Which Option to Buy (08:05)

By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 8, No. 5 on March 11, 1999. 

From questions asked at seminars and personal appearances, it seems that most people have some difficulty in determining which option to buy once the decision to buy something has been made. This topic is perhaps more elementary than some of the rather high-powered volatility discussions of the past few issues, but it is a very important one. The option speculator must be able to make the “correct” decisions about which option to own, lest the research that was done in order to predict the forthcoming direction of the underlying instrument be wasted by the purchase of the “wrong” call (or put).

This discussion is about directional trading – wherein the trader is concerned with predicting the movement of the underlying stock, index, or futures contract. Directional trading, of course, is riskier than volatility trading, say, but the rewards can be greater as well. So, for the purposes of this discussion we will be considering which call option to buy if one has (independently) generated a buy signal for the underlying instrument, or which put to buy if he has generated a sell signal. There is no getting around the fact that you can’t make money in directional trading unless you correctly predict the direction of the underlying. In fact, the time horizon of your prediction for the underlying will have some impact on which option is the correct one to buy. For example, if you are using fundamental analysis to decide which stock to buy, you should probably buy a longer-term option since fundamental analysis is useless for timing. If, on the other hand, you are using technical analysis to generate shortterm signals, then you should concentrate on buying shorter-term options.

Let’s suppose that you’ve identified a short-term bullish trading signal in some stock. Which call option should you buy to capitalize on it? First, don’t even bother with out-of-the-money calls. Your results will be much better in the long run if you buy in- or at-the-money options. The reason is, that if the stock moves up at all, you will most likely profit with this option, but an out-ofthe- money option might lose, even when the stock rises – if that rise is only moderate and takes some time to occur. You still have plenty of leverage with the in- or at-themoney option and, if your stock selection techniques are trustworthy, you will do quite well with that sort of call.

Even if you are not overly concerned with theoretical value, you should still use a model before buying an option. You want to make sure that you don’t “overpay” in terms of implied volatility.

Let’s assume that you have a short-term buy signal on IBM, and the following prices are relevant. With only one week remaining in the life of March options, April would be the expiration month of choice if you’re expecting a short-term move (if you’re less certain of your timing, then one could consider options as long as 3 or 4 months).

            IBM stock: 181
   Option        Price      Implied
                          Volatility
   Apr 180 call    9         36%

The first thing one should do is to compare the implied volatility of the option he is considering to the history of implied volatility. A quick way to do this is to use the free option history page, at www.optionstrategist.com, our web site. There, we see that the three measures of historic volatility are 35%, 40%, and 41%. So this option’s implied volatility is certainly in line with those readings. Furthermore, we see from the web site that the latest “snapshot” of implied volatility indicated that a 31% implied volatility was in the 42nd percentile – so even though this option is slightly more expensive than that, it is probably “okay” for purchase. So, this one was simple: go ahead and buy that call.

Let’s use a little more complicated example, now. Suppose that, separately, you determined that you had a sell signal in Intel (INTC), and that this is the choice facing you:

              INTC stock: 115
   Option         Price         Implied
                              Volatility
   Apr 120 put     10             52%

Again, looking at the web site, we find that the latest “snapshot” of implied volatility shows that a 47% implied volatility is in the 90th percentile. Thus, this option with a 50% implied has to be considered quite expensive – i.e., “overpriced”. In this case, the procedure is to look at consecutively deeper in-the-money options until one is found that either a) has a much lower implied volatility (unlikely) or b) has much less time value premium. Here are the other INTC options:

              INTC: 115
Option        Price    Implied      Time
                       Volatility   Premium
Apr 120 put   10         52%        5.00
Apr 125 put   13         50%        3.00
Apr 130 put   16-3/4     49%        1.75
Apr 135 put   21         48%        1.00

As you can see, implied volatilities don’t differ much from one option to the other – they’re all pretty expensive, considering that 47% is the 90th percentile. So, at this point, we look at the time value premium and see that it decreases substantially the farther in-the-money we go. An additional advantage of using an in-the-money option is that it has a high delta – that is, its movements more closely mimic those of the underlying stock, so a small movement in your favor by the stock should also produce a profit for the in-the-money option. I would buy the Apr 130 or Apr 135 puts in this case to minimize time value premium expense and negate the fact that these options are overpriced.

I realize that such options have a very high absolute price. Frankly, that shouldn’t be a consideration for you unless you don’t have the capital. You are still going to realize a very nice percentage profit if you’re right about Intel dropping in price. Say INTC drops 10 points. The Apr 135 put would gain about 9 points, if that happened. That’s a 45% appreciation on a 10-point move by the underlying. That’s plenty of leverage.

“Overpriced” Options with wide bid-asked spreads

Rather than question the absolute price of the option, though, it might be better to ask yourself what to do if all the options are expensive and time value expense remains large. This often happens with options on the indices – since the indices trade at very lofty prices. Such options often have wide bid-asked spreads, too.

Here is a situation regarding a recent recommendation to buy the Natural Gas Index ($XNG) April 200 calls. We recommended buying the calls, which were selling at about 15 with the index at 204.50. That’s an implied volatility of about 40% – well above the median volatility of 34%. This expensiveness, plus the fact that there is a fairly wide bid-asked spread in theses options, reflected itself right away: $NDX closed at a 212.32 just four trading days later (so time value decay was not much of a factor), but the options were only bid at 17-5/8. Thus, an 8-point move in the underlying index had resulted in only a 2-5/8 point gain in the options.

Could we have done something that would have given us a better profit potential on this quick, but relatively small, move by the underlying? Yes, we could have synthetically created the index itself and bought it. Any readers who have attended one of my seminars know that I “harp” on the fact that one can and often should use the option equivalent strategy instead of actually buying or selling the underlying. In the case of an index there is no underlying, so if one wants to have a position that pretty much exactly replicates the performance of the index itself, he needs to use these facts:

Buying the underlying = buying a call and selling a
                        put with the same terms
Selling the underlying = selling a call and buying a
                         put with the same terms
By the “same terms”, we mean the put and the call have the
same expiration date and strike price.
Let’s see how this would have worked in the case of the
$XNZ Apr 200 calls:
$XNG: 204.50
Apr 200 call: 15 offered
Apr 200 put: 7-1/4 bid

So if we want to have a position that mimics the behavior of the underlying more or less exactly, then we would buy the call and sell the put – for a debit of 7-3/4. Let’s see how the performance of this “combo” compared with the performance we saw from merely owning the call itself.

    Date:     2/26/99    3/4/99
Symbol          Price     Price
$XNG           204.50    212.32
Apr 200 call    15       17-5/8
Apr 200 put     7-1/4     3-1/2

So the call gained 2-5/8, as we saw previously. But the sale of the put also made 2-3/4, so by using the equivalent strategy one could have made 6-3/8 points when the index moved just under 8 points. Why did the “equivalent” strategy not gain 8 points, just like the index did? Because of that fact that we assumed the transactions were made by buying at the bids and selling at the offers. These options had a spread that was about 1-1/2 points wide (both the put and the call combined), so that accounts for the difference in performance between the equivalent strategy and the index itself.

Still, the equivalent strategy can often be useful when the options are expensive – for it is not affected by a decrease in option premiums, whether that decrease comes from time decay or a decrease in implied volatility.

The “downside” of using the equivalent strategy is that one must margin the sale of the put as a naked sale. In other words, one must advance money as if he were buying the index itself on reduced margin. The margin requirement is 20% of the underlying plus the option premium for a narrow-based index or a stock. For a broad-based index, it’s 15% plus the option premium. This type of margin requirement can be satisfied with equity from long bonds or stocks in your account.

In the above example, then, the margin requirement for the sale of the $XNG Apr 200 put would be 0.20 x 204.50 x $100 (20% of the value of 100 “shares” of the index) + $725 (the put premium) = $4815. Add to that the actual cost of the options in the trade: $1500 for the call less $725 for the sale of the put = $775. The total margin required would thus be $5590.

The reason that this extra margin is required is because this position has large downside risk. You, as a trader, would have to utilize a stop to limit your risk from this position. This requires a little extra work over just owning the call option, which has limited risk (although that risk is 100% of the investment).

So, is it worth it to put up margin of nearly $5600 to make $638, as opposed to making $263 for an investment of $1500 on just the call alone? The answer is unclear in this case, but one should remember that the equivalent strategy removes the disadvantages of time decay and implied volatility shrinkage. If the move had taken longer to occur, the equivalent strategy might actually make money in cases where a straight call purchase could lose money, due to time decay.

This strategy is especially useful if you have excess equity in your account. Utilizing that equity in this manner doesn’t really require you to “invest” extra money – it just allows you to own the underlying $XNG in this case instead of just buying a call on it. It may behoove you to use the equivalent strategy instead of just buying calls outright when such calls are “expensive”.

This article was originally published in The Option Strategist Newsletter Volume 8, No. 5 on March 11, 1999.