Options Forum: Never Rich Enough
Steven Smith
10/24/03 - 03:34 PM EDT
Steve, thanks for all the good stuff. I was wondering if you had any thoughts on a recent options trade. I had bought KLA-Tencor(KLAC Quote) 12/60 puts before the close on Tuesday for $3.50 with the stock just over $60. I just sold them for $7.50 with the stock around $53.30. So I got a whole 80 cents of time premium with nine weeks until they expire. That's nuts! There should have been at least $1.50 to $2 of time premium built in. There is not an ounce of fear in this market, and I find that quite frightening.
--M.B.
Don't be frightened -- be glad. It sounds like you made a great call and realized a 114% gain on your option trade. Still, there are two elements worth addressing here -- accurate projections for a potential profit and loss, and what an options pricing might be saying about investor sentiment.
Great Expectations
Thinking you've made the "right" call and that you aren't being duly rewarded is one of the great frustrations of trading options. When an options position changes in value and it doesn't correlate with your expectations for the given price change in the underlying security, you must first ask yourself if you had realistic expectations.
In the reader's example, the resulting 100% increase in the price of the put for the approximately 11.5% decline in KLA-Tencor is about what should have been expected. The first step in gauging how an option's value will change relative to a move in the underlying stock price is understanding the delta. (Please look at this past
column for a more in-depth discussion on delta.)
The reader purchased an at-the-money put with nine weeks remaining until expiration, which according to my handy options
calculator means it had a delta of negative 0.48 when purchased. This means that for every dollar decline in KLAC's share price, you'd expect the December 60 put to increase 48 cents. So the fact that a $6.70 decline in KLAC's stock price resulted in a $4 increase in the put's price seems about right. Remember: Delta isn't linear, its rate of change (defined as gamma) increases and decreases on a sloped scale. With KLAC at $53.30 the put's delta is now negative 0.77.
The lack of perceived premium has more to do with the fact that the puts have moved into the money than to any change in volatility or time remaining. As options move further into the money, their price increasingly comprised of intrinsic value. On the other hand, out-of-money options have no intrinsic value so their price is comprised entirely of time premium and implied volatility.
Addressing the second part of the first reader's question, he is correct in being surprised that despite a steep decline in KLAC -- which has a current implied volatility of 40 for at-the-money strikes, and was near a 52-week low -- volatility did not increase. How should one interpret that?
"They came, they saw, and they conquered KLAC," said Adam Warner, an options trader and contributor to
Street Insight, a sister publication of
TheStreet.com. "The stock is down roughly 10% so you'd expect the implied volatility to go higher. Yet volatility is hitting lows again in all time frames. So, here we have a stock that's made a huge move up this year with legitimately bearish news and it's met with option selling. That's complacency."
Skinning Cats and Balancing Acts
Another reader asks:
Which is a better way of buying upside exposure while limiting downside risk: (1) buying one call contract, or (2) buying 100 shares of the underlying stock with a stop that limits your loss to the cost of the call? Is one strategy always better than the other, or does it depend on the situation and your objective?
--U.V. .
This is related to the first reader's frustration of not reaping what he thought he had sowed. Would there have been an alternative position that better aligned with predicting reward expectations within the acceptable risk boundaries?
There is no simple way to answer that without knowing all variables and then inputting various scenarios into a number of positions.
Sticking with the example above, shorting 100 shares of KLAC at $60 and covering it at $53.30 would have produced a $670 profit, or a 22% return based on 50% margin. As we noted above, a purchase of the put would have produced a profit of only $400, but a return of nearly 115%. The other main difference is that the risk of the short stock is unlimited, while the maximum loss of the long put is limited to its purchase price.
The use of stops certainly can bring the risk levels into line, but the leverage of options will usually provide much greater return percentages. The real trick is choosing the right option, in terms of strike price and time remaining, that provides the best match and balance for your objectives. And for that, there is no single best answer.
