<i>TSC</i> Options Forum:<BR/> Risky Business

Steve:

Love your columns on options. I'm a neophyte but I'm learning fast. Here's a quick question:

The April 25 calls on Microsoft (MSFT) were trading at $1.85, and the April 27.50 calls were at 45 cents. It seems to me that MSFT only has to get to $26.90 to make money with the 25 strike price, but it has to be to $28 for the $27.50 strike price. Am I reading something wrong? Thanks,

-- T.P.

You are reading this exactly right. With Microsoft currently trading around $26.50, the $25 call is "in the money" and therefore already has some intrinsic value, whereas the price of the $27.50 call comprises mostly time and implied volatility. But the trade-off (and there is always a trade-off) is that the price of the $25 call represents three times as much risk or cost of the $27.50 call.

On the profit side, if Microsoft ( MSFT) rose to $29, the $25 call would be worth $4, more than doubling your money. The $27.50 would be worth $1.50 for about a triple.

Those are the payouts. The option's price represents the odds. You get what you pay for, and a position's potential reward is usually commensurate with its risk. The 25 calls are an odds-on favorite to expire with some intrinsic value (in the money), possibly delivering a small profit or at least getting a good portion of your money back. The $27.50 calls, while not a total longshot, have a much-higher probability of finishing out of the money, leaving you holding a "ticket" with no redeeming value. Tear it up and move on to the next race -- I mean, options cycle.

On the 'Trampoline'

Hi, Steve:

You obviously saw Jim Cramer's piece today: "Some good news about why Friday could turn out OK: There's massive put-buying on the semiconductors and the QQQs ... we could see an initial decline and then a snapback rally as all of these put positions get unwound."

My question is, why would offsetting the heavy put action in this scenario mean a likely rally in the underlying shares? Isn't it cheaper and easier for the big put-buyers to simply close out their options positions? I'm obviously missing something.

-- T

The basic forces at work for the "trampoline" that Jim described would be twofold. First, you have all that downside protection in place (and paid for), so any dip can be bought pretty aggressively, because the safety net is in place.

More important are the forces unleashed by the unwinding of the positions. This process begins with those who are long puts beginning to sell them; these sales could come in the form of taking profits if the market initially drops on a weak jobs number, or, if the data are positive and the market opens higher, simply unloading the puts once it's thought that put protection is no longer necessary.

It will be mostly market-makers taking the other side (buying puts) of the trade. They in turn will then be buyers of the QQQs ( QQQ) or Semiconductor HOLDRs ( SMH) or individual issues such Intel ( INTC) to keep their positions basically neutral. This is how large put positions can both put a floor on prices and act as a springboard as the unwinding creates fresh buying in the underlying issues or index.

The reader wasn't completely satisfied with my initial answer and submitted a follow-up question:

"Isn't it way cheaper for the market-makers to offset their risk exposure with options vs. the stocks themselves?"

Because customer service is a top priority here at the Options Forum, let's expand the answer.

Market-makers typically use the underlying equity as the first choice in laying off a facility position or trade, i.e., a transaction done strictly in the capacity of being a market-maker. In this case, market-makers would have probably gained an edge (bought on the bid or sold at the offer), and they want to lock in that pricing edge as quickly as possible.

"These guys don't want to hold anything more than 10 to 20 seconds if they are merely facilitating a transaction," said Tim Tuttle, an independent floor trader on the floor of the Chicago Board of Options Exchange.

The underlying equity usually provides the quickest, most liquid and tightest markets (narrowest bid/ask spread), thereby making it a more efficient and exact means for hedging and maintaining a delta-neutral position than the options market.

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 steve.smith@thestreet.com.

More from Options

Amazon's Stock Is Facing a Major Test

Amazon's Stock Is Facing a Major Test

Here's a Better Way to Hedge Using Stock Options

Here's a Better Way to Hedge Using Stock Options

Let the Najarian Brothers Crash-Proof Your Portfolio

Let the Najarian Brothers Crash-Proof Your Portfolio

Let the Najarian Brothers Help You Generate Income With Options

Let the Najarian Brothers Help You Generate Income With Options

Learn Options Trading from the Najarian Brothers, the Best in the Business

Learn Options Trading from the Najarian Brothers, the Best in the Business