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Time Spreads and the Summer Doldrums For many stocks, the summer-months can be a pretty boring time to trade. Let's face it; there are better things to do than sit in front of your computer-screen-golf, the beach, watch the Cubs lose... With no action and no interest, many stocks end up sharply unchanged after this 3-month hiatus in trading activity. What's an investment advisor to do? Lack of movement in the marketplace isn't necessarily a problem. In fact, it can be an opportunity. Time spreads are a way to potentially capitalize on the doldrums of the summer markets. A time spread involves buying one call (put) option and selling another call (put) on the same underlying, with the same strike but with a shorter term to expiration. Here's an example (commissions and other transaction costs are not included in the following example): With XYZ stock trading around $40 per share, Buy 1 XYZ 3-month 40 call at 4.00 and
Sell 1 XYZ 1-month 40 call at 2.10
Total debit 1.90 How can this help us to profit from stagnant prices? This type of strategy is what is often referred to as an income generating strategy. Here, we are trying to generate income from the sale of the 1-month call but we have the 3-month call against it as protection. The concept at the heart of this strategy is the concept of time decay. All options have a limited life. As the useful life of an option decreases, so does its value-all other factors held constant. At this point, a logical question is: if we are buying one option and selling another option, how do time spreads benefit from time decay? At-the-money options decay at a non-linear rate. This means options with a shorter-term to expiration lose their value at a faster rate, often a much faster rate, than longer-term options. Notice how the concept of the non-linear rate of time decay is at work in our example. If XYZ is trading right at 40 at expiration, the 1-month call will expire worthless meaning the 2.10 premium collected will be ours to keep. We will still own the 3-month call we purchased for 4.00. This option will lose value as well, but at a slower rate. After 1 month it loses only .75. So the 1.90 initially invested will now be worth 3.25. Having the stock trading at the strike-price at expiration is the best-case scenario. The risk occurs if the stock moves too much in either direction. If the stock declines sharply at the end of the first month, the 1-month call still expires worthless, but the 3-month call will lose more of its value due to the adverse move in the stock price. To be sure, if the stock is trading at, say, $20 at the expiration of the 1-month call, the 3-month call will likely be worthless as well. Here, the 1.90 investment will all be lost. If, conversely, the stock is trading above $40 after one month, the short call will be assigned and a short stock position will be created. The 3-month call will be helped by the increased stock price, but not to the extent that the newly created short position hurts us. By the end of the 1-month period, if the stock is drastically higher, it is possible to lose up to the 1.90 initially spent on this position. If the stock is trading at, say $60 per share, we can exercise the 3-month call thereby acquiring a long stock position at $40 to offset the short stock position incurred at $40. We're simply out the 1.90 net premium. If you are concerned about assignment and getting short stock, it is important to keep in mind options can be traded out of prior to expiration. Barring gap openings in the stock, active management can often allow a trader to avoid assignment. It may also help avoid the maximum loss of 1.90 if the stock begins to trend strongly in either direction. Time spreads are a way to generate income with controlled risk in the sideways markets often associated with the summer months. When your clients are at the beach or on the golf course spending their summer days hard at play, their money can be hard at work seizing the opportunities presented by the summer doldrums.
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| The Options Institute at CBOE
Master Session (OIMS) The OIMS is an engaging educational opportunity for serious traders and investors. Given the proliferation of options and trading education, traders and investors are challenged to find educators who are experienced and trustworthy. The OIMS combines the talent and credibility of leading educators with the trusted brand of The Options Institute. The goal of the OIMS is to provide a high quality educational experience for active traders and investors who are seeking to refine their trading and investing ability. This 2-day intensive seminar is designed for experienced traders and investors who are interested in trading both stock and index options. July 30 & 31, 2006 - Chicago - Featuring Larry McMillan Larry McMillan is the author of Options As a Strategic Investment, the best-selling book on stock and index options strategies, which has sold over 200,000 copies. The fourth edition of this work was released in March, 2002. In addition, he has written two other books, McMillan On Options (2nd edition, 2004) and Profit With Options and coauthored another, New Insights On Covered Call Writing. He currently authors a unique daily advisory service - Daily Volume Alerts - which selects short-term stock trades by looking for unusual increases in equity option volume. He also edits and publishes "The Option Strategist", a derivative products newsletter covering equity, index, and futures options, as well as "The Daily Strategist", covering many of the same strategies but on a daily basis. In these capacities, he is the President of McMillan Analysis Corporation, which he founded in 1991. Topics to be covered: - Probability Calculator ("ever" vs. "end-point") Expected Return Calculator Using Options as a Technical Indicator Options as a Contrary Indicator Put-Call Ratios Computer analysis of put-call ratios Volatility (VIX) analysis Trading volatility and variance futures VIX options - pricing and trading Momentum Trading "alerts" Volume Alerts Predicting the broad market - the 4 basic indicators Naked Option Writing Insurance: collars (with LEAPS®) Holy Grail trading system Structured Products Seasonal Trades (January and October) Expiration day trading - individual stocks; broad market (arbitrage)
- Futures Fair Value and how to use it in trading
SPECIAL OFFER Call Laura Johnson at 312-786-7818 and ask about the Options Institute Alumni Discount and/or the “Bring a Friend” Discount. |
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Lease the Stock Now to Limit Election Risk
This has been a volatile summer for stocks. Why? Oil, interest rates and political unrest abroad for starters. In general, it seems to always come down to politics. Here, in the US, we have our own political uncertainty to contend with-elections in November. There are 36 state governor seats up for re-election this fall. Of course there are the House elections, not to mention the 33 out of 100 US Senate seats being challenged. Will the GOP gain a heavier position in Washington? Or, can the Democrats tip the scales in their favor? Whatever the outcome is, it will surely affect business, the economy and ultimately the stock market in this country. Is this a good time to be buying stocks? Why Buy a Stock When You Can Lease It®?
LEAPS® options, or Long-Term Equity AnticiPation SecuritiesSM, have been used by conservative investors to manage risk since 1990. These long-term options-they are listed with 12 to 30 months until their expiration date-are tradable on over 1,000 different stocks. They are available on many indexes, as well. LEAPS trade much like conventional options with a few subtle differences. The time-horizon is longer, of course. And LEAPS always expire in the month of January. Right now LEAPS that are listed expire in January of '07 and January of '08. What's the advantage of trading long-terms? LEAPS give traders the option to take a position in a security without actually buying (or shorting) the underlying instrument. This can translate into lower risk. Here's an example (commissions and other transaction costs are not included in the following example): Let's say you are considering buying 100 shares of XYZ stock. The current market price is $65 per share. You have reservations about buying the stock because of the pending elections in the fall. Instead of buying the stock, you buy 1 XYZ Jan '07 LEAPS 65 call at 5.00. Here, you're paying $5 for the right to buy the stock at $65. Why not just buy the stock? What if there is a major adverse move in XYZ stock? This $65 stock can go to zero. Ouch! When you buy an option, the most you can lose is what you pay for it-in this case $5. But, if the stock rallies like you think it will, you may participate in some upside profit. When the underlying stock increases, call values tend to increase (all other factors held constant). In this case, you can sell the call for a profit and, if you later decide to buy the stock (at the new, higher price) your effective purchase price will be lower because of the profit generated from the call option. Why buy LEAPS instead of shorter-term options? One answer, of course, is they simply give you more time. Another answer has to do with a concept called time decay. All options incrementally lose their value with the passage of time (again, assuming all other factors, like the underlying stock price, are held constant). Options that have a long time until expiration, like LEAPS, lose only a small percentage of their value each day, while options that have a shorter time until expiration decay much faster. For this reason, in some instances, buying a LEAPS call may be better than a short-term option-they retain their value better. Whatever the results of the November elections will be, LEAPS can help investors with their long-term goals. If events, such as these, cause concern about buying stocks remember: Why Buy a Stock When You Can Lease it®?
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recommendations or other information contained therein. Advertise in CBOE Advisor eNews: To find out about advertising in CBOE Advisor eNews, please visit our website. FOR REGISTERED REPRESENTATIVES ONLY. NOT FOR CUSTOMER DISTRIBUTION. The appropriateness of this strategy for individual investors depends on each investor's unique financial situation in light of the investor's particular objectives and needs. Because of the importance of tax considerations to all options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions. Options involve risk and are not suitable for every investor. For more information, consult your investment advisor. Prior to buying and selling options, a person must receive a copy of Characteristics and Risks of Standardized Options which is available from your broker or from The Options Clearing Corporation (OCC) by calling 1-888-OPTIONS, or by writing to OCC at One North Wacker Dr. Suite 500, Chicago, IL 60606. To remove yourself from this e-mail list or if you have any questions, please click here or e-mail fcsupport@cboe.com. To unsubscribe by postal mail, please write to CBOE Internet Marketing, 400 S. LaSalle St., Chicago, IL 60605.
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