The Right Preposition for Your Money

Should options investors be in, out or at the money? Also, covered call writing and expiration issues.
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As the market finishes a lackluster week, showing more fear of commitment than the average 25-year-old bachelor, options traders have to figure out more ways to make money without drastic moves.

Doing this successfully will require a change in the thought process of traders who've found easy money in taking out-of-the-money positions and watching sharp moves.

This week, we discuss that briefly with some readers who are wondering whether to buy in-the-money or at-the-money options or just what's so terrible about covered call writing. And, since it is an expiration week, we offer counsel on expiration-related problems that seem to be afflicting many investors.

We'll be back next week, so send your questions to, and be sure to include your full name.

In, At or Out

When I decide to take a small position in OEX (S&P 100 index) options, I tend to buy them right at the money for speculation, not a hedge. For instance, I recently bought the June 680 puts for 16 1/4. They moved in the right direction, but when they go in the money, the spread widens so much. Am I better off going out of the money for a better percentage gain on my money? Am I risking more by buying at the money with five weeks until expiration out of the money? -- Dave Kehrl


What sounds like a simple question is, in fact, pretty complicated. We can try to work it out for you.

Our pals in Chicago boiled it down to this: If you're a little bit right, you want to be holding at-the-money options. If you're very right, however, it becomes more important to have as many options as possible, and thus, you'd want to buy a pile of the less expensive out-of-the-money options.

You're essentially right: Percentagewise, you will get a bigger pop from the out-of-the-money options, but you also have less of a chance of being right at expiration. If you buy the in-the-money calls, let's say, and the index moves up slightly, the delta (which measures the expected change in an option's premium for a given change in the price of the underlying stock) on those will give you a nice ride.

As far as the spread issue, there are rules that govern the width of spreads. At the

Chicago Board Options Exchange

, on a bid of 5 1/8, the maximum spread is 1/2 wide; on a 10 1/8 bid, it can only be 3/4 wide, and on a 20 1/8 bid, the ceiling is 1 wide.

If you don't feel comfortable with a particular spread and don't mind missing a chance to play, you can always put in a limit order. It might mean you'll never get filled, but it'll keep you from buying into a spread you consider too wide.

Covered Call Caution

Tell me what I am missing, please. I have an IRA stock portfolio that is almost entirely in the techs: Internet, telecommunications, computers and biotech. I have the notion that it would make sense to sell covered calls on essentially everything. How do I lose money doing this? What would be bad about doing this? I know that these stocks are volatile and that in the event of a sharp upward move I would get called, but I could then buy it back, couldn't I? How bad is that? -- Henry Hirschman


Nothing is inherently wrong with selling covered calls.

Your letter, however, presented us with the alternatives but not with the reason why you would want to do this. If you simply want to reduce your cost basis on the stocks, then sure, sell some covered calls.

If you imagine it as a hedge of any type, however, just don't do it. A covered call protects you from a significant drop in a stock's price as much as a sofa pillow would break your fall from the observation deck of the

Empire State Building


Now, once we have that understanding out of the way, a few more things are important to remember.

First, when you sell an option, you are betting that the market has overestimated volatility, no matter its level, on a particular stock. You're speculating, essentially, that the volatility portion of the option's price will decrease. Problems occur when the market is correct, which it has an uncanny sense of being.

That has pretty much been the case with the types of stocks you own -- the Net sector, biotech, old techs -- the market prices in a certain degree of volatility, and the stocks generally are happy to live up to their volatile reputations.

Selling calls on these can end up costing you a ton of money if you want to buy them back -- and even more if you end up giving up the stock to meet your assignment obligation. Remember, the volatility on these stocks is already high. If it breaks its pattern enough for you to have to buy the calls back, those calls are going to cost you. If you can't afford to buy them back, then you'll give up any gains over the strike price of the options you sold.

Even professional traders who sold Net stocks like


(AMZN) - Get Report

were having

trouble buying options back at prices that were reasonable.

And, remember, you have to pay commissions on this trading. If you're selling five calls a month, then buying back two at higher prices, those other three options better be big winners or you're shelling out too much money for too little reward.

We regularly speak to experts on the idea of covered call writing on tech stocks, and many think it is far too dangerous and costly a game.

Expiration Approaching

I am new to the game of options and need some advice. I bought a May 135 call for 12 ($1,200) May 3. Since then, the price of the option has plummeted, and the expiration date is near. Because the price of the option is so low, I am willing to ride it out until the last minute before it expires. My question is what happens if I don't sell or do anything with the option before it expires? Does it mean I have to fork over the $13,500 for the stocks or do I just lose $1,200? -- Sam Chao


No need to worry, unless you


needed that $1,200.

Judging from the information in your letter, you own an out-of-the-money call option (one in which the strike price is higher than the share price).

The value of that option will erode heading into expiration. If the stock doesn't move closer to the strike price by expiration, the call option will expire worthless. As a result, your $1,200 will be gone, but you're under no obligation to buy the stock.

If the stock does rally, however, and end up at a price 3/4 higher than the strike price, the option will be automatically exercised and you'll have to come up with $13,500 to buy the shares.

It is very, very, very (did we say very?) important that you get in touch with your broker on expiration. If, for instance, you don't have the $13,500 to cover the stock purchase, you can sell the call itself at a higher price than you bought it and realize gains in that manner.

You need to give the firm instructions on how you want to proceed. If you don't have the money in your account, you're likely to get a call if the option is in the money.

Also, if you are automatically exercised and don't realize you own the shares, you are subject to risk over the weekend between expiration Friday and the following Monday. That event risk is very real, and you could end up paying $13,500 for a stock position that may only be worth $11,000 on Monday morning.

Read the next question to find out what happens when you and your broker have a difficult expiration day.

Expiration Exasperation

I owned 20 April 7 1/2 calls of PT Telekomun (TLK) - Get Report that closed on expiration day 5/8 in the money, worth about $1,262. I faxed my online broker Friday afternoon and called the firm's customer service department after the close to declare my intention to exercise the calls, but the people there told me the options principal had already gone home. I was finally assured by the back office that the matter should not be difficult to work out the following Monday when the options principal returned. However, when I finally spoke to the options principal before the opening of trading the next Monday, he defensively said that he had received my instructions too late to act on them and that there was nothing he could do at that point to exercise my calls. I feel strongly that I'm right, but what's your take? Is there anything I can do to get those shares assigned to my account at this point? -- Mike Snow


You'd have to be a heck of a customer to get those shares now, according to the terms of the April expiration.

You're in a tough situation because you just missed the 3/4 auto-execution trigger (any option that's 3/4 in the money at expiration gets exercised automatically).

Your brokerage firm is under no obligation to exercise on your behalf, absent an instruction received and tendered before the exercise notice cutoff time mandated by the

Options Clearing Corp.

Options are such a dynamic product that it is absolutely essential not to leave exercise (or a nonexercise) up to chance, or whatever brokerage firm you do business with.

Volatility Numbers

I am just about to close down my online brokerage account, but its options analytic section was the only one I have found that publishes volatility. Is there a free Internet site somewhere that offers access to historical volatility? -- John T. Curran


We consulted lots of different sources on the options volatility Web site question, asking traders and analysts what sites they have bookmarked.

Let's dispense the usual disclaimer:

doesn't endorse, enforce, adore or deplore any of these sites.

Caveat emptor

, and remember, usually, with exceptions, there is no free lunch.

First, it wouldn't hurt to check out the ever-useful Web site of the

Chicago Board Options Exchange. Then, get to the Trader's Tools section, where you can find 30-day historical volatilities for optionable


The CBOE site also offers

Volatility Index

historical data, which is updated weekly. The VIX, a measure of the market's fear, is key in determining the prices of options.

Brad Zigler of the

Pacific Stock Exchange

adds that he knows of no free charting of options series online. He says, however, there is a subscription option chart service called


As for free stock charts online, one simulating a trader's desk display (albeit with delayed quotes) that has "live" charts and trade recaps side by side is at

George Fontanills, president of

Pinnacle Investments

, plugged his own subscription-based

Web site as a great place for volatility and other data. We decided to include it since there is a 14-day free trial.

Finally, options dean and author Larry McMillan maintains a free volatility information

database , updated weekly for historical stock volatility and historical implied volatility.

TSC Options Forum aims to provide general securities information. Under no circumstances does the information in this column represent a recommendation to buy or sell securities.