trading will only magnify this inadequacy.

The need for speed

There are three conditions the underlying stock must satisfy for an option buyer to achieve a substantially profitable option trade: 1.The underlying stock must move in the predicted direction. 2.The move must be sufficiently large to overcome the options time premium. 3.This move in the predicted direction must occur quickly; otherwise, the option will expire before the move unfolds. Option buying is a constant battle between the leverage that options pro-

vide and the time decay that will inevitably occur. You can beat time decay only if the underlying stock moves quickly in the proper direction. In other words, speed allows the leverage of the options you buy to overwhelm their inherent time decay. Thats the foundation for a profitable optionbuying program. The challenge is to pick stocks that meet the previously outlined conditions. Most stock pickers tend to use some combination of fundamental technical analysis to predict future price movement. Generally speaking, however, price-to-earnings ratios, dividend yields and other well-known fundamental indicators are not particularly useful for short-term options trading. These are good reflective tools, but they are not very helpful in forecasting short-term stock prices, something that is critical for the time frames in which option traders operate.

Although technical analysis is certainly not a fail-safe method for predicting price movement, it has an advantage: Price and volume patterns are grounded in the real world of how investors are currently viewing a stock or market (i.e., they are a direct indication of how much buying or selling is going on at a precise moment). Technical charts are useful for identifying trends and support and resistance

level to one that reflects the real world. Conversely, high expectations can ultimately put downward pressure on a stock, as the price adjusts itself lower from its unrealistic heights to better match reality. Put another way, low expectations translate into potential buying power, as skeptical investors wait on the sidelines, ready to bolster a stocks appreciation by buying up the supply from

The key to successful option trading is not knowledge of options or option strategies; its the ability to correctly forecast the direction, magnitude and speed of the underlying stock.
levels, and give a good indication which way the underlying position will move. However, they dont provide a clue about the magnitude or speed of the move. profit-takers. This excess demand drives the price even higher. On the other hand, high expectations usually mean that most of the sideline money has already been committed to a stock. Buyers are now scarce and selling will dominate on any perceived negative news, resulting in a price decline.

The option-buying edge

Although strong fundamentals and technicals are usually necessary for a stock to move higher, their confluence does not ensure future strength. A stock needs a catalyst to give it the necessary boost to power higher following an earnings report or quickly decline following an encounter with overhead resistance. This additional ingredient is investor expectation, which can enhance the reliability of technical and fundamental signals. In fact, sentiment analysis the study of the beliefs and convictions of traders and investors is often the most important factor in stock selection. It can provide you with a tremendous edge in evaluating the price movement of individual stocks and the market as a whole. Expectations are critical because a stocks price represents traders and investors perceptions of reality and these perceptions are often excellent contrary indicators. If expectations for a stock are relatively low, there is a good chance of a rally, as the stock price will rise from an artificially low

Sentiment tool kit

There are a number of tools traders can use to gauge investor sentiment. Well take an in-depth look at a few of the most useful. Short interest. Short interest measures how many shares of a particular stock were sold short during a specific period of time. (A short-selling strategy is profitable when the price of the stock declines, allowing the short seller to buy the stock back at a lower price.) Monitoring a stocks monthly short interest provides an idea of the publics level of pessimism toward the stock. In most instances, increasing short interest indicates the general outlook for the company is negative. This pessimism is bullish for the stock if it is in an uptrend, because negative sentiment in the context of strong price action often implies a resumption of the prevailing trend. Another factor is the short-interest ratio, which is the number of shorted

shares divided by the stocks average daily volume. Low ratios (around 2.0 or lower) suggest the shorts could be covered in just a few days and would not likely impact a stocks price move. Higher ratios (6.0 or greater) could result in a short-covering rally if the stock continues to gain ground. Magazine covers. The covers of business magazines are often amazingly accurate contrary indicators, and when a business story is featured on the cover of a general news magazine (e.g., Time, Newsweek) the contrarian implications are even stronger. Quite simply, when a magazine cover features a stock or an investment trend (either bullish or bearish), the trend is very likely at or near its peak. Magazine covers work as contrary indicators for a simple reason: A trend will be featured on a magazine cover only when it has been in place long enough to become widely known and almost universally accepted. Once a trend reaches the magazine-cover level of awareness, it is almost certainly at its peak, as the last to know in the investing public finally gets the word. Cover stories are most effective as contrarian indicators when several publications have a similar theme with similar concluding remarks. Put/call ratios. Option open interest is a highly effective means of measuring investor optimism and pessimism. Open interest represents the number of open contracts on an option at the end of each day. When open interest data is displayed in the form of put/call ratios, it is most useful for gauging whether a stock is poised for a rally or vulnerable to a sell-off. High put/call ratios often indicate excessive pessimism and, thus, large amounts of money on the sidelines. Conversely, low put/call ratios indicate a point at which there is so much optimism that very little money is left to push the stock or index higher. Its important to note that contrarian views of public sentiment often prove to be more reliable than those of institutional sentiment. For that reason, focus on the front three months of
continued on p. 28




options data, which is where the retail speculators tend to gravitate. Each stocks put/call ratio behaves differently and has its own particular timing implications. By comparing the current put/call ratio to previous readings for that stock, you can accurately gauge relative levels of investor optimism and pessimism. This is extremely important because absolute readings can vary substantially from stock to stock. Comparing a stocks ratio to its previous ratios is an apples to apples gauge that provides a more accurate picture of sentiment. Comparing ratios also allows you to see if current readings are among the highest or lowest readings of the past year. Ratios that are among the highest of the past year suggest a relatively extreme level of negative sentiment, which can have bullish implications for a stock with strong fundamentals and technicals. The opposite is true for a ratio that is among the lowest of the past year. Option open interest configuration. Another way to use open interest is to examine the open interest configuration of the underlying stock, which is the number of open puts or calls at its various option strike prices.

In early October, KKDs solid fundamentals were backed by strong technical signals: The stock had rallied above the 10-week moving average (MA), and was supported on an even longer-term basis by its 10-month MA (inset).
Krispy Kreme Doughnuts, Inc. (KKD), weekly Monthly
40.00 35.00 30.00 25.00 20.00 30.00 35.00 40.00



2001 Feb.







Sept. Oct.


Source: TradeStation Platform by TradeStation

lative investors may buy the underlying stock to balance their bearish positions. These long positions will ultimately be sold when the options expire or the call buyers unwind their positions. Moreover, call sellers can

tals, lets take a look at an early October 2001 call option trade in Krispy Kreme Doughnuts (KKD). From a fundamental perspective, the company had made an impressive showing in the second quarter of 2001,

Sentiment analysis the study of the beliefs and convictions of investors is one of the most important factor in stock selection. It can provide a tremendous edge in evaluating the price movement of individual stocks and the market as a whole.
It can be analyzed by plotting a chart with adjacent call and put bars representing the open interest at every strike price (typically for front-month options). This approach is effective in determining possible resistance and support levels, especially at strike prices with the highest open interest for the month. A high level of call open interest identifies a potential point of extreme market optimism that usually coincides with a drop in buying strength. This suggests it will take less selling to change the stocks direction. Also, those who sold these options to specu28

become a very significant factor as the options approach expiration, because they generally own stock they can sell to create overhead resistance. The opposite applies to puts. A high level of put open interest reflects a level of extreme pessimism toward the stock, which usually coincides with a lack of selling strength. Put sellers may short the stock to balance their bullish position, and they must eventually buy these shorts back.

Trading with sentiment

To see how sentiment indicators combine with technicals and fundamen-

with profits soaring 65 percent from the same quarter a year earlier. In addition, KKD reaffirmed earnings guidance for the rest of the year, something most companies wouldnt (or couldnt) do. On the technical front, the stock had rallied (and closed) above the 10-week moving average (MA), which had turned back a rally in late August (see Figure 1). In fact, KKD hadnt closed above its 10-week MA since mid-July. From a longer-term perspective, the stock was bouncing off the support of its rising 10-month MA (see inset on Figure 1).


Perhaps the strongest technical case, though, was KKDs relative strength vs. the broader market. KKDs weekly relative strength vs. the S&P 500 (SPX) had just made a higher high after a pullback in a powerful uptrend (see Figure 2). In fact, the stock had outperformed the S&P by more than 250 percent since its IPO in April 2000. Despite these factors, investor sentiment was clearly entrenched in the pessimistic camp. The number of shorted shares stood at more than 8 million, which represented more than 15 percent of the shares outstanding. Furthermore, KKDs short-interest ratio was just under eight, which made the stock vulnerable to a short-covering rally. Analyzing option data revealed the stocks put/call ratio was hovering around 1.00, meaning that puts and calls were about equal among options expiring within the next three months. For most stocks, calls outnumber puts, so this ratio suggested a relatively high preference for puts, or bets the stock would decline in value. This sets up an ideal bullish scenario, because there would likely be many skeptical investors waiting to jump on the bandwagon if the stock continued its renewed ascent. Finally, the stocks open interest configuration added to the bullish picture (see Figure 3). By moving above 30, the stock overcame the level with the greatest call open interest and the potential resistance that such high levels often provide. Also, investors had been adding puts at the 30 strike, making it the level for peak put open interest in the October series. This concentration of puts set up the possibility of optionrelated downside support at that level. With the stock at 30.62, a long position in the November 35 call was established. Because this option was more than four points out of the money (i.e., the calls strike price was more than four points above the stock price), a large stock move was needed to produce a substantial return on the $1.10 option premium. The stock ended up making a major run over the subsequent week. In fact, it raced above 35 in just four days, producOPTIONS TRADER April 2005

KKD had dramatically outperformed the S&P since its IPO in April 2000. The stocks weekly relative strength vs. the S&P 500 (SPX) shows it had just made a higher high after a pullback in a powerful uptrend.
505.47 450.00 400.00 350.00 300.00 250.00 200.00 150.00 99.98

July 2000 Source: ILX Systems


Jan. 2001




FIGURE 3 OPEN INTEREST CONFIGURATION KKDs open interest configuration (the number of open puts or calls at its various option strike prices) rounded out a bullish scenario. By moving above 30, the stock overcame the level with the greatest call open interest (and the potential resistance such high levels often provide). Investors also had been adding puts at the 30 strike, making it the level for peak put open interest in the October option series. This created the possibility of option-related downside support at that level.
5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0

Call Put



30 Strike price



Source: Schaeffer's Daily Sentiment

ing a profit of 140 percent on the call option position from a 16.5 percent move in the underlying stock. This was only possible, though, because the stocks move was: in the right direction; of sufficient magnitude; and occurred quickly, reducing the impact of time erosion.

tations of market participants and selecting profitable option trades. Incorporating these tools will allow you to take advantage of opportunities the crowd has not yet discovered.
For more information on the authors, see p. 4.

My sentiments exactly
Combining sentiment indicators with technical and fundamental tools provides an extra edge in gauging expec-

Questions or comments? Click here. A version of this article previously appeared in Active Trader magazine.


Options can seem complex, but learning a few basic concepts will remove much of the mystery and

intimidation. Heres what you need to know to get started in the world of puts and calls.

t is a concept as old as free markets: You can pay for the right to buy or sell something at a fixed price for a certain period of time. Its called buying an option. This concept is just as much a part of the real estate and movie industries as it is the financial markets. For example, a common practice in real estate is to buy an option on a piece of property: You give the property owner some money, and he agrees to give you the opportunity to buy the property from him for an agreed upon price any time in, say, the next six months. If you dont buy the property within that time period, you no longer have any claim on the property and the current owner gets to keep the money you gave him (and sell the land to someone else, if he wishes). In the movie business, studios routinely buy options on hot screenplays or books for possible development into feature films. A studio might pay a screenwriter $50,000 for an option on his script, locking up the rights to it for a certain period of time the screenwriter cannot sell the script (or sell another option on it) to another studio who might be interested in making a movie out of it during this period. Again, if the studio that bought the option does nothing in the allotted time period (that is, they dont purchase the script outright, or perhaps pay more money to the screenwriter to extend the length of the option), they lose their rights to the screenplay, and the writer keeps the money (and can turn around and sell or option the script to someone else). Options on stocks, futures and other financial markets operate on the same principles. By purchasing an option on a stock, you can acquire the right to buy or sell that stock at

a specific price for a certain period of time. For example, you could buy an option that would give you the right to buy Oracle (ORCL) at $30 any time in the next three months. If the stock rises during that period, you could profit two ways: You could sell the option (which would have increased in value because of the rally) to someone else, or exchange it for shares of ORCL priced at $30, and sell those.

Why options?
To get an idea of why and how to use options, lets consider some possible rationales for the participants in our hypothetical real estate scenario. First, why would someone interested in a property buy an option for the right to purchase it in the future, instead of simply buying the property outright? One motivation for the option buyer might be limited risk. Because hes not required to purchase the property he simply has the right to do so while the option is in effect his risk is limited to what he pays for the option. By comparison, if he bought the property outright and real estate values plummeted, hed be left holding the bag. In return for his investment, he also stands to make a handsome profit if the property value increases during his option holding period. For example, if the option buyer bought an option that gave him the right to purchase the property for $5,000 an acre any time in the next six months, and the value of the real estate jumped to $10,000 an acre during that period, the option buyer has effectively doubled his money (less what

he paid for the option). He could buy the property for $5,000 an acre and turn around and immediately sell it for $10,000 an acre on the open market. Here are two versions of what things might look like from the option sellers viewpoint. First, if the current owner of the property was already planning on selling the land, but was in no rush to do so, he has a chance to make some extra money by selling the option to the option buyer. If he does, he is obligated to sell the property at $5,000 an acre to the option buyer (if the option buyer chooses to make the actual purchase, which may or may not happen), but because his eventual plan is to sell anyway, his only risk is that, if the property value suddenly increases, he may have to sell his property at a price below its open-market value. However, if $5,000 per acre represents a significant profit over what he initially paid for the property, this last point is moot; in effect, hes locked in what he considers to be an acceptable profit (even though it might not be as big as it could have been). Second, the property owner might not be particularly interested in selling his property, but he might think its value may drop in the near future. In that case, selling the option is a way to create some cash flow that will offset the depreciation of his property. If the property drops to $3,000 per acre on the open market, its unlikely the option buyer

Calls and puts

There are two types of options: calls and puts. A call option gives the buyer the right (but not the obligation) to buy the underlying stock at a specific price (the strike or exercise price) until the designated expiration date of the option. The price of the option is referred to as the premium. A standard option represents 100 shares of common stock. If you buy three call options, you are buying the right to purchase 300 shares of the stock in question. FIGURE 1 Underlying stock DELL Expiration month May Strike (exercise) price 20 Type Price (premium) 4 .25


Figure 1 shows the different elements of an option. The example shows a Dell (DELL) May 20 call option trading at a premium of 4.25. Buying this option would give you the right to purchase 100 shares of Dell (the underlying stock) at 20 (the strike price) until expiration, which in the case of May 2001 stock options is May 18. Each point of a stock options premium represents $100 (because each option contract represents 100 shares of stock), so you would pay

The major advantages of options are limited risk (in some, but not all cases) and flexibility, in terms of establishing trades that can profit in different circumstances or market environments.
will want to use his option rights to buy it at $5,000 per acre, and the owner will get to keep the money he collected for selling the option. However, if the property owner is wrong, and the property value rises, he runs the risk of having to sell his land. In short, the major advantages of options are limited risk (in some, but not all cases) and flexibility, in terms of establishing trades that can profit in different circumstances or market environments. (This aspect will be discussed in greater detail in the sections on options strategies.) These characteristics attract stock and futures traders to these instruments. Also, options can be cheaper to trade (because of more favorable margins in some cases) than outright stock or futures positions. Learning to trade options begins with understanding the basic definitions of these tools and the aspects of price behavior that affect how they trade. The following discussion is given in terms of stock options. However, the concepts apply equally (except where noted) to futures options.

$425 for this option; a premium of 4 .25 would translate to a price of $450, and so on. (Premiums for options on futures are generally quoted in terms unique to the specific underlying futures contract.) A put option gives the buyer the right (but not the obligation) to sell the underlying stock at the strike price until expiration. Figure 2 (below) shows the elements of a Dell put option trading on Jan. 10. In this case, the strike price and expiration month are the same as the call example, but the premium is 2 .5625 ($256.25). FIGURE 2 Underlying Stock DELL Expiration Month May Strike (Exercise) Price 20 Type Price (Premium) 2 .5625
continued on p. 32





A typical option quote display. Note the difference in premium (time value) between options with the same strike prices but difference expiration months.

Source: QCharts by

Figure 3 shows a typical quote screen with option chains (industry-speak for lists of option price quotes) for DELL call options. Options are typically described in terms of their underlying market, contract (expiration) month, strike price and option type. The DELL call option expiring in May with a strike price of 20 would commonly be referred to as a DELL May 20 call. An ORCL put option expiring in June with a strike price of 25 would be a ORCL June 25 put. Buying a call is a way to go long the underlying stock without actually purchasing it; buying a put is a way to go short the underlying stock without actually selling it. Because you are not obligated to buy or sell stock when you buy a call or put option, the risk on a long option position is limited to the premium you paid for it. The profit potential is theoretically unlimited (for calls), because there is no limit to how high a stock can rise. (Stocks can only drop to zero, limiting the put side of the equation.) Accordingly, option buyers pay the premium for this combination of profit potential and limited risk. The next section will explain some of the risks of selling options. Stock options are listed in contracts that expire each month; you can buy or sell options that expire in any month. Option contract months for futures will vary from market to market.

Options can be bought and sold to profit from their price fluctuations (like any other trading instrument) or exchanged for stock to profit in the underlying market. The act of translating a long option position into a stock position is called exercise. You do so by notifying your broker you

wish to exercise your option (you will pay an extra exercise fee for this, on top of your brokerage commission). The underlying stock represented by the option is then assigned to a seller of the same option (not necessarily the same person you executed the option trade with the process is more random), who must sell you the stock at the options exercise price. You must exercise an option before expiration day, which (for stock options) is the third Friday of the month for each option contract month. April options expire on the third Friday of April, and so on. The risks for a person who sells an option (referred to as an option writer) are reversed from those of an option buyer. The writer makes money by collecting the premium the option buyer pays. This money is the option writers to keep, regardless of what happens to the option price or the underlying market. However, this revenue comes with a price tag of its own, in the form of risk. For example, by selling a call option, the writer assumes the obligation of having to sell the underlying stock to an option buyer who exercises his option, as previously described. Say a trader bought the DELL May 20 call option in Figure 1 when Dell was trading around 19, assuming the stock would rise significantly by expiration day. A seller of the same option might have established his or her position assuming the stock price would drop, in which case it would be unlikely option holders would exercise their options because they would be paying more for the stock than the current market price. Assume the stock has rallied to 30 two weeks later. The option buyer may want to sell his option for a profit, or exercise it and establish a long position at 20 in a stock now trading $10 higher. In the latter case, the option writer will be forced (if assigned) to sell the stock at 20 when it is trading at 30. If the writer does not own the stock, he or she would have to buy the required number of shares in the open market at 30 and sell them to the option holder at 20, taking a 10-point loss. Similarly, a put seller runs the risk of having to buy stock at a loss if assigned when a put buyer exercises his option. In short, option writers assume the risk of unprofitable stock assignment in return for receiving premium. Selling calls and puts outright (referred to as naked options because these trades are not covered by a position in

the underlying market) is the same as having a short or long position, respectively, in the underlying market.

The Greeks
Option Greeks are measures of how an option behaves in relation to shifts in its underlying market and the interaction of different option-pricing components. Delta is the change in an options value relative to a change in the price of the underlying market. Delta varies between 0 and 1. An option with a delta of .50 (50 percent) would move a half-point for every 1-point move in the underlying stock; an option with a delta of 1.00 would move 1 point for every 1-point move in the underlying stock. Gamma is the change in delta relative to a change in the underlying market. Unlike delta, which is highest for deep ITM options, gamma is highest for ATM options and lowest for deep ITM and OTM options. Rho is the change in option price relative to the change in the interest rate (i.e., how sensitive the option is to interest rates). Theta represents the rate at which an option decays each day (the rate of time decay). Theta is relatively larger for OTM than ITM options, and increases as the option gets closer to maturity (i.e. its expiration date). Vega is how much an options price changes per a 1-percent change in volatility (i.e., how sensitive the option is to volatility).

How options are priced

A stock options price is influenced by six factors: the underlying price of the stock, the strike (exercise) price, the time (days) until expiration, volatility, dividends (if any) and the prevailing interest rate. (For options on commodity futures, the dividend factor is irrelevant, but you may have to factor in storage costs for the commodity in question.) The relationship between the price of the underlying stock and the strike price is the easiest part of option pricing to understand. Say a stock is trading at 50 and you are looking at two call options with the same expiration date, one with a strike price of 40 and another with a strike price of 30. The option with the strike price of 30 should be trading at a higher price than the option with the strike price of 40 because the former option could be exercised for stock at a price of 30 while the latter option could only be exercised for stock at 40. Because the stock could be immediately sold in the open market at 50, the owner of the first option would make a profit of 20 points if he exercised his option (not taking into account commissions or the premium paid for the option) while the owner of the second option would make only 10 points. Accordingly, the option with a strike price of 30 should command a higher price for its larger built-in profit. The difference between an options strike price and the price of its underlying stock is called intrinsic value. In this example, the first option has an intrinsic value of 20 and the second has an intrinsic value of 10. In terms of the relationship between strike price and underlying price, options fall into three categories: in-the-money (ITM), at-the-money (ATM) and out-of-the money (OTM). ITM options are calls with strike prices below the current underlying price and puts with strike prices above the current underlying price. The minimum value of any ITM option is its intrinsic value. ATM options are calls and puts with strike price equal to (or, in practice, nearly equal to) the current underlying price. OTM options are calls with strike prices above the current underlying price and puts with strike prices below the current underlying price. Only ITM options have intrinsic value; the intrinsic value of all other options is zero. A call option with a strike price of 60 has zero intrinsic value if the underlying is trading at 50. The next component of an options price, time until expiration, also is a straightforward concept. The more time left until an option expires (referred to as its time value), the greater the options value. This is a function of the unpredictability of the future. If you had to make a prediction

whether a stock would close above or below a certain price level, would you rather try to predict whether it would reach that level in the next 24 hours or the next 24 days? For example, if you calculated the average close-to-close move in a particular stock over the past 20 days and found it was three points, and your bet was to determine whether the stock would close tomorrow more than 10 points away from todays close, you would probably say it would not, because the stocks typical price behavior suggests it will only move three points from today to tomorrow. (By the way, the average close-to-close move over the last 20 days used in this example is a measure of the underlying stocks volatility, which will be discussed shortly.) Now assume you are trying to determine whether a stock will close x points away from the current close three months from now. Without going through the entire analytical process again, two things are apparent: First, the stock could potentially move much more over this period than it could in a day; second, you would be much less confident
continued on p. 34



FIGURE 5 COVERED CALL WRITE FIGURE 4 LONG CALL SPREAD The long call spread consists of long and short call options at different strike prices. Its a limited-risk, limited-potential strategy designed to profit from an up move in the underlying stock
Profit Long call

Selling call options against a long stock position is called a covered write. The position is most profitable if the stock expires at, or just above, the strike price of the options, allowing you to keep the premium.
Profit Long stock

Long call spread Price of stock

Covered call write Price of stock Short call Loss

Short call Loss

predicting where the stock is likely to close three months from now because of the inability to know all the possible events that could affect the stock between now and then. Because this uncertainty decreases as expiration approaches, the time value of an option disappears at an accelerated rate with the passing of time (a process known as time decay see Theta in The Greeks). One of the advantages of selling options is that time decay works in your favor. Figure 3 provides a clear example of time value: The May 25 call is trading at 2.5; the August 25 call is trading at 3 .5.

Accordingly, it is covered in greater detail in other articles in this issue. For an in-depth discussion of the role of volatility in option pricing and trading, see Putting volatility to work,and Indicator Insight. Dividends and interest rates are the final option-price components. The more dividends a stock will generate over the lifetime of an option, the greater the value of the call options on that stock, and the lower the value of put options. (As mentioned, dividends are irrelevant to commodity futures options.) Similarly, the higher the prevailing interest

Of all the option price components, volatility is the most variable, and the most important to understand.
Same stock, same strike price, different expiration month. In this case, the difference in time value between the May and August expirations is one point. An options value also fluctuates with the level of volatility in the market at a given time. The higher the volatility (i.e., the more price movement), the more uncertainty in the market, and the higher the premiums options sellers will demand for the risk they assume. The lower the volatility, the less uncertainty there is in the market and the lower option premiums will be. Another way to look at volatility and time value is the higher the volatility and the further away from expiration, the better the chance the stock will trade favorably to the option holder. For this higher likelihood of success for the holder, the option seller will demand a higher compensation. Of all the option price components, volatility is the most variable, and the most important to understand.

rate, the higher call premiums will be, and the lower put premiums will be, all other conditions being equal. Option values can be calculated using any number of option pricing models, the best-known of which are the Black-Scholes, Black-76 and Binomial models. Such models are computationally intensive, but they all essentially factor in the option price components outlined in this section and produce a theoretical price for an option. However, because markets are made up of human beings driven by fear and greed, the price of an option can vary significantly at a given moment from its theoretical value.

Trading strategies
Options can perform many functions. An investor long a stock could buy a put option as a hedge against a price drop. Or, a trader with a long stock position could sell calls against

his stock to generate additional income. A trader could buy a call (or sell a put) to take part in an expected up move, or buy a put (or sell a call) to profit from a down move. In practice, using options is a more sophisticated process than these approaches suggest. In short, its easy to determine that buying a call will allow you to participate in an up move. The tough part is determining which particular call to buy, or whether to consider an alternate strategy, including one that consists of more than one option and offers a more favorable trade. Well look at a few option strategies, show how they illustrate the concepts outlined earlier and how they are typically used in the market. While we will just scratch the surface here, these examples will give you an idea of the possibilities available to option traders and the considerations that go into establishing an option trade.

FIGURE 6 LONG STRADDLE Purchasing calls and puts with identical strike prices and expiration dates allows you to profit from a large move in either direction in the underlying stock.
Profit Long put Long call

Price of stock


Long straddle

Option spreads: Customized trading

Professional option traders create option spreads combinations of long and short options far more often than they buy or sell options outright. They do this because they can construct trades with very specific reward-risk characteristics that can profit from a wide range of market situations (i.e., not just whether a stock or future goes up or down, but how much it moves in either direction). Outright option positions are like buying a suit off the rack. Option spreads are like having a designer suit tailored to your specifications. Two of the most basic option spreads are the call spread (bull spread) and its opposite, the put spread (bear spread). A long call spread consists of simultaneously buying a call option with a lower strike price and selling another call option with a higher strike price. An example of a long call spread would be, with the underlying stock trading at 50, buying a 50 call for 6 .5 and selling a 60 call at 3. The goal of this trade is to profit on the long call from an up move in the underlying stock while limiting risk with the sale of the short call option (although this short option will limit your profit potential as well). Figure 4 is a diagram of the profit-loss profile of a long call spread. The trades maximum profit occurs when the underlying stock price is the same as the higher strike price, in this case 60. Above that price, additional gains in the value of the long call option are offset by losses in the short option. The strategys risk is limited to the difference between premium paid and premium received, in this case 3 .5 points. A long put spread is a bearish trade in which you would buy one put with a higher strike price and sell another put with a lower strike price. good example of this approach is covered call writing (selling OTM calls against a long stock position). For example, with a long stock position at 50, you could sell a call with a strike price of 60. Covered calls profit most if the stock ends up just higher than the strike price of the call (in this case 60). These trades should be executed in stocks on which you are neutral to mildly bullish. If the stock rallies too strongly significantly above the strike price youll lose money on your options. Figure 5 shows the profit profile for a covered call write at expiration. There is no limit to the downside risk for this position, but because of the premium received for the call option the stock needs to decline by at least that amount before the position starts to lose money.

The flexibility factor

One of the strengths of options is that you can build nondirectional strategies that can profit regardless of the direction of the underlying market. Such strategies are volatility-based. They seek to profit, in the case of long-option strategies, from an increase in volatility (which will inflate option values), and in the case of short options, from a decrease in volatility (which will deflate option values). The classic non-directional, volatility-based option trade is the straddle. It consists of buying a call and a put with identical strike prices and expiration dates; the position profits when the underlying stock moves enough in either direction to overcome the premium paid for the options. For example, consider a stock trading at 50 with ATM June (i.e., with strike prices of 50) calls trading at 6 .25 and ATM puts trading at 5 .5 (which, by the way, implies a slight bullish bias in the stock since the call and put should theoretically have the same value in a completely neutral market environment). If you buy the straddle that is, simultaneously purchase the June 50 call and put for a total cost of 11.75 the stock must move 11 .75 points (plus what you paid in
continued on p. 36

Combining options and the underlying instrument

Combining the reward-risk characteristics of options and their underlying stocks is another way to construct flexible option strategies.



commissions), up or down, to generate a profit. If the stock goes up, youll lose money on the put and make money on the call; vice versa if the stock drops. Your risk is limited to what you paid for the options. Figure 6 shows the profit-loss profile of a long straddle The key to this kind of strategy is to buy low-volatility options, because lower volatility means cheaper option premiums, which in turn means the options have greater potential to increase in value if and when the underlying market moves. For example, a stock in a very tight trading range would have low volatility, which might make options on it a good candidate for this kind of trade. Straddles, then, are ways to play breakouts in situations when youre unsure which way the market will break out. In practice, option traders will try to identify the best options for this kind of long-volatility trade by calculating the volatility (perhaps both the implied and historical volatility) and determining whether it is exceptionally low, which would mean the options are a good buy relative to other options. Selling a straddle is a technique to capitalize on an expect-

a great deal of time value and buy options with less time value. Such techniques allow you to tailor strategies with highly defined risk characteristics that can capitalize on various market conditions or forecasts. On a practical note, because options commissions are more expensive than straight stock commissions, executing many well-known multi-option strategies, such as butterfly spreads, are impractical for most off-floor retail traders, especially short-term traders.

Build on the basics, appreciate the subtleties

The topics presented here have been simplified to make them more accessible. As mentioned, most successful options professionals do not simply buy calls when they think a market is going up or buy puts when they think a market is going down. They use combinations of options (spreads) and stock-option mixtures to construct either directional or non-directional strategies, keying their strategies to the relative volatility levels in the market at a given time. In short, they want to own low-volatility options and sell high-volatility options.

The importance of volatility cannot be stressed enough. Understanding this aspect of price behavior is the key to buying inexpensive options and selling expensive ones.
ed drop in volatility (a short-volatility trade). In this case you would want to sell identical calls and puts when volatility is exceptionally high, collecting the accordingly inflated premiums, and then profit as volatility returns to more normal levels and the options drop in value. The reward-risk profile of this trade is exactly the opposite of the long straddle: Your return is limited, but your risk is not. In return for this risk, you get the premium. As long as the market doesnt move (in either direction) enough to erase your total collected premium, youll profit. The closer it stays to the strike price, the more you will profit. This is only one example of the flexibility options provide. The nuances you can add to a trade are virtually limitless. For example, if you see evidence of a slight upside bias in the underlying market, you could purchase more calls than puts say, three calls for every two puts to take advantage of an up move. The more calls you buy relative to puts, the greater the bull bias in the position. You would reverse the ratio to give the position a greater downside bias. Using such ratios is a common technique for adding flexibility and directional bias to all kinds of options spreads, not just straddles. Another layer of flexibility can be added by selecting options that are in the money or out of the money by varying degrees. You also could use options with different expiration dates, or sell options with

In this regard, the importance of volatility cannot be stressed enough. Understanding this aspect of price behavior is the key to buying inexpensive options and selling expensive ones the real edge in trading options. Despite what some people may want you to believe, theres a dirty little secret in options trading: Professional option traders sell options more often than they buy them, to put time decay on their side. Who are they selling them too? The public, of course, whose predisposition is always to buy first. This is not exhortation for retail traders (especially beginners) to exclusively sell options there are risks to doing so but this reality should provide some food for thought. Options trading is not rocket science (even rocket science isnt rocket science if you can get someone to explain it to you in plain language), but it is multi-layered and nuanced. To come out ahead, you have to understand its subtleties as well as its hard-nosed realities and that takes time. Remember, there is no free lunch in the markets. Limited risk is always accompanied by limited profitability. Similarly, the joy of collecting premium comes with unavoidable risk. Questions or comments? Click here. A version of this article previously appeared in Active Trader magazine.

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The Options Investigator

he Options Industry Council (OIC) performs and Options Strategies. The screen is separated into three windows. The largest many functions, from lobbying for the U.S. options exchanges to providing volume statis- window features the information (audio of the text is also tics and other data to the media. THE OPTIONS INVESTIGATOR However, the OIC also is an educator, through its Web site ( and other endeavors. One of its most popular educational tools is a CD-ROM called The Options Investigator. The Investigator is designed for beginners, as it covers everything from the difference between a put and a call to how to place an order. It can be ordered free of charge through the OIC Web site. The program is a combination of text and multimedia, and its presented in a straightforward fashion. The home page has four sections The Tutorials, The Strategy Explorer, The Position Simulator, and Live Seminars. To a beginner, the latter three wont make any sense without the first, so its best to start with The Tutorial. The Tutorial is broken down into seven main sections Options Basics, Introduction to Premium, Strategy Basics, Placing an Order, Test your Options IQ, Principal Factors Affecting Price,



raders trying to find options suitable for a specific strategy might find help at PowerOptions ( The subscription-based site, which offers a 14-day free trial, has plenty of basic features (options chains, list of new 52-week highs/lows, etc.) and a helpful education section, but it also has search capabilities and other tools. One of the sites features is the SmartSearchXL, which allows users to find strategies as simple as covered calls or as complex as iron butterflies. The search engine has almost three dozen different parameters, ranging from option volume to stock price to implied volatility to delta to P/E ratio. Depending on the strategy, PowerOptions has pre-selected values for certain criteria, although all can be changed by the user. PowerOptions also features more than 20 reports, where pre-configured scans search for things such as stocks trading for less than $25 a share that are in an uptrend with at-the-money options available, or naked calls that are at least 10 percent out of the money and in a

downtrend. Again, users can change the pre-set parameters chosen by PowerOptions. While the searches require the user to have a working knowledge of options, the site also includes some very simple features. One is the Strategy Search Summary, which



available); the upper left window features charts, graphics, or more information, depending on what is being discussed; and the lower left window has the table of contents. The information is quite detailed. Each section features several sub-sections, and most finish with a quiz to make sure youve grasped what youve read. No single page provides too much information, which makes it easy to read and provides impetus to continue to the next section. The right side of the screen has a toolbar, with instant links to a glossary, a resource section (which provides numerous links to additional, more advanced information), and a virtual notepad that allows you to jot down thoughts and other observations. And, you can print out any page. The Explorer and the Simulator allow you to test different strategies; this is one tool even knowledgeable options traders can use. And, the seminar section takes you to the OIC Web site, where upcoming free seminars are listed. For those looking to cut their teeth in the options market, The Options Investigator is a simple and free program that provides a good place to start.

Exploiting Volatility: Mastering Equity and Index Options By David Lerman Marketplace Books, 2005 DVD, 108 minutes $99.00 This DVD presentation is designed to teach options traders how to profit from volatility instead of falling victim to it. David Lerman covers how to analyze and incorporate volatility in at least four forms historical, implied, forecast and future. Also, he outlines positive and negative aspects of common index and equity options strategies. Some topics include time decay, straddles, and volatility percentile rankings. An options literacy quiz is offered as well.

The Ten Most Powerful Option Trading Secrets By Bernie Schaeffer Marketplace Books, 2005 DVD, 102 minutes $99.00 Schaeffer presents 10 secrets of his contrarian trading style in this DVD presentation. He details how to go against the crowd and explains why he opposes some popular options trading strategies. Trading tactics Schaeffer proposes include using time stops rather than price stops to limit losses; trading options based on more than a high or low volatility; and buying put options as well as call options.

returns all the possibilities for covered calls, credits, spreads, etc. when you enter a stock symbol. Depending on the strategy, data is given for various statistics such as downside protection, delta, breakeven price, etc. A similar tool the OneStrike allows you to enter a stock symbol and search for a specific strategy. Another simple tool is the Optimized Long Option Finder. Enter a symbol and, if you wish, the expected price of the stock, the amount you are going to invest, and the date you expect the stock to reach your target price, and PowerOptions will produce a list of options suitable for buying. The Stock Repair Strategy allows users to enter a stock and view a list of options that can help recoup some of the money lost on the stock, as long as the original price of the stock is not too far from the current price. While a repair is not always available, when one is, the site provides a detailed explanation. Three subscription levels are available, ranging from $9.95/month to $79.70/month, and the site says if you dont make at least five times the monthly subscription fee trading options, your fee will be waived for the next month.

The Bible of Options Strategies: The Definitive Guide for Practical Trading Strategies By Guy Cohen Financial Times Prentice Hall, 2005 Paperback, 255 pages $49.95 This reference book features stepby-step instructions, disadvantages vs. advantages, and tips on mitigating loss for 60 options strategies. Cohen divides the approaches into five categories: income, volatility, sideways market, leveraged, and synthetic. An appendix includes a 13-page glossary and a summary table listing important aspects of the books strategies.



Options glossary
Call option: An option that gives the owner the right, but not the obligation, to buy a stock (or futures contract) at a fixed price. Put option: An option that gives the owner the right, but not the obligation, to sell a stock (or futures contract) at a fixed price. At the money (ATM): An option whose strike price is identical (or very close) to the current underlying stock (or futures) price. In the money (ITM): A call option with a strike price below the price of the underlying instrument or a put option with a strike price above the underlying instruments price. Out of the money (OTM): A call option with a strike price above the price of the underlying instrument or a put option with a strike price below the underlying instruments price. Deep (e.g., deep in-the-money option or deep out-of-the money option): Call options with strike price that are very far above the current price of the underlying asset and put options with strike prices that are very far below the current price of the underlying asset. Exercise: To exchange an option for the underlying instrument. American style: An option that can be exercised at any time until expiration. European style: An option that can only be exercised at expiration, not before. Expiration: The last day on which an option can be exercised and exchanged for the underlying instrument (usually the last trading day or one day after). Intrinsic value: The difference between the strike price of an in-the-money option and the underlying asset price. A call option with a strike price of 22 has 2 points of intrinsic value if the underlying market is trading at 24. Premium: The price of an option. Strike (exercise) price: The price at which an underlying stock is exchanged upon exercise of an option. Time value: The amount of an options value that is a function of the time remaining until expiration. As expiration approaches, time value decreases at an accelerated rate, a phenomenon known as time decay. Volatility: The level of price movement in a market. Historical volatility measures of the price fluctuations (usually calculated as the standard deviation of closing prices) over a certain time period e.g., the past 20 days. Implied volatility is the current market estimate of future volatility as reflected in the level of option premiums. The higher the implied volatility, the higher the option premium.

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The information on this page is subject to change. Options Trader is not responsible for the accuracy of calendar dates beyond press time.

Event: CME Options Online Seminar Part One: The Basics; Part 2: Trading Strategies Presenter: Dan Gramza Date: Part One, April 26 and Part Two, April 27; 3:30 p.m. - 4:30 p.m. CT For more information: Log on to Event: The Options Industry Council is conducting a handful of options seminars across the country this winter. They are taught by exchange professionals in a classroom-style format and run from 6 p.m. to 9 p.m. There is no cost to attend. For more information: Log on to for an updated listing of seminar locations, as well as schedules for OICs Covered Calls and Directional Strategies seminars.

Event: The 17th Annual Las Vegas Money Show. Date: May 9-12 Location: Paris & Bally's Resorts; Las Vegas For more information: Log on to Event: First Annual European Managed Futures Conference 2005. Finance IQ's First European Managed Futures Conference will focus on the risks and opportunities available when utilizing managed futures in your portfolio. Date: April 21 - 22 Location: The Selfridge Hotel, London For more information:

Event: Expo Trader Brazil International Asset Managers and Traders Conference. Speakers include John Bollinger, Larry Williams, and Frank Tirado. Date: June 23-24 Location: Sofitel Hotel, Rio de Janeiro, Brazil For more information: Event: The Traders Expo Chicago. Date: July 13-16 Location: Hyatt Regency Chicago For more information: or call1-800970-4355