Tag Archives | call options

Options: How not to use them

Mark Hulbert, at MarketWatch is primarily known for his ratings of advisory newsletters.  But he also  writes about some very interesting stuff.  Here's an example from yesterday.  The story is about a completely irresponsible use of options – by someone who should know better.

Indented text is Hulbert's (slightly edited) words

"Michael Murphy is the editor of an investment advisory service
called New World Investor. Among several portfolios that he
reports on in his service is a college fund that he created for his
seven-year old daughter. He typically allocates 100% of this portfolio
at any given time to just one security."


There is no question that this is a kill or be killed investment approach.  I've never heard of anyone using such a strategy for a college savings program.  I'm assuming he is sufficiently wealthy that this is not truly the only assets available for his daughter's future.

"last Wednesday night, Murphy went even further out the “go the
broke” spectrum: He invested his daughter’s entire college fund in just
one option—the Jan. $10 calls on Arena Pharmaceuticals"


(ARNA). 

"The call options
Murphy bought are now worth about 90% less than where they stood last
Wednesday evening.

The reason for the big drop: A Food & Drug Administration advisory
committee voted 9-to-5 against recommending that the FDA approve a new
drug that Arena is trying to develop.

Murphy had been betting that FDA
approval would be forthcoming, and had timed his purchase of Arena’s
call options to occur on the eve of the FDA announcement."


The fact that anyone would do any of the following, disqualifies him as an investment advisor – at least from my perspective.  And Murphy did all of them:

  • Invest an entire portfolio on a single investment
  • Buy call options – in a size trade – as an investment
  • Buy options when they are priced at their very highest – and that occurs just prior to a known news release
  • Admit to anyone that you made this trade – if you want to continue to have an audience for your newsletter.  Even if the investment result had been spectacular, it's not the type of gamble that you want to advertise.


"There are plenty of investment lessons to draw from Murphy’s experience,
and perhaps the most important is how one misstep can more than negate
many brilliant investment decisions."

Why would Murphy pursue such a high-risk strategy—one that some might
even characterize as reckless? I have no idea, but I do know that, for
many people in the investment arena, the excitement surrounding such
strategies is what makes them irresistible.


Just as some people go to a casino for the thrills of
possibly winning big, while simultaneously recognizing that they
probably will lose, some investors choose high-risk advisers for the
same reasons. And that’s entirely OK.

The problem [with investing this way] arises when you kid yourself into thinking that your
motivation is wealth building, when it is thrill seeking. You are likely to allocate more than just your play money to a
particular adviser or strategy—with all-too-predictable dangerous
outcomes, when this or that trade doesn’t work out"

Hulbert offers a very good analysis of the thrill-seeking (non) investor.  if you are serious about trading or about making money, don't be that thrill seeker when using your 'regular' trading account(s).

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Coming soon, a major announcement from Options for Rookie's.  It's too soon for details; still in the planning stages.

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Excercising a Call Option for the Dividend

I recently had an email conversation with an experienced option trader.  He's not a full-time trader, but has been using options for several years.  The point of mentioning this is to illustrate that anyone can have a blind spot that's difficult to resolve.

***

Hi Mark,

I've been buying ITM calls on several stocks – trying to capture upside, while limiting potential losses. Usually, I've done these 10% ITM, and typically trade 6-month options.

Eventually I may do it for nearer months, and roll more often, but I wanted to get going with positions I didn't have to watch so closely.

For investors, rather than traders, I prefer the 6-month options you are using.  In fact, I recently blogged on that idea.

 

I choose stocks that have little or no dividend, because the higher yielding stocks have less volatility, and presumably need less 'protection'. One stock that I've done this for is PG.  With a current yield of almost 3%, I'm questioning the wisdom of this choice.

 

PG has an upcoming dividend of $0.44, with an ex-dividend date this Apr21. [Obviously it's now after that ex-dividend date] My Oct $57.50 call is $6.10, with PG now at 63.00.

Can I expect the value of my call to drop by this $0.44 amount on Apr21, and the same amount on the Jul21 ex-date?  Am I leaving money on the table if I buy such an ITM call and don't exercise or sell before the first ex-date?

Assume you exercise the call. Look at the interest rate you must pay to carry stock (which may be almost zero if you have a large cash balance) from the day you would exercise – before ex-div date please – through expiration.  If the cost to own stock is greater than the dividend, then you obviously do not want to exercise. 

If you can exercise profitably by that standard, in return for collecting the dividend you gain substantial downside risk.  If you buy the Oct 57.5 put, you would own a position equivalent to your long call (long stock plus long put = long call).  If the cost to carry
plus the cost of the put is LESS than the dividend, then you should exercise
to earn that extra difference. [Don't ignore trading expenses]

The problem arises when you cannot buy that put at an appropriate price, and that's almost all the time. 

In general, a call is an exercise for the  dividend when two things obtain:  1) delta = 100.  That does not mean 99;  2) Time premium is zero.  That means you cannot sell the call and collect a price above the option's intrinsic value.  When the option bid is below parity (intrinsic value), there is no time premium remaining in the option.

If youmcan collect time premium, then it's more profitable to unload your call and NOT exercise. To prove that to yourself, check the price of the option when the stock opens for trading on ex-dividend day.  You will see that the time premium in the option is greater than the dividend. 

In other words, you are better off by NOT exercising. Remember, exercising gives you all the downside risk you rejected when buying the call in the first place.  If the put is not cheap enough to buy (eliminating the risk) then you do not want to exercise the call.

For a low yielding stock, I really don't care about the dividend. I'm not sure I want to do an ITM play if I'm squandering the equivalent of a 3% yield, as in this example.

You are not squandering anything.  This is a basic part of how options work.

If the option is not truly an exercise for the dividend, then you bought the option – at a premium that recognized the stock price would be lower – due to the dividend.  In other words, you got a 'bargain' on the call when you bought it.  If there were no dividend, the call would have been priced higher.

However, when the stock rallies, your call may move far enough in the money that it becomes an exercise for the dividend.  Please be aware that not every ITM option should be exercised. And that's especially true for 6-month options.  The Apr 57.5 call was probably a good option to exercise, but not an October call.

If your call should be exercised (by the criteria above) and you don't want to do that, just sell it.  Then buy a different call, if you want to maintain an investment in this company. Perhaps the Oct 60 call?

The conversation continued:

If I don't really leave money on the table by not exercising (actually, I'd just sell the option before ex-div date - I have no interest in the stock itself), I'd really prefer to let the option ride, and hope the stock goes up over time. I'm not interested in rapid trading and over-trading. 

Some options must be exercised or it is tossing money in the trash.  Use a calculator.  Calculate theoretical value day before ex-div and day after (lower price of stock by dividend amount).  If the option is WORTH LESS  the 2nd day, then it should be exercised or sold (prior to ex-date).   Replacing the call is a separate decision.


Right now, the Oct 57.5 PG call has a delta of .75, and at $6.10, has a time premium of $0.60, given the stock is now at $63.00. So, you seem to be saying that there is no point in exercising (or selling back the call) before the Apr21 ex-div date. Will the option drop in price to $5.56 on that date ($6.10 less $0.44)? I still need to wrap my head around that.

It will not decline in price.  If delta is 75, nothing should change.  The computer 'know' the stock will be lower (due to dividend) and that information is already factored into the option price.  Do as I suggested above.  Use a calculator. If you don't do that, you will not discover all you need to know.

And if it does drop in price, why do you think it would be $0.44?  The delta is not 100.  You are over-thinking this simple problem.

The conversation continued in another email

I'll follow PG ITM option prices, as PG goes ex-div next week. 
Below is
what Hoadley would say for my PG 57.5 call. I set the expiration for May. The graph's red line clearly predicts an increase in the call's value on the ex-date of apr21.

No, it does not.

Likewise for the yellow line, were the ex-date to be May 15. Why do you say this is wrong?

2010-04-21_1047_hoadley_div_2

I cannot tell you how disappointing it is – that you ask this question.  You have been trading options for too long not to understand this.

You are not thinking – you are just using an available graph to get a quick answer.  You are assuming the graph is answering your question – but it is ignoring your question and choosing which question to answer.  Thus, it gives the right answer to the wrong question.    Use the calculator to get the right
answer.  More on this below.


Let's look at it this way:

1) Have you ever seen a call increase in value – overnight – when the stock price is not higher and/or the implied volatility is not higher?

2) The question you are asking Mr. Hoadley's graph is:  If the stock price is unchanged on ex-div date, will the value of my call change?  Good question. 
However, the graph answers this question:  If the stock trades ex-dividend, and if the stock price rises by the amount of that dividend, does the value of my call change?



3) Take a close look at the graph. Specifically the data below the graph.  The stock price is 63.  The stock price is not 62.56.  That is the price at which the stock would open for trading on ex-dividend day.  It's at that price – down 44 cents, but really  'unchanged' – that the call value remains the same (except for a decline – if any – due to theta. 

The reason you see the call price go up is because this graph shows the stock rising 44 cents to 63


That's what I mean by just looking at the graph and assuming it's
useful.  That's why a calculator is better.  Using the calculator, you would set the stock
price to 62.56 and not make this mistake.

I truly hope this clarifies the situation.

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Coming in the May issue of Expiring Monthly

The Trade Off: Risk-Reward vs. Probability of
Profit by Tyler Craig

Interview with Dr Brett Steenbarger by Mark Wolfinger

and much more.


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