TSC Options Forum: Vega the Greek

Given that AMR had already jumped from $2 in April to $6 in May as the airline averted bankruptcy, it seems perfectly prudent to use a spread in anticipation of only moderate gains over the term. But if D.A. was looking for a quick "double," there was no reason to spread, especially not using November expiration. Instead he could make outright purchases of calls as he suggested, or some other vega-positive strategies such as a "back spread," which involves selling in-the-money options while simultaneously purchasing a greater number out-of-the-money options, typically at least at a 3-to-1 ratio, leaving you net long options in terms of quantity. It also creates a position in which your delta (the change in price for every one-point move of the underlying security) increases with the predicted price movement. In this example, the position gets more bullish as the price rises.

An important distinction between a volatility play and one based on expectations of fundamental improvement in price is that profits in the former should happen as soon as a large move occurs, while the latter's maximum profit typically won't be realized until the option expiration date.

While D.A. would have loved cashing out of some straight long calls for a double, he needed to think about his expectations. The fact is, with AMR now trading at $9.80, his spread looks increasingly likely to end up in the money and achieve maximum profit. But I understand his frustration and worry in needing to wait four months to reap the rewards of his great call. The question he now faces is whether to make some adjustments.

He could choose to create a box by buying the November $7.50/$10 put spread. While this would lock in some profits, it would greatly reduce the maximum gain. He could short some stock to create a delta-neutral position, but this would expose him to risk by making him short should AMR continue to trade higher. He could sell a few calls with a shorter expiration to offset the cost of the spread, but this again entails the risks creating a negative delta. The choices go on and on, leading to the choice of doing nothing.

Leaving It Alone

I know this may seem sacrilege coming from an option proselytizer, but sometimes it's better not to use options at all.

Earlier this week one reader wondered whether having "recently sold short 200 shares of Corning(GLW) (at $7.25), would it be a smart move to buy some August $7.50 calls at 55 cents in order to protect my position?"

My gut feeling is, given the low stock price and the implied break-even points, to say nothing of the relatively high commission costs, this is a case where simply using a stop-loss order on the short stock would make more sense than hedging with options. Buying the calls means you don't profit until Corning drops to $6.70 on your short and your upside protection doesn't begin until $8. That's a 17% price range in which the long calls add little or negative value.

Sometimes options just add a layer of confusion and muck up a simple plan. If you have a clear-cut opinion, consider less spreading and less hedging; it will yield better results.

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