TSC Options Forum: Choosing Your Weapon

Readers' questions about what options strategy to employ usually take two forms; the first asks what will deliver the best returns for a given scenario:

Suppose I come to the conclusion that a certain stock or commodity will be trading at least 20% higher during, say, the next six months than it is now. I look up the option chain and see many different call strikes offered that expire six or more months from now. Is there a theory that will help me make a rational decision on which expiration/strike is the best? Up until now I have been going for the cheapest, most out-of-the-money one. That probably isn't the best strategy. Many thanks again. R.R.

or people looking for alternatives to a suggested position:

Steve, How about selling puts, let's say February '04 of 320 and buy February '04 375 and finance the call. Thanks, R.B., referring to last week's column on gold and the suggested calendar spread.

Once I'm over the initial shock that someone would consider an alternative to my suggestions, I realize these great questions bring together many of the concepts discussed in previous columns. Seriously, this is a good time to emphasize that any recommendation is just one of many ways to skin a (insert your animal here).

One of the primary attractions of using options as a trading or investment tool is the flexibility they provide, essentially allowing you to create a customized position that jibes with your specific situation or prediction; there is no one right "answer." Unlike going long or short the underlying, whose success is measured in the single dimension of buy low/sell high, option positions have a multiple of inputs, such as time and volatility, which create a much more dynamic strategy.

I am going to leapfrog to R.B.'s gold-specific question and in doing so hope to address some broader strategy issues raised by R.R.

My choice of a calendar spread as the appropriate strategy was based on the thesis that gold might work higher in slow, steady fashion. I also showed my complete lack of conviction in my doubletalk about how gold could still trade back down $320 without violating the long-term trend.

The reader's suggested alternative of selling the February '04 320 put and buying the February '04 375 essentially creates a synthetic long position. Unlike the calendar spread, which uses offsetting calls positions to reduce cost and lower risk, the two pieces in the synthetic are directionally aligned, giving the position a much more bullish profile and higher risk than the calendar spread. If gold prices fall, you lose money on both pieces. In this position the short put doesn't really finance the long call but rather works in conjunction with it. A settlement between $325 and $375 next February means both the put and call are worthless.