For the Eight Days of Hanukkah the readers asked of me...
In this week's article on the January Effect you noted, "This doesn't mean the market will actually rise, only that small-caps will outperform large-caps." If that's the case, then rather than buying calls on the Russell 2000, wouldn't this argue for some sort of strategy that is long Russell 2000 and short S&P 500 -- thus capturing the differential performance? Thanks for your thoughts. -- B.
You are absolutely correct. A paired trade might be the best way to capture the statistically probable trade. However, becausee there are no options on the
S&P Depositary Receipts
, it would require selling calls on S&P futures. Not only do the futures represent nearly 10 times the value of the SPY (meaning it would need to be done on a ratio basis), but it also might necessitate a separate commodity trading account.
This could be a problem and unattractive for many readers. Of course, you could pair the trade simply using the two exchange-traded funds: buy the
shares and sell the SPYs. But this wouldn't take advantage of the leverage and limited risk offered by using options.
But thank you for the insightful comment and pointing out an alternative and possibly a better way to take advantage of the January Effect.
I'm new to the options game and I appreciate your outlook on options vs. the markets. In your Columnist Conversation post today (and previously) you indicate that people would buy the market if they are in the money on calls, specifically if the SPX was over 1075. Intuitively, I'd think they would sell the market to lock in gains. Do they buy to maintain their exposure? Thanks. -- W.C.
You are right thinking that a large open interest at a given strike should act as a magnet; some details regarding the dynamics creating the pinning effect are discussed in
this article. But there are other factors and theories at work heading into expiration. One is that the predominant or existing trend in place during the two weeks prior to expiration will remain. Given that the
has gained some 3% over the last two weeks, we'd expect this Friday's expiration to have an upward bias.
More to the point of your question is what led me to suggest that "as the 1075 calls move into-the-money, it may trigger buy programs." This was based more on opinion and art than science and statistics. Nearly 65% of the current open interest (some 55,000 contracts as of Thursday morning) in the December 1075 calls was established during the first two weeks of December when the S&P was being repeatedly turned back at 1070 resistance.
It's my belief that these positions were entered into by professionals as opening short sales. As it became increasingly apparent that what once appeared on its way to worthlessness (the option having traded as low as $3.50 on Tuesday) would be increasingly valuable (it was worth $15.50 on Thursday's closing price), it forced those short to cover. The quickest and most efficient way to cover the short calls would be to buy index futures.
I wonder if you can discuss the place for options in an ongoing retirement portfolio. I have a portfolio of stocks and bonds that constitute the bulk of my retirement. I wonder at times when I read your column how I might use options as a way of enhancing returns or, more importantly, protection against the downside. My most-used strategy is to hold plenty of cash (at least two years of income) and be quick to sell when stocks break their 50-day moving average. -- D.G.
Covered calls are the most obvious way to both generate incremental income and offer some downside protection. In this sense they act to smooth out your returns. A covered call portfolio's profits will be limited on the upside, but losses should be reduced when the market declines. A look at the data of the returns on BXM, the CBOE's BuyWrite index that tracks the performance of a systematic approach to writing at-the-money calls against the S&P 500 Index, shows an average annual return of some 12% over the last decade. This
article provides some detail into its construction, methodology and returns. Currently, the BXM is up 14% for the year to date. This compares to the S&P 500's approximately 20% gain thus far in 2003.
If you are looking to put more emphasis on hedging the risk of your portfolio against a market downturn, I suggest you review this
article on hedging. You can use this free
portfolio protection analyzer to calculate the cost of hedging a portfolio for various scenarios.
Remember me? I'm a market maker on the Amex (long live open outcry!). Steve, all good stuff but I noticed in your article on straddles that you didn't even mention the prospect of actively hedging these straddles. It makes sense for your readers to adjust their deltas, thus coming through with many base hits instead of one home run, as being long premium is like a rat who has to keep gnawing away to stop his teeth from growing through his head. All the best.-- S.N.
This reader gives a great example (and some colorful imagery) of how the leverage of a long option position can be used to make short-term trades. For active traders, those with the time and the inclination to track their positions throughout the day, the brokerage or commission fees associated with making this type of trading economically feasible means you are essentially becoming a professional trader. This is because you will need to set up the appropriate infrastructure, such as low commission fees and direct access trading platforms, to accommodate intraday trading strategies. By professional I mean someone whose primary income (or lack thereof) is derived from trading. For all others, straddles and trading in general should be used with a slightly larger time frame.
But the reader brings up a good point that the
straddle article omitted: When the underlying stock makes a sharp move, it is sometimes wise to sell out the side of the straddle that has moved into-the-money. This will not only secure a profit, but also allow you to maintain a "free" position on by holding long the other, seemingly "worthless" options. Once in a while you may get a reverse move, putting the other side of the straddle back into play, giving yourself a second chance at profit from the original position at little additional risk.
In regard to open interest when dealing with calls or puts, who decides how many contracts there are outstanding? In some smaller companies I have noticed only a few contracts, e.g. 10, willing to be traded, while with Cisco and other large companies there are several thousand. Thanks again for all your help and I appreciate your insightful articles.-- A.Z.
Unlike shares of stock, which are bound by the shares outstanding and the publicly traded float, option open interest is unlimited and bound only by investor activity. The reason the
option has a much larger option volume and open interest is simply that more people want to trade its options. There is nothing preventing a smaller company's options from also trading a large number. You just need two willing parties.
I would like to get involved with options but, with the exception of one options and futures course in college, have only been exposed via some of the articles on RealMoney and snippets in Columnist Conversation. Is there any software that simulates actual option action and trading that you would recommend? I'm having a hard time getting my arms around what type of dollar exposure I am putting at risk when trading options. Thanks for your help.-- E.A.
While real-time experience is always the best teacher, new technology has allowed some verisimilitudinous simulations. The online brokerage firm
recently added a paper-trading feature to its site. It simulates how orders get executed in terms of price and time and will tally up your profit/loss on a market-to-market basis. While it is mainly offered to those that have current accounts with the firm, it requires no actual dollar deposit and they do offer a free demonstration. I hope this helps.
Are you a complete moron?-- A.
No, unfortunately one of my personality flaws is that I am not a complete anything. I believe my intelligence has been tested as average.
Have you written any books regarding the A-to-Z of options trading or do you have your own Web site or newsletter regarding options and other investments vehicles?-- M.
No, I haven't written a book ... yet. But that gets me thinking -- it would've made a great stocking stuffer. In the meantime, accept these columns as a bit of Hanukkah gelt.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to