Tuesday, September 7, 2010

Don't Be Afraid of Options - Part 6: Fancy Options

If you have read all of my posts on options, your knowledge of options would hopefully have increased.  In this post, we are going to look at some of the fancier option strategies that are used by investors/traders.  Without further ado, let's get started!

Strangles and Straddles
A few factors affect the price of an option.  Without going too much into the Black-Scholes model that is widely used as a pricing model of derivatives, let's look at what might make an option more or less expensive.  We know that an option is all about what might happen in the future.  When I buy a call option, I'm betting that the underlying stock price will rise to a certain point in the future, before the expiry of the option.  There are several factors that affect the likelihood of this happening.

Volatility is one of these factors.  If you expect the underlying stock to fluctuate a lot (i.e. increased volatility) because of some future event (e.g. earnings or announcement of a new product, etc.), then it is possible to use strategies to capitalize on this.  Two examples are the strangle and the straddle (please don't ask me how they came up with the names).

For both the strangle and the straddle, you buy both a call option and a put option of the same stock.  The goal is for the stock to move either up or down so much that you end up making money on one of the option that it covers for the losses of the other and then some.

The Straddle

A Straddle

The straddle is a strategy where you buy a call and a put with the same strike price, that is closest to the current price of the stock.  The example we'll use today is the Canadian potash maker, Potash Corporation of Saskatchewan (Ticker: POT).  There has been recent news of a potential hostile takeover and the stock has almost doubled in a matter of 2 months!  This is extreme upside volatility for a company that has a market capitalization similar to that of Ford!  Anyway, POT is trading at $148.50 at time of writing.  For the month of October, there are options available at $150 strike price.  The call option costs $4.85/share and the put costs $6.60/share.

You can see in the above figure the behaviour of this position for the different stock prices at the time of expiry.  If the stock moves below $138.55 or above $161.45, then the position would start to become profitable.  At $161.45, the put option would be worth nothing since the strike price allows you to sell the stock at $150, and who would want to do that when he/she can sell it for $161.45?  The call option, on the other hand, would be worth $11.45, because the stock has risen $11.45 above the strike price.  So, you initially spent $11.45 on the 2 options, and now the call option covers that cost.  Once the stock moves higher, that difference would go right into your pocket.  In the same way, the put option would be worth $11.45 if the stock dropped to $138.55.  The lower the stock moves, the more the put would be worth.

The absolute worst case for this strategy is if the stock moved to $150 and stayed there until expiry.  Both options would expire worthless, and you would have lost $11.45/share.

The Strangle

A Strangle

A strangle is very similar, except that both the call option and the put option are out-of-money.  So, if the stock price is at $148.50, I would buy a call option at $150, and a put option at $145.  The call option would cost me $4.85/share and the put, $4.05/share.  The total cost is $8.90/share.  So, if the stock moves up or down $8.90 beyond the higher/lower strike price, respectively, the position would become profitable.

The strangle is a lower cost option over the straddle and it also becomes profitable more quickly than the strangle.  The maximum lost, in our example, is $8.90/share versus $11.45/share for the straddle.  The price range between the 2 strike prices (i.e. from $145-$150) is where your maximum lost occurs.  The strangle is probably a better bet all around.  I see no real advantage of buying a straddle over the strangle.  Having said that, both strategies requires a large fluctuation in stock price in order for you to profit.  The strangle, for example, requires a movement of $8.90, which is 6% of the current stock price.  Sometimes, the stock doesn't even fluctuate that much in a few months, nevermind 1 month!  I also did not include commissions cost in this analysis.  By entering into a strangle/straddle, you have to buy 2 options, which doubles the cost of the position.  If you decide close the position before expiry, you'd have to sell 2 options, incurring commissions costs again.

It is not uncommon for either of these strategies to be used when an unusually long period of inactivity has elapsed.  If a certain stock has traded within a narrow range for a few months, it is likely that increased volatility is just around the corner.  And since volatility of the stock has decreased recently, the price of its options may also have decreased in value.  As such, it would be an opportune time to enter into a strangle/straddle position.  Just keep the commissions cost in mind.

Another concept that is popular is called spreads.  The idea is to buy and sell a combination of options to create a semi-bullish or semi-bearish position.  The semi-bullish position is called the bull spread, and the semi-bearish one is called, surprise, the bear spread.  If you create a bull spread position using call options, it is further defined as the bull call spread.  Let's look at one right now.

A Bull Spread

In the figure above, we have the behaviour of a bull call spread of POT.  To create this position, a call option is bought with strike price at $145, while another call option with strike at $150 is sold.  Here, the October $145 call costs $7.60/share, and the $150 call can be sold for $4.85/share.  Therefore, we spent a total of $2.75/share to open this position ($7.60 - $4.85).

We all know what buying a call option at $145 gives us, which is limited loss and unlimited gains if the option rises above $145.  What happens when we add selling a call option at $150?  When we have sold a call option at $150, we give the right to buy 100 shares of the underlying stock at $150 to the buyer.  If the stock price remains at or below $150, nothing happens.  The option expires worthless and we get to keep the premiums.  If the stock rises above, $150, we have to give our shares away for $150/share.  Now, if the stock rises to, say, $155, the option is exercised, and our shares are called away.  But we don't have 100 shares...so, what we do is use our $145 call option to buy 100 shares at $145, and then give the shares away for $150.  Thus, we pocket $5/share, but we need to take away our initial investment of $2.75/share.  Our profits are $2.25/share.

The advantage of a bull spread is that the initial cost is lower than a plain call option.  Let's compare.  With a bull spread, if the stock rises to $150, we make $2.25/share (like above) on $2.75/share investment.  That's 82% gains.  For a plain call at $145, we have to pay initially $7.60/share for the option. That's the first thing, higher initial cost.  Then, when the stock price rises to $150, you make $500 by exercising the option to buy 100 shares at $145 and then immediately selling them for $150.  The gain is $5/share, which is only 66% profits.  So, on a percentage basis, the profits are decreased.

The disadvantage of a call spread is also precisely what it was designed to do, limit upside potential.  Once the stock price rises beyond $150, your profits are capped off and you make only $2.25/share, even if the stock price goes up to $1000!  Therefore, this position is semi-bullish, because you make money if the underlying stock price goes up, but your gains are capped if it goes up beyond the strike price of the higher option.

A bull put spread has essentially the same outcome, except that you buy a put option with a lower strike price, and sell a put option with a higher strike price.  For bear spreads, the concept is exactly the same, but the position is profitable if the stock price decreases.  I'm sure you are knowledgeable enough now to work out what options you need to buy and sell to make that happen.

Anything Else?
Heck, yes!  If you can imagine a combination of buying/selling calls/puts, chances are people would have thought of it and have given it a fancy name already.  If you want to do further research, start with butterfly spreads, calendar spreads, and ratio spreads.  I typically like the KISS principle (Keep it Simple, Stupid) and avoid anything with more than 2 options.  You really don't need to get that fancy to make money.  Also keep in mind that if you sell uncovered calls/puts, you would need to have a margin account.

In the next and last post of this series, I will make available a spreadsheet that I have built to evaluate the various option strategies out there, and even ones that you make up yourself.  Stay tuned!