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Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT... More
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  • Options And Asset Allocation

    How do you place a value on options positions within a portfolio? Actually, because of the nature of options it is extremely difficult - if not impossible - to accurately balance an asset allocation target that includes derivatives.

    For example, a portfolio of $1 million specified the following targets:

    Large-cap equities 30%

    Mid-cap equities 10

    International equities 10

    Total equities 50%

    Real estate domestic REITs 20

    Real estate directly held 25

    Total real estate 45%

    Derivatives 5%

    Total 100%

    According to this allocation target, the investment manager is allowed to invest $50,000 in derivatives position. But there is a problem. How do you place a value on the derivatives?

    For example, what is the value of a synthetic short stock position in which the net between long put and short call is zero? The manager might decide, for example, to open a synthetic short stock position in a stock valued at $41.16, so opening a synthetic short stock position at a 41 strike could consist of:

    June 41 call 0.84 short

    June 41 put 0.74 long

    Net credit 0.10

    Whether this position is opened with one option on either side or with 100, the problem remains. How does this fit with the allocation value of $50,000 (5%) maximum. With only $10 per position (one short call, one long put) there is no effect on the maximum allocation allowance. If you count the potential exercise value, you could create 1,200 short calls and 1,200 long puts. If the 1,200 short calls were all exercised, the portfolio would acquire $49,200 in stock.

    However, even if you count the maximum potential exercise as the allocated portion, exercise would add to the equity position, potentially distorting the alpha and beta components of the portfolio and acting contrary to the purpose of tracking risk characteristics

    A strategic asset allocation approach may divide a portfolio into the "beta component" in which passive risk-tracking is expected; and the "alpha component," in which risk-adjusted positions are entered with the intention of adding to profitability. A modern trend in asset allocation is to pair passive index positions with active individual or index positions. It is most likely that derivatives would be classified within the alpha portion of an allocated portfolio, although a beta investment in an index fund including option positions may contradict this assumption.

    Asset allocation is aimed at achieving a specific beta for each allocated portion of the portfolio, relative to a benchmark. Returning to the Verizon example, being exercised and required to buy an additional $49,200 of long equities would no doubt throw off the overall beta for the equities portfolio, as well as distorting the equity allocation limits.

    So what equities would be appropriate for a derivative section of the allocation? And what positions would be allowed? If the positions create net credits, isn't the derivative portion unlimited? You need to count some level of "worst case" outcome to limit derivatives activity. For example, a company is valued at $33.59. You could create a synthetic long stock position with:

    July 33 call 1.21 long

    July 33 put 0.82 short

    Net debit 0.39

    If the stock remains above the 33 strike, the call (or calls) can be exercised or sold at a profit. If the price falls below the 33 strike, the short puts will be exercised or will need to be closed or rolled to avoid exercise. Here again, depending on how many contracts are opened, the exercised outcome distorts the allocation direction. You could set up 1,500 calls and puts. Exercise of the 1,500 calls would lead to the sale of $49,500 shares. If the short puts were exercised against you, the same result would occur but the price would be above current market value. Both outcomes would distort the allocated equity portion.

    Since the purpose of allocation is to diversify the risk and control beta while accomplishing the desired alpha goal, any derivative activity is going to be impossible to value accurately. In the above examples, are the exercise values of the strikes assigned derivative allocation? And if so, what happens upon exercise? Is the beta distorted because the portfolio's equity portion is taken above limited previously set? They are, of course; so for portfolio managers, defining how derivatives are valued within the allocation field is very troubling. Even if conservative strategies like covered calls or protective puts represent the limits of allowed hedging activity, the outcomes still affect the overall allocation, notably of equities. In the case of covered calls and protective puts, the equity portion could be taken well below the desired level of allocation, which could have an equally disturbing affect on beta.

    Investment managers facing this dilemma may want to limit the types of derivative trades they allow themselves to make. For example, the allocated portion may be specifically limited to long positions in hedge funds or to individual long options for very limited purposes, such as insurance puts to protect paper profits. However, limitations should also be placed on derivative trades. For example, the specific strategy should be very clearly defined without exception, and no combinations or short positions should be allowed directly. Otherwise, the door is opened to allow investment in much greater levels of risk than intended.

    To gain more perspective on insights to trading observations and specific strategies, I hope you will join me at ThomsettOptions.com where I publish many additional articles. I also enter a regular series of daily trades and updates. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site at ThomsettOptions.com to learn more. You can take part in discussions among members on the site at the Members Forum.

    I also offer a monthly newsletter subscription if you are interested in a periodic update of news and information and a summary of performance in the virtual portfolio that I manage. Join at Newsletter - I look forward to having you as a subscriber. Please also check out my other site, ThomsettStocks.com

    Apr 12 1:05 PM | Link | Comment!
  • Options – 3 Ways To Resist Temptation

    So many traders start out with a sensible plan, only to abandon it because of the way the markets move. This abandonment of a smart plan invariably leads to potentially small added gains but large added losses.

    In entering a trade, it is sensible to set two goals: the point where profits will be taken, and the bail-out point where losses will be cut. If you buy a long option, you should know going in that 75% of options expire worthless, so setting goals to sell and close make sense.

    For example, you buy a long option for 4 ($400) and set the following two goals: Sell when net value grows to 6 or above, representing a 50% profit; or sell when the value falls to 3 or below, a 25% loss. You know going in that time decay works against you, so you face the strong possibility of incurring losses from which recovery is unlikely. This means you have to select long options with some additional goals:

    1. Pick options at the downside swing. This means you enter the long position on sessions when the market drops dramatically. Stocks tend to follow the broader market, so when an otherwise well-managed quality stock falls several points, you know it is part of the index drop and not a factor of the company. This may be the best time to buy a call for a fast swing trade turnaround.

    2. Pick options at the upside swing. This suggestion does not contradict the one before. It is the opposite. Prices often rise just as irrationally as they fall. So when the index values jump sharply, stocks tend to go along for the ride; but you may see a retreat in the following two or three sessions. When the overall market prices rise quickly, but puts on the upside swing, anticipating a drop back to "normal" levels of trading.

    3. Know your stock beforehand. Every stock exhibits particular trading tendencies and rhythms. Some tend to over-react to broader markets while others hardly react at all. This tendency, called beta, is a valuable technical factor in identifying how stock prices react to market movement. Stocks may tend to exaggerate news as well. So for example, a disappointing earnings report of only a penny per share may cause the stock price to plunge, only to get back most of its decline in the following session or two. Knowing how a stock tends to act and react helps pick options with better market intelligence

    To gain more perspective on insights to trading observations and specific strategies, I hope you will join me at ThomsettOptions.com where I publish many additional articles. I also enter a regular series of daily trades and updates. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site at ThomsettOptions.com to learn more. You can take part in discussions among members on the site at the Members Forum.

    I also offer a monthly newsletter subscription if you are interested in a periodic update of news and information and a summary of performance in the virtual portfolio that I manage. Join at Newsletter - I look forward to having you as a subscriber. Please also check out my other site, ThomsettStocks.com

    Apr 12 1:04 PM | Link | Comment!
  • Covered Calls – Increasing Income

    When you write covered calls, did you know that you can produce greater profits by writing six two-month covered calls per year, than you will realize writing one 12-month covered call per year? It's true - time decay for further-out options is quite small, so writing options more than few months away is equal to lost time. Based solely on option premium profits, focusing on short-term ATM or OTM contracts produces annualized double-digit returns.

    An example of the covered call and how to identify profit, loss and breakeven points: You purchased 100 shares of stock two months ago and paid $54 per share. Today those shares are worth $58 and you decide to sell a covered call with a strike of 60 and expiration in two months. You receive a premium of 3 ($300).

    In this example, you have several crucial price points. Your basis in stock was $54, but because you received 3 for selling the call, you net basis is reduced to $51 per share. This is your breakeven point and if the stock price moves below this level, you will have a loss. With a strike of 60, your potential profits are called as well. If the underlying stock moves above 60 and the call is exercised, your profits are limited to:

    Capital gain on stock:

    Exercise price, 100 shares $6,000

    Less: Purchase price - 5,400

    Capital gain $600

    Profit on the covered call 300

    Maximum profit if exercised $900

    If the call is not exercised, you keep the $300 as profit. And when the call expires or when you close it, you are then free to create another covered call with a later expiration date. And as long as you own shares, you also continue earning dividends - which is one reason to limit covered call writing to value companies that also pay exceptionally high dividends.

    To gain more perspective on insights to trading observations and specific strategies, I hope you will join me at ThomsettOptions.com where I publish many additional articles. I also enter a regular series of daily trades and updates. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site at ThomsettOptions.com to learn more. You can take part in discussions among members on the site at the Members Forum.

    I also offer a monthly newsletter subscription if you are interested in a periodic update of news and information and a summary of performance in the virtual portfolio that I manage. Join at Newsletter - I look forward to having you as a subscriber.

    Apr 12 1:03 PM | Link | Comment!
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