By: Steve Smith
Summer reading for the option enthusiast.
As someone who writes about and actively trades options I belong to the camp that believes options are a valuable investment tool that, when properly utilized, can both boost returns and reduce risk.
That said, I acknowledge the validity of many of the arguments made against options. Perhaps pointing out the most common pitfalls, rather than proselytizing on the benefits, is the best approach to bring some evenhandedness to the subject.
Despite what the calendar says, for me summer time officially kicks off with July 4th weekend. As things slow down and maybe you start extending your weekends to three days you might find some extra time on our hands. What could be more fun than boning up on your options education? It may lack the drama of reading about Greece and central banks interventionist policies, but I promise the long term benefit is better.
I’ll tee up a few topics and offer some reading suggestions for those that want to delve deeper and don’t mind being spotted on the beach with an swiping through an options book on your tablet.
As with any tool, before using options, make sure you are familiar with the basic rules and guidelines that govern their behavior.
For starters, make sure you know the contract specifications the product you are trading. Items such as margin requirements (pay special attention to leverage), the exercise and settlement procedures, and what strikes and expirations are currently listed for trading are important to know.
For example, you should be aware that index options, such as for those on the S&P 500 or SPX, can only be exercised on expiration day and are cash settled; also note that SPX options actually cease trading on the third Thursday of the month, a day earlier than equity options, though they officially expire on the third Saturday.
By contrast, equity options, including those on the Spyder Trust (SPY), can be exercised at any time during the life of the contract. This is especially important when trading options on stocks that pay dividends.
A terrific book that covers all the basic concepts and strategies is Options as a Strategic Investment by Lawrence McMillan.
Dealing in Dividends
If you own in-the-money calls on Exxon (XOM) make sure you know when the ex-dividend date occurs — you will need to exercise your calls if you want to qualify for the payment. Likewise, if you are short an in-the-money call on a dividend-paying stock, be prepared for assignment and being short the actual shares the day before it goes ex-dividend.
Most ETFs pay dividends. Some, like the Spyders pay out on a quarterly basis and for some reason the ex-dividend date often falls on the Thursday prior to a quarterly expiration. Meaning many people have failed to exercise an ITM call and lose out on the dividend while others or are unwittingly assigned puts and forced to pay.
Others, like the Dow Jones Diamonds (DIA) make monthly distributions. The point is, knowing the basic rules by which the various vehicles operate will help you avoid surprises such as an early assignment on an in-the-money call.
Option traders, like other professionals, love to use industry jargon. Talking the lingo serves several purposes: It connotes a high level of knowledge and expertise in one’s specific field, it accurately conveys complex concepts in a concise manner, and it just sounds so cool to say things like, “I’m long vol up the ying-yang and bleeding theta,” which basically means one owns options that are suffering from time decay.
Or that scalping gamma is a fancy way of saying “I’m trying to buy low volatility and sell higher volatility as the price of the underlying stock moves back and forth within a trading range.”
For deeper dives into there are plenty of good books out there. One of my favorites on harnessing Vega and Gamma is Options Volatility Trading: Strategies for Profiting from Market Swings by Adam Warner.
A great site for finding and analyzing current and historical volatility, along with an amazing amount of free tools, is IVolatility.com.
The downside of lingo is that sometimes it’s used to purposely conceal the true level of understanding, or is simply a means for the speaker to bolster his self-esteem and get the upper hand in a conversation or negotiation.
This can be very off-putting to the layperson put in the position of deferring to the expert because he is reluctant to ask a “stupid question.” So, with that in mind, while it’s not important to know all the jargon it is imperative to understand the concepts so as not to make a needless costly error.
If you have topics or questions you’d like me address in coming weeks e-mail me email@example.com. We can whip up some margaritas and talk about options until the sun goes down.