.From the performance graph in Figure 4.14, you can see that this position makes money fast after gold falls below 290. Or, if gold moves higher,it still makes a small proﬁt. Costing less than $1,200 to put on, the spreadmakes a $2,600 proﬁt if gold falls to 280. The only way you can lose moneyis if gold settles into a range between 290 and 305 and stays there, whichwe believe is unlikely. Simply a beautiful, tailor-ﬁt strategy!
COVERED WRITING—ENHANCING YOUR RETURNSMany investors use covered writing to enhance returns from their longstock portfolios. Actually, it is debatable whether covered writing truly en-
FIGURE 4.13 A Put Backspread
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FIGURE 4.14 Graphic Analysis of Put Backspread
hances returns overall. Admittedly, stocks move in a sideways, slightly upward or slightly downward pattern much of the time, and in those timescovered writers beneﬁt greatly from the additional income generated bythe sale of call options.A covered write is the sale of a call option against, or covered by, along position in the underlying. When you sell calls against your stocks,you are giving someone the option of buying your stock from you anytimeduring the life of the option for a stated price—the strike price of the option. In return for giving up all possible gains above the strike price, youreceive cash for the options you sold.When someone tells me they don’t trade options because options aretoo risky, I usually cite the covered write as an example of using options toreduce risk. And it’s true. The sale of covered calls reduces the risk of astock portfolio in the sense that returns are less variable. In theoreticalterms, you have reduced your portfolio’s variance, and therefore you havereduced its risk.However, the covered writer’s short calls do little to protect himagainst losses as the market falls. This is the only knock on covered writing—that it takes away the upside and leaves you with the same downsiderisk as a regular stockholder.Still, some investors manage to keep some of their upside potential
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through careful management of their positions. How? By rolling. After astock moves up, they repurchase the short calls (at a loss) and sell newcalls at a higher strike. This allows them to stay in an uptrending stock sothat capital gains (from the sale of the stock) are deferred. Losses from repurchasing the short options can be claimed immediately.The other smart thing covered writers do is time the sale of optionswhen options are expensive. As we discussed earlier, option prices ﬂuctuate between periods when they are cheap or dear. If you focus on sellingwhen options are expensive, it can make a big difference! Historicalvolatility charts help you know when a stock’s options are cheap or dear(see Figure 4.15).At the time of this writing, Halliburton’s options were expensive. Ananalysis shows an excellent potential return of 13 percent in 67 days fromselling at-the-money calls. (See Figure 4.16.)Again, that’s only if the stock behaves well. Back when I was ﬁrstlearning about options, my broker introduced me to covered writing byhanding me a copy of a handwritten sheet. On this sheet were the detailsof a proposed trade involving the purchase of 1,000 shares of a relativelylow-priced stock on margin and the sale of 10 call options against it. Theﬁgures, which only included “return if stock called away” and “return ifstock unchanged,” were compelling. (I think the return if stock calledaway was more than 50 percent in two months.) However, it was a trap. Idon’t know if brokers are still handing out proposals like this today, but to
FIGURE 4.15 Historical Volatility Chart
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FIGURE 4.16 Halliburton’s Volatility History
be more disclosing, they should also show what happens if your stockdrops a certain amount, say, one standard deviation. With the stock beingbought on margin, I’m sure it would have been a signiﬁcant negative result!(By the way, I did not go for the proposed trade, because I was more interested in speculative option buying at that time, and probably lost mymoney faster as a result!)
LEAPS—AN ALTERNATIVE TO STOCKLEAPS are an attractive alternative to stock ownership. Not only do theyoften have a more favorable risk/reward proﬁle than the stock, inexpensive LEAPS are easy to ﬁnd and thus come with an inherent edge.LEAPS stands for Long-term Equity Anticipation Securities. Practically, LEAPS are just long-term options—longer term than the standardlisted options. The only thing special about them is that the exchangesconsider them securities and allow brokerages to lend you up to 25 percent of their value. Not all brokerages honor this, however. Note that if youhave a long LEAPS position that covers a short position in any of the other
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options on the same underlying security, you no longer get to margin thelong LEAPS.LEAPS are available with expirations one to three years out on hundreds of the most popular stocks and many indexes. When LEAPS haveonly nine months of life remaining, they convert into standard listed options (and no longer have any loan value).
ValuationOne interesting thing about LEAPS is that they often trade at lower volatility levels than the nearby options on the same stock. In other words,LEAPS trade at prices implying that their underlying won’t be as volatile.Thus LEAPS are, in a very real sense, cheaper than the nearby options.There is no theoretical basis for this that I’m aware of. Some may argue that more volatility is usually expected near-term than far-term, and Iknow that to be true from time to time. But why should it be true on a consistent basis? Note that all volatility numbers, no matter how short thetime frame, are normalized to a one-year time frame. Thus they should bedirectly comparable. So, theoretically, a stock’s near-term volatility shouldbe no different than its long-term volatility, barring any pending news orunusual market activity.Not only are LEAPS valued at lower volatility levels than the nearbyoptions, many LEAPS also trade at lower volatility levels than the statistical volatility of their underlying. (Remember, statistical volatility measureshow much the price of an asset bounces around.)Charles Schwab (SCH) was a good example of this. At the time of thiswriting, Schwab had January 2004 LEAPS (715 days to expiration) thatwere trading at a 46% volatility level. In contrast, Schwab stock’s volatilityhad been running in a range of between 60% and 80% over the last severalyears. Thus the prices of these LEAPS did not fully reﬂect the volatility oftheir underlying. Unless you have some reason to believe that this stockwill quiet down at some point, Schwab’s LEAPS were undervalued.Figure 4.17 shows how an at-the-money Schwab call LEAP would perform relative to an appropriate number of shares of the underlying. In theillustration, the two lines going highest to the right belong to the LEAP.The dashed line represents the performance of the LEAP in today’s timeframe; the corresponding solid line represents the performance of theLEAP at expiration—two years from now. The ﬁnal (solid) line representsthe performance of the stock position. Note that we scaled the horizontalaxis logarithmically this time—thus the stock’s line has a gentle bend.Sometimes it can be better to use a logarithmic scale, especially when projecting far into the future, because it appropriately brings higher stockprices into the picture.
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FIGURE 4.17 Performance of Call LEAP vs. Stock Shares
The appropriate number of shares to use for a direct comparison isdetermined by using the delta of the option. The delta of this option was50, meaning that when the underlying moves one point, the option theoretically moves half a point. Therefore a comparable position in the underlying would be 50 shares. That way if the underlying moves up one fullpoint, we would gain $50 from the LEAP, or an equal $50 from the 50share stock position.That the two different positions have the same delta can be conﬁrmedin the illustration. Note that the vertical wand marks the current price ofthe stock. At that point the LEAP’s current (T+0) (dashed) line and thestock’s (solid) line have identical slopes.
Risk/RewardNotice that the LEAP has better characteristics to the upside, outperforming the stock by an ever greater margin the higher the stock price goes. Tothe downside, the LEAP is also better below a certain point. Although botha stock and a LEAP can go to zero, in this example the shares of stock costtwice as much as the single LEAP (presuming you pay cash for the stock);thus the stock can lose more money.
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In other words, the LEAP has better risk/reward characteristics because of its nonlinear performance. Just as with any call option, there is nolimit to the upside, while the most you can lose is the investment.Where the LEAP underperforms the stock is if the stock is still near itscurrent price level two years from now. If that happens, the LEAP willgradually decay in value until it is nearly worthless. But who would expectthe stock to be at the same price two years from now?One caveat: If your stock is bought out, valuations in the LEAPS willcollapse. Sure, your LEAP may be helped by a jump in the stock price, butat the same time almost all of the time value will come out of it, and youmay end up worse off than if you simply owned the shares. This shouldn’tbe a worry, however, if you are selecting companies that are unlikely to become takeover candidates.
THE SYNTHETIC—ANOTHER ALTERNATIVE TO STOCKDid you know there is an option strategy—involving just two options—that behaves exactly like a position in the underlying? It’s called a synthetic, because you’re “synthesizing” a position in the underlying.A synthetic is constructed by buying a call and selling a put of thesame strike and duration (to simulate being long the underlying), or buying a put and selling a call of the same strike and duration (to simulate being short the underlying).Since a synthetic performs exactly the same as being long or shortthe underlying, the question naturally arises: Why would you do a position with two transactions when you can do it with one? Well, the fact isthat the capital requirements for a synthetic can be a lot less than goinglong or short the stock, even when using maximum margin (50 percent)on the stock.For example, to purchase 100 shares of Johnson & Johnson (JNJ)at a price of 58 would cost $5,800 cash, or $2,900 collateral on 50 percent margin. To buy an at-the-money synthetic would cost a net $30cash, plus $960 collateral, for a total of $990. Not only is this a considerable difference in collateral, but the cash ﬂow difference means thatwith the synthetic you get to keep your cash (all but $30 of it) and use itto earn interest.You’re probably thinking there must be a catch. Is the syntheticriskier? Actually, since the synthetic delivers exactly the same performance as a position in the underlying itself, there is no additional risk inusing a synthetic.
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There are just two minor catches. One is the fact that with a synthetic, you miss out on any dividend income. The other is the possibilityof early assignment if the short leg goes deep in the money. Early assignment is especially likely with a short, deep in-the-money put. If this happens, you will suddenly be long the stock (instead of short a put) pluslong a call option. Since the long call option is far out of the money at thispoint, it is low priced and has very little delta. So you are essentially justlong stock, which is the same in its performance as the original synthetic.Thus you are not exposed to any sudden risk and there is no urgency torespond immediately in some way following assignment. Also, the cashﬂows of the assignment itself do not create a loss for you (nor a gain). Theonly difference is that your collateral requirement jumps up, as you nowown the stock.Figure 4.18 shows a synthetic long as compared to a long stock position. The two lines are very close together. The line for the long stock position runs just above the line for the synthetic because of dividends.Another advantage of synthetics is that you can use them with assetswhere there is no tradable underlying, such as indexes.
FIGURE 4.18 Comparison of Synthetic Long and Long Stock Positions
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THE BUTTERFLY SPREAD—WHEN YOUHAVE A NARROW TARGET RANGEThere is a strategy involving three options that performs well when youexpect the underlying to stay right where it is. It’s called, very colorfully, abutterﬂy spread.A butterﬂy is constructed using three options of the same type and ofthe same expiration. You sell two at-the-money options, buy one option ata higher strike, and buy one option at a lower strike. The strikes don’t haveto be adjacent, but the strikes of the long options need to be equal intervals away from the short options. See Figure 4.19 for an example of a butterﬂy spread in OEX calls.In this instance we’re using nonadjacent strikes. That’s okay, just aslong as the “wings” are equidistant from the center position. Also note thata butterﬂy is essentially a debit spread (in this case, the 540–560 spread)plus a credit spread (in this case, the 560–580 spread). The performancechart for a butterﬂy looks like an A-frame (see Figure 4.20).You can see that this trade performs well only if the underlying remains in a narrow band, and does not mature until right at expiration. No-
FIGURE 4.19 Butterﬂy Spread in OEX Calls
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FIGURE 4.20 A-Frame Performance Chart for Butterﬂy Spread
tice that the preexpiration lines slope down to the right. That is becausethe software was including the effects of slippage and commissions. Allthree options would be driven in-the-money if the underlying movedhigher, thus causing slippage and commissions to take a larger toll.As with any option strategy, you can “short” a butterﬂy as well as“long” it. And, as with any option strategy, this would ﬂip the performancegraph top to bottom, making it a position that wins if the underlying doesanything but stay right where it is.Personally, I don’t care for butterﬂy spreads. The transaction costs arehigh, and the performance graph usually reveals unappealing risk/returncharacteristics.
USING THE RIGHT OPTION STRATEGYWe have covered many different option strategies with many different performance graphs. How does the individual trader select the best strategy?In short, the individual trader must choose the strategy that matcheshis or her own trading goals and psychology, based on knowledge of howeach strategy performs.Each strategy has its own unique risk/reward characteristics. Say
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you’re trying to pick the right strategy to play an expected rally. The ﬁrststrategy that comes to mind is the simple call purchase.However, the simple call purchase is a position that responds dramatically to every move in the underlying. And once the underlying has movedyour way to a certain extent, the call option, now more expensive, gains orloses even more money with every move in its underlying. In other words,its delta, or sensitivity to the underlying, has increased.This is where trouble can arise. Increased stress on the trader, nowtrying to pick an appropriate selling point, may contribute to a bad decision. For example, a sudden (but not great) drop in the underlying canlower the price of the option and cause the trader remorse that he did notsell earlier. Now he must decide whether to sell and lock in whatever gainhe has before the stock drops any further. On the other hand, a sudden risein the stock can easily double the value of the call option, possibly leadingthe trader to feel euphoric and smug, emotions just as dangerous to successful trading as anxiety!It takes a strong, disciplined trader to proﬁt from simple call purchasesconsistently. The trader must understand the kind of position he is usingand be disciplined—using an objective, a stop, and perhaps a trailing stop.For the more conservative trader, less aggressive positions can befound among the various types of spreads. Spreads allow the trader moretime to make an exit decision. You can even hold a spread all the way toexpiration without concern over rapid time decay.A computer simulation can help in selecting the best spread to use.Consider the price chart for Forest Labs (symbol: FRX) and a reasonablybullish price projection to the May expiration date (see Figure 4.21). TheX1 line represents the upcoming March expiration, while the X2 line represents the upcoming May expiration. The rectangle in the upper right corner represents our projection, or target, in terms of a price range and adate range.In Figure 4.22 we have analyzed and superimposed the performance offour different strategies. For the same money in each case ($5,000), welooked at (1) a simple call purchase; (2) a vertical debit spread in calls; (3)a vertical credit spread in puts; and (4) a 2 × 1 ratio spread in calls. Eachposition was singled out as having the best expected return in its strategyclass, based on our projection for the underlying.Each position has a different proﬁle. The vertical debit spread in callshas the best overall expected return within the target zone (depicted withshading). However, that won’t always be the case. Under different conditions, with a different target or time frame or a different volatility environment, another strategy might perform better. You never know until you runa simulation.
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FIGURE 4.21 Price Projection
FIGURE 4.22 Four Strategies
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The next best strategy, purely from the standpoint of expected returns, is the simple call purchase. However, the put credit spread’s expected return is just a bit less than that, and when you consider that theperformance of this strategy is ﬂat within the target zone and better thanthe simple call purchase at lower stock prices, I think you’d have to agreethat it beats the simple call purchase handily. (This is where it helps tohave a picture in front of you!)The ﬂattest, most sedate line belongs to the ratio spread. This strategyperforms better than the others if the trader is wrong and no rally materializes. Thus the ratio spread is the most conservative strategy this time.By the way, all four of these strategies perform better than simply buying shares of the underlying stock—much better.So you’re trying to pick the right strategy? Select the strategy that willperform the best based on your expectations for the underlying, and at thesame time will match your trading temperament. Don’t pick an aggressivestrategy like a call purchase just because it looks like you could make a little more proﬁt. As I mentioned before, successful traders are unemotional,unstressed traders.
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CHAPTER 5
SpecialSituations
F
rom time to time, special situations occur that warp the standard options model. These include takeover deals, other restructuringplans, and even just pending news sometimes. The investor must becareful not to quickly jump on an apparent bargain. Look before you leap,because discrepancies are often there for a good reason.
PLAYING TAKEOVERSAn enormous amount of options activity accompanies takeovers andtakeover rumors, and they can be a gold mine of opportunity. Yet youmust be careful.One way to play takeovers is to bet on the price. If you want to play itto the upside (as the target company’s stock often does go much higher after the initial news or rumor), you can pick a call to purchase, or open avertical debit spread in calls or a vertical credit spread in puts.Or you can use some good analysis tools and do some volatilitybased trading. This approach can be very safe and lucrative. Returns aremore predictable, as you do not have to guess the direction of the underlying security.Volatility-based trading does, however, require some ﬁnesse. Playing atakeover is like ﬂying your plane through a storm. The ﬁgures can lie toyou. What seems like a proﬁt opportunity might not be. You have to becareful how you interpret the numbers.105
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At one time, RJ Reynolds (RJR) was awaiting a Nabisco shareholdervote about its being acquired. In anticipation of this vote, Nabisco’s nearbyoptions were inﬂated to higher premiums than its farther out options. Forexample, the October calls were trading at an IV of 37%, while the December calls were trading at only about 18%. A similar differential existed inthe puts.This automatically suggested opening a horizontal debit spread, selling the more expensive nearby options and buying the cheaper, farther outoptions. However, before rushing in, the trader must stop and ask himselfwhy the options are being priced this way. Let’s search for some logic thatwould possibly explain what you are seeing.In Nabisco, traders were probably giving the nearby options higherpremiums because, if something was going to happen with Nabisco, it wasgoing to happen very soon or not at all. The expected near-term pricevolatility in Nabisco translated into a higher IV for the October optionsthan for the December options.Horizontal debit spreads have the life squeezed out of them when theprice of the underlying moves much higher or much lower. Therefore, ifyou were to take a horizontal debit spread in Nabisco, you would be accepting the seemingly favorable odds (and apparent bargain) to bet onNabisco staying about the same price, against the many traders who wereaccepting worse odds to bet on Nabisco taking a big jump. Were the horizontal debit spreads such a bargain after all? Perhaps not.Big differences between put and call implied volatilities can also occur. In a previous RJR takeover situation several years prior, there was tobe a large dividend payout. As you know, a dividend causes the stock priceto drop the day the stock goes “ex-dividend.” In this case, the dividend wasto be so large that all the puts seemed extraordinarily overpriced and allthe calls were “ﬂat.” Naively selling the expensive puts might have been ruinous. Good options analysis software will take the effect of dividend payments into account. Finding out about such a dividend, you would enter itinto your options pricing model. As soon as you did, the calls and putswould seem to be more normally priced.In a more recent takeover scenario, Weyerhaeuser was bidding forWillamette. During the period of time when Willamette was weighing theoffer and exploring alternatives, the out-of-the-money puts were tradingat high implied volatilities (see Figure 5.1). Thus they were attractive forshort selling. However, one needs to question why these puts were so expensive. Even before reading the news, one could guess that many people thought there might be a good chance that the stock price woulddrop sharply.A few days later, Willamette rejected Weyerhaeuser’s offer andWillamette’s stock plunged to 44. Anyone who had sold puts just before
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FIGURE 5.1 Expensive Willamette Puts During Weyerhaeuser Bid
this would have been sorry. However, at that point the out-of-the-moneyputs were still trading at high implied volatilities. Viewing the price chartat that point, one might have decided that now was a good entry point fora short put position based on the opinion that the stock price was now atan apparent support level. Also, Willamette was still in play and could beacquired at any time.In fact, it would have been a good decision because on January22, Willamette and Weyerhaeuser reached a deﬁnitive agreement.Willamette’s stock jumped to 55 and locked in at that level (see the pricechart in Figure 5.2).Takeovers can be proﬁtable for the option trader, but you must beshrewd. If you see something strange, try to ﬁgure out why. Read everything about the situation. Dig into the arithmetic of the deal and learn ofany ratios that may apply. Then, once you’re sure, act fast! Option tradingopportunities in takeovers can come and go quickly.
LETTING THE OPTIONS MARKETTIP YOU OFF ON TAKEOVERSInsider trading is illegal, but reading the telltale signs in the options marketand taking a position is not! News often leaks out prior to an ofﬁcialtakeover announcement, and people try to quietly buy call options in the
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FIGURE 5.2 Willamette Stock Jumped when Agreement Was Reached withWeyerhaeuser
target company. Their activity can lead to unusually high volume and inﬂated premiums in the call options, and this can tip you off to a potentiallybig move.Scanning services are available that can alert you to unusual call option activity. For example, on December 11, 2001, OptionVue System’s OpScan service alerted subscribers to exceptional activity in Willamette calls.Call option volume was soaring that day (see Figure 5.3).Look at the ﬁrst spike in the lower chart—representing call option volume. Two days after that spike, the stock jumped several points, and fourdays later it moved several more points on the ofﬁcial announcement.Clearly, insiders knew something was coming, and they took long call options positions in advance of the announcement.Not every takeover is preceded by unusual options activity. And notevery spike in call options trading volume is followed by an event thatmakes the stock jump. And sometimes, even after a takeover announcement, the target stock doesn’t move at all.However, tradable opportunities come along often enough to makethis a really intriguing pursuit. Once an alert has come up, how does oneevaluate the situation and decide what kind of position should be taken?After an alert, one needs to evaluate the activity and see if it bears the
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FIGURE 5.3 Call Option Activity on Willamette before Announcement ofWeyerhaeuser Bid
imprint of pre-takeover buying interest. It’s important to look for inﬂatedprices. Also look for higher than usual volume, especially in the nearbyout-of-the-monies, but also spread out among several of the available calloptions. The best way to check for inﬂated prices is to look for a jump incurrent implied volatility (IV) as compared with recent historical IV.If IV is not higher, or if the unusually high volume is concentrated injust one or two of the call options, then there might be nothing specialabout this instance. It might just be that a big institutional order has beenﬁlled. In the case of Willamette on December 11, 2001, average call IV was41.5% versus 26.7% the week before, and volume was heavy in several different call options. So far, so good!Curiously, more volume was seen in the second expiration than in thenearby expiration. Perhaps this was because the buyers knew the dealwould probably take more than a couple of weeks to consummate, and theDecembers wouldn’t allow enough time. (See Figure 5.4.)Clearly, this example ﬁts the pattern of pre-takeover activity that we
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FIGURE 5.4 Higher Volume in Second Expiration—Willamette, December 2001
are looking for. A bullish position could be taken, either through buyingcalls, selling naked puts, buying a call debit spread, or some other bullishstrategy. A simulation and graphic analysis could help you decide. A simple call purchase often turns out to be best, despite the extra expense.Taking our cue from others, we might avoid using the nearbys.As you can see from the price chart, a bullish position would havebeen proﬁtable, as the stock moved from 45 on December 11 to 52 on December 19, at which point it would have been wise to sell.It is natural to wonder how often qualiﬁed alerts come along, and whatpercentage of those alerts lead to proﬁtable trades. Jim Graham, a memberof the OptionVue Research staff, did a study on this and published the results on the web site (www.optionvue.com) in October 2001.In that study, Jim analyzed the candidates that came up during onebrief period from September 25 through October 3, 2001. Twenty-two candidates come up during that period. Of these, Jim eliminated eight that didnot pass his minimum price and increasing open interest ﬁlters. I’ll explainthese ﬁlters, because you may want to use them. He ruled out stockspriced below 7.5, based on personal preference and his usually disappointing experiences with lower-priced stocks. This eliminated two stocks. Thesecond ﬁlter, which Jim considers very important, is that the call open interest needs to be increasing over the previous two days. To Jim, this indicates that investors are buying calls. This ﬁlter eliminated six stocks.To the 14 qualifying candidates, Jim applied further checks, as dis-
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