Saturday, August 06, 2005

Some Options Strategies Not As They Seem
Saturday August 6, 3:24 pm ET
By Ellen Simon, AP Business Writer

Amateurs Embracing Options Trading, but Some Strategies May Not Be As Safe As They Appear NEW YORK (AP) -- Options trading used to be considered an exotic form of investing that most individual investors left to the pros. But the price of options drops in a strong market and options have been getting cheaper since 2003. As a result, individuals have become more active in the world of puts and calls.

While volume on broad equity indexes like the Standard & Poor's 500 and the Nasdaq composite has stayed in a narrow band for much of the year, options volume keeps hitting records. July's option trading volume was up by 21.7 percent over last July, according to the Options Industry Council.

As options have boomed, some investors have bought into option strategies and options funds that may not be as safe as they seem. But more on that later.

First, what are options?

Here's a thumbnail sketch of how options work: Broadly, a put gives the buyer a right to sell a specified number of shares at a particular price within a specified time. Put buyers expect the price of the underlying security to fall.

A call gives the buyer a right to purchase a specified number of shares of stock at a fixed price before a specified future date. Call buyers are speculating that the underlying shares will rise.

The holder of the underlying shares who sells options is called the options "writer." The writer gets a fee, called a premium, for writing the option. The premium is based on the stock's most recent close.

There are usually multiple dates and strike prices on the options for most big stocks. There are also options on indexes and exchange traded funds.

So, for instance, if you think Microsoft Corp.'s stock is going to fall, you can buy a three-month put to sell 100 shares at $30 a piece, paying a premium of about $275. If Microsoft falls to $25 a share, you buy shares at the market price, then sell them to the writer for $30 each, pocketing $5 per share, minus your $275 premium, for a nifty profit of $225.

Of course, if Microsoft stock rises to $30 or above within three months, you are, as they say, "out of the money." Your options are worthless and you've lost the $275 it cost to make the bet.

If you're intimidated by options, you're not alone. The Chicago Board Options Exchange runs the Options Institute, whose six full-time instructors usually teach seminars for brokers, and have also run sessions for workers at the Internal Revenue Service and the Federal Reserve.

What's the breakdown of institutional versus individual options investors?

"It's a perennial question," said Jim Binder, a spokesman for the Options Industry Council. "The best we get is anecdotal evidence. ... It's probably 50-50, but the institutional side is growing faster."

One relatively new product institutions are selling to individuals goes by the cumbersome name of "the closed-end covered write fund."

The funds, which hold on to their underlying equities but sell options for others to buy them, can make a tidy profit on the premiums they charge to write the option. In many respects, the funds look like a bet that the market will continue to go sideways, trading in a narrow range.

"Closed-end covered write funds have become extremely popular," said Tom Stotts, director of hedging options at RBC Dain Rauscher. Assets under management in such funds are "probably in the billion dollar range," Stotts said.

"Lots of people are consuming them; they may not know exactly what they're consuming," he said.

Like all closed-end funds, the write funds raise their money, then take no new investments from either existing or prospective investors. One fund is the Madison/Claymore Covered Call Fund, which has $284.9 million total managed assets, according to its Web site. Another is the First Trust/Fiduciary Asset Management Covered Call, which has $386 million in assets under management.

Bernie Schaeffer, chairman and CEO of Schaeffer's Investment Research and an expert in options, is skeptical of the strategy the funds employ.

"Because the market hasn't been doing anything, lots of people are selling options, selling calls for the stock they own," Schaeffer said.

That's a risky strategy, he said, and the funds are risky, too. The funds make their income from the premiums, which are shrinking. They're unprotected if their stocks fall. And they've sold away appreciation if their stocks gain.

"Investors are mistakenly looking at these as conservative income funds without the kind of downside risk you would have in a conventional investment," he said.

"While you can sell an option for a dollar and that gives you a bit of a cushion, what good is that going to do you if the market plunges 10, 15 or 20 percent?" he said. "It's not going to cover you at all."

"There's a disconnect between what people are doing and the reason for buying stock in the first place," Schaeffer said. "Why are you risking your money if you're not expecting, potentially, some very attractive appreciation down the road?"


Blogger charti said...

Hard-to-Borrow Stocks
May Offer Easy Discounts


ANYONE WHO'S BEEN on the wrong side of a short squeeze knows it can be a painful and costly experience. But what if an investor wants to own a stock with a high short-interest level? Option markets may offer better opportunities.

As the amount of stock available to borrow for shorting becomes tight, the stock becomes "hard-to-borrow." The more "hard-to-borrow" a stock becomes, the more arbitrage principles begin to break down, creating a unique situation in the marketplace where synthetic stock (or the "future on the stock") can trade at a discount to the current stock price.

Buying a call and selling a put of the same strike and expiration creates a synthetic stock position (often referred to as a "combo") which is equal to the price of the call minus the price of the put plus the strike price. The variables that determine the price of the synthetic stock position are interest rates, dividends and stock price. As a stock becomes more difficult to borrow, there is a cost that investors may be willing to pay in order to obtain a short position. This cost is essentially the discounted price at which investors are willing to sell the stock because they believe it can still decline further.

For example, Netflix (NFLX) stock is "hard-to-borrow." While the discount between the synthetic stock price and the real stock price has narrowed since reporting blowout quarterly earnings, a discount still exists. Intraday on Aug. 4 with a stock reference of $20.77, the Jan. 20 "future on the stock" or "combo" (buying the Jan. 20 call on the offer and selling the Jan. 20 put on the bid) was offered at $20.05 (January expiration is 1/21/06). If NFLX stock was easy to borrow, the "future on the stock" based on arbitrage-pricing would be $21.16 (assumed rate of 4.25%). With investors essentially pricing in a cost to the stock being "hard-to-borrow," the options offer the synthetic stock at a 5.3% discount to the real stock (assuming no commission or transaction fees). So a synthetic stockholder has the same directional risk and return characteristics as a real stockholder, but has the advantage of getting into the position at a lower price.

Options activity in NFLX has seen a notable increase over the past two weeks with investors positioning for further strength. Ahead of the quarter, investors bought Aug. 20 and Jan. 15 calls. Since the earnings report, the options are more active, with a persistent bullish sentiment in August, September and December options. Investors who agree with the recent bullish sentiment and are considering buying the stock might find better opportunities in the options. Using December options intraday on Aug. 4, some other stocks that trade at a discount are Global Crossing (GLBC) at 8.1%, which recently traded at $17.38, Martha Stewart Living Omnimedia (MSO) at 5.7%, which recently traded at $26.31, and Antigenics (AGEN) at 6.3%, which recently traded at $5.68.

This strategy is not without risks and should not be viewed as free money sitting in the marketplace. When a stock becomes "hard to borrow" because interest in shorting the stock is significant, investors should be cognizant that the sentiment is bearish and other investors are willing to sell at a discount. Additionally, since most equity options are American exercise (i.e. can be exercised any time between purchase and expiration), investors incur the risk that the options may be exercised early. This risk increases for longer-dated options, and there is nothing that can be done to eliminate the risk.

Another risk that is difficult to eliminate is "pin risk." With a long synthetic stock position, an investor is long a call and short a put of the same strike in the same month. For example, in NFLX, an investor would be long the NFLX Jan. 20 call and short the Jan. 20 put. At expiration, if the stock closes at exactly the strike, the investor is long synthetic stock. Or, if NFLX closes $20 at January expiration, the amount of calls to exercise, or the amount of puts which an investor may be assigned, becomes difficult to assess.

In addition, investors who are long synthetic stock are not entitled to the same rights as long shareholders; corporate actions, proxy votes or dividend increases benefit long shareholders, and those that are long synthetic stock could lose to this position.

In sum, while risks exist with the strategy, investors should at least be aware that options can be used as an alternative to obtain a stock position.

4:27 AM  

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