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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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  • 5 Option Strategies To Optimize Portfolio Returns
    Options are one of several tools you can use to (NYSE:A) optimize profits and (NYSE:B) minimize risks in your portfolio. But you need to know specifically which options strategies are going to achieve this difficult two-part goal.

    1. Covered calls

    The covered call is a popular and widely understood strategy. You own 100 shares and you sell one call. As long as you accept the downside risk of the stock (which you have whether you write covered calls or not), this is a smart and profitable idea. But the first step should be to make sure you pick stocks wisely, using smart fundamentals to ensure low market risk and strong financial trends. Also make sure you pick a strike that, if exercised, will produce profits in the stock. If you write covered calls slightly in the money with about one month to expire, you are going to generate annualized double-digit returns consistently. It's more profitable to write one-month calls every month than to write a one-year call once per year. Check the options listings and you will see that although you get less cash for the short-term options, it works out to more on an annualized basis, because time decay is accelerated in the last month.

    2. Uncovered puts

    In considering the risk/reward scenario of covered calls, also think about the uncovered put. Usually considered very high-risk, the actual market risk of uncovered puts is the same as risks for covered calls. Among the pro and con is the flexibility to roll out of the put without regard to the stock price. With a covered call, a roll has to be made in consideration of the basis in stock, so that exercise will not create a net capital loss. With the uncovered put, it does not matter which strike you roll to as long as you avoid exercise. Early exercise is not impossible, but it will not occur as long as the put remains out of the money (when the stock price is higher than the put's strike). The uncovered put strategy benefits from time decay. The short position loses value as expiration approaches, and the put can be bought to open at a profit as long as the stock has not moved below the put's strike.

    3. Ratio writes

    Think beyond the covered call as well. A ratio write is a covered call with partial covered and partial uncovered sides. For example, if you own 300 shares and you sell four calls, you create a 4:3 ratio write. You can think of this as four calls with 75% cover, or as a combination of three covered calls and one uncovered call. As long as time decay outpaces any growth in future intrinsic value, this is a profitable strategy. Pick strikes out of the money and then track carefully to make sure you don't get exercised. Also watch out for any ex-dividend dates that arise before expiration. If your ratio write positions are in the money at ex-dividend date, exercise is a strong possibility. If these positions go in the money, you can close (hopefully at a profit), roll forward, or accept exercise.

    4. Variable ratio writes

    The ratio write can be made safer with a variable ratio write. This is the same strategy but using two strikes. For example, if you bought 300 shares at $37 and the stock is now at $39, a 4:3 variable ratio write could consist of two 40 calls and two 42.50 calls. Using expiration within one month will maximize time decay, reducing market risks effectively for OTM positions. If the stock begins moving up, either of the strikes can be closed or rolled. But having the cushion between the two strikes makes it easier to avoid exercise and to end up with positions you can "buy to close" at a profit.

    5. Synthetic stock

    A defensive position is justified at times as well. For example, if you are bullish on appreciated stock, but also concerned about the possibility of a downside correction, consider some advanced options ideas. This is especially worthwhile for high-yielding stocks when you want to hold on to your positions at least through ex-dividend date. These positions include synthetic short stock (100 shares plus a long put and a short call) or collars (the same idea, but with two out-of-the-money strikes. A synthetic short stock has calls and puts with the same strike, but a collar involves a short call with a strike above the current price plus a long put with a strike below.

    In both of these defensive positions, if the stock price rises, the short call is covered by the 100 shares of stock, so this side of the trade is a covered call. If the stock price declines below the put's strike, you can sell the put at a profit to offset stock loss; or you can exercise the put and sell shares at the fixed put strike.

    All strategies involving uncovered short positions are also subject to collateral requirements. For uncovered short options, this is 100% of the strike value. For example, if you sell an option with a 45 strike, you must have at least $4,500 per option in your margin account as collateral.

    There are many more ways to use options for portfolio management. The point to remember is that more and more, conservative investor as are using options to reduce or eliminate portfolio risks, and that is just smart investment risk management. The older perception of options as reckless high-risk gambles still applies if options are used speculatively, but conservative investors now can play the game as well.

    Jul 06 9:30 AM | Link | 1 Comment
  • Trends: Two Types Or Three?
    Traders know all about bullish and bearish trends. The direction of price movement is easily spotted and given technical signals and confirmation, reversal is also somewhat predictable.

    A third trend beyond bullish and bearish is the consolidation, a sideways price movement.

    Most traders view consolidation as a time of pause between bullish or bearish trends, in which buyers and sellers are indecisive about what happens next. However, I believe that the sideways period is a third type of trend, notable because - like other trends - it may last a period of days, weeks, or even months.

    This is uncomfortable for many because without a dynamic movement in price, how do you spot reversal? There is no dynamic trend to reverse, so does this mean consolidation's end cannot be predicted? No. Some specific signals indicate the end of the consolidation trend. Most notable among these is a narrowing price range within consolidation, in the form of triangles or wedges. This narrowing forecasts breakout. Augmenting the narrowing range and breakout to follow is the Bollinger Squeeze, one of the strongest signals that consolidation is coming to an end.

    Great confusion is created by the misuse of some terms. For example, consolidation is often wrongly called "continuation." A true continuation signal forecasts that a dynamic trend (bullish or bearish) is likely to continue, and is especially predictive as price moves above resistance or below support. A true continuation signal is as important as a reversal. Many candlestick signals are specifically identified as continuation predictions.

    The distinction between consolidation (a sideways, range-bound trend) and continuation (a signal predicting that the current trend will not end in the immediate future) is an important one for technical analysts. Unfortunately, the confusion is widespread in this distinction.

    Another error is to assume that a reversal signal appearing in the wrong place works as a continuation signal. This is misguided. A reversal only works when it appears at the end of a current trend (bullish reversal after a downtrend or bearish reversal after an uptrend). If these signals appear elsewhere, the right interpretation is that the pattern is a coincidence.

    The entire science of trend analysis is a specific set of observations combining signals and confirmation, understanding statistical tendencies and probabilities, and commonsense discipline about matters like convergence and divergence, combining dissimilar signals (price, volume, moving average, and momentum), and a clear understanding of the different types of trends. It is not complicated; it is specific.

    I have written a book on the topic of trend analysis, and it will be out on August 10. A Technical Approach to Trend Analysis can be pre-ordered on Amazon.com or direct from the publisher, FT Press. This book contains the following contents:

    Illustration List

    Introduction-Defining the Trend

    Chapter 1 The Theory of Trends-Dow, EMH and RMH in context

    Chapter 2 Statistically Speaking-Trends by the Numbers

    Chapter 3 Resistance and Support-A Trend's Moment of Truth

    Chapter 4 Trendlines and Channel Lines-The Shape of Things to Come

    Chapter 5 Reversal Patterns-End of the Trend

    Chapter 6 Continuation Patterns-A Bend in the Trend

    Chapter 7 Confirmation Signals-Turning the Odds in Your Favor

    Chapter 8 Consolidation Patterns-The Sideways Pause

    Chapter 9 Volume Signals-Tracking Price Trends

    Chapter 10 Mind the Gap-When Price Jumps Signal Change

    Chapter 11 Moving Averages-Order in the Change

    Chapter 12 Momentum Oscillators-Duration and Speed of a Trend

    Chapter 13 Volatility-Marking Risk within the Trend

    Chapter 14 Fundamentals-Connecting the Two Sides

    Chapter 15 Overview-Putting It All Together

    Endnotes

    Bibliography

    Index

    Jul 03 2:20 PM | Link | Comment!
  • 9 Fatal Flaws In The Black Scholes Pricing Model
    How can we rely on a pricing formula with a series of variables that are provably unreliable and based on a flawed assumptions, exponentially inaccurate variables, and outdated pricing concepts about the nature of options?

    The pricing model under the Black Scholes (B-S) formula is premised on several assumptions. Today, in spite of advances and changes in the options market, this model continues to be used by many as the standard for theoretical options pricing.

    In fact, 15 years after the original Black Scholes paper was published, one of its authors, Fischer Black, wrote about the model and its flaws. To read about it in Mr. Black's own words, visit Fischer Black: The holes in Black Scholes.

    Augmenting this criticism was a paper published by Espen Gaarder Haug and Nassim Nicholas Taleb in the Journal of Economic Behavior and Organization, entitled "Options traders use (very) sophisticated heuristics, never the Black-Scholes-Merton Formula." Link to this article at http://tinyurl.com/d5fynms

    Both articles refer to the original formula's assumptions which contain many flaws. The initial assumptions of the formula were:

    1. Exercise. Options will be exercised in the European model, meaning no early exercise is possible. In fact, U.S. listed stocks are exercised in the American model, meaning exercise may occur at any time prior to expiration. This makes the original calculation inaccurate, since exercise is one of the key attributes of valuation.
    2. Dividends. The underlying security does not pay a dividend. Today, many stocks pay dividends and, in fact, dividend yield is one of the major components of stock popularity and selection, and a feature affecting option pricing as well. (This flaw in the original model was corrected by Black and Scholes after the initial publication once they realized that many stocks do pay dividends.)
    3. Calls but not puts. Modeling was based on analysis of call options values only. At the time of publication, no public trading in puts was available. Once puts began to trade, the formula was again modified. However, if traders continue relying on the original BSM, even for put valuation, they may be missing a fundamental inaccuracy in the price attributes.
    4. Taxes. Tax consequences of trading options are ignored or non-existent. In fact, option profits are taxed at both federal and state levels and this affects net outcome directly. In some instances, holding the underlying over a one-year period may lead to short-term capital gains taxation due to the nature of options activity, for example. The exclusion of tax rules makes the model applicable as a pre-tax pricing model, but that is not realistic. In fairness to the model, everyone pays different tax rates combining federal and state, that any model has to assume pre-tax outcomes.
    5. Transaction costs. No transaction costs apply to options trades. This is another feature affecting net value, since it's impossible to escape the brokerage fees for both entry and exit into any trade. This is a variable, of course; fee levels are all over the place and, making it even more complex, the actual options fee is reduces as the number of contracts traded rises. The model just ignored the entire question, but every trades knows that commissions can turn a marginally profitable trade into a net loss.
    6. Interest does not change. A single interest rate may be applied to all transactions and borrowing; interest rates are unchanging and constant over the life span of the option. The interest component of B-S is troubling for both of these assumptions. Single interest rates do not apply to everyone, and the effective corresponding rates, risk-free or not, are changing continually. What might have been applicable, at least in theory, in 1973, is clearly not true today. Even adjusted pricing models since the original BSM tend to overlook this fact in how value is determined.
    7. Volatility is a constant. Volatility remains constant over the life span of an option. Volatility is also a factor independent of the price of the underlying security. This is among the most troubling of the BSM assumptions. Volatility changes daily, and often significantly, during the option life span. It is not independent of the underlying and, in fact, implied volatility is related directly to historical volatility as a major component of its change. Furthermore, as expiration approaches, volatility collapse makes the broad assumption even more inaccurate.
    8. Trading is continuous. Trading in the underlying security is continuous and contains no price gaps. Every trader recognizes that price gaps are a fact of life and occur frequently between sessions. It would be difficult to find a price chart that did not contain many common gaps. It is understandable that in order to make the pricing model work, this assumption was necessary as a starting point. But the unrealistic assumption further points out the flaws in the model.
    9. Price movement is normally distributed. Price changes in the short term in the underlying security are normally distributed. This statistical assumption is based on averages and the behavior of price; but studies demonstrate that the assumption is wrong. It is one version of the random walk theory, stating that all price movement is random. But influences like earnings surprises, merger rumors, and sector, economic and political news, all affect price in a very non-random manner. Sheldon Natenberg (Option Volatility and Pricing, 1994) concluded that price changes are not normally distributed (p. 400-401).

    One big question often overlooked in all of the debate over pricing models: Do traders even need the model itself? Or are traders much more concerned with levels of volatility and the momentum of change in volatility? If this is the case, then focusing on delta and gamma makes much more sense than trying to identify the theoretical price of the option.

    Even volatility is useful only until the last week of the option's life. In this final period, volatility collapse makes even delta and gamma unreliable. This is especially true on the Thursday and Friday, when volatility tracking becomes quite unreliable, as pointed out by Jeff Augen in his book, Trading Options at Expiration: Strategies and Models for Winning the Endgame (FT Press, 2009).

    Is it heresy to say that traders don't care about the option's price? Like many heresies, it is true. Traders care about the level of volatility, the direction it is moving, and the momentum of that change. I doubt that any serious trader relies on Black Scholes to time actual trades, using their own money, and believing that the assumptions underlying the formula are reliable or accurate in making those trade decisions.

    Jun 22 9:04 AM | Link | 1 Comment
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