Stocks & Commodities V.

22:1 (37): Explore Your Options by Tom Gentile

Explore Your Options

Got a question about options? Tom Gentile is the chief options strategist at
Optionetics (www.optionetics.com), an education and publishing firm dedicated
to teaching investors how to minimize their risk while maximizing profits using
options. To submit a question, post it to our website at http://Message-
Boards.Traders.com. Answers will be posted there, and selected questions will
appear in a future issue of S&C.

EUROPEAN VERSUS AMERICAN dard & Poor’s 100 options traded on the
At the end of your November 2003 col- CBOE that are both American and Euro-
umn, you referred to the European- pean style: the OEX and the XEO, respec-
style settlement, saying that you could tively. So for a calendar spread, you
sell options without the risk of unex- would sell a European-style option
pected early assignment. Could you against an American-style long position
please explain what you meant by this? to take advantage of this anomaly.
—D. Streich One last note: unlike American-style
There are two types of settlement options, which settle on the Saturday
with options: European style and Ameri- following the Friday expiration, Euro-
can style. European options cannot be pean options settle on the same Friday
exercised on any date prior to expira- they expire. With this in mind, should
tion, though they can be bought and you need to liquidate your positions, it’s
sold at any time. American-style op- best to do so on the Thursday prior to
tions can be exercised at any time prior expiration.
to expiration.
CHEAPER OPTIONS
Though there are virtually no equity
options traded on US exchanges that
Some traders tell me they buy options
are European style, the majority of in-
that expire in three months or more
dex options are. This can be very help-
because, relatively speaking, they’re
ful when setting up a strategy. If you’re
“cheaper.” I’m confused. How are
more certain of where an index may lie
longer-term options cheaper than
at expiration in the future, but not cer-
shorter-term options?
tain of the near term, employing a strat-
As far as the actual dollar amount you
egy involving the short sale of a Euro-
pay, short-term options are indeed less
pean-style option makes sense.expensive. But relatively speaking,
Another beneficial aspect of Euro-
short-term options lose more time value
pean options is that because a trader
in comparable time frames than do
longer-term options. If you were to com-
must hold them for a required length of
pare the dollar amount each option loses
time before exercising them, they tend
to be more expensive than their Ameri-
on a delay basis (this is known as theta),
can counterparts. Therefore, in strate-
the loss is greater for short-term options.
gies where there are both short and long
Since the majority of an option’s time
premium decays in the last 30 days,
positions such as calendar spreads, you
generally, it’s not a good idea to pur-
can sell short-term, European-style op-
tions against long positions that are
chase or hold onto options that expire
within one month.
American style, thus taking in a greater
Let’s use a hypothetical example to
premium. For example, there are Stan-
illustrate: XYZ on
November 10,
Taking the time to expiration into 2003, is trading at
account can make a big difference in $30. Suppose you
are looking to buy
your profitability and serve to help your an at-the-money
peace of mind, if trading short-term option on XYZ and
options is a stressful proposition for you. you see that there
are several expira-
tions available.
Tom Gentile of Optionetics
December’s 30 call is $2.00, January
2004’s 30 call is $3.00, and April 2004’s
is $4.50. Since each of these premiums
represents 100% time value (since
they’re all trading at-the-money), you
can see that the cost of time for Decem-
ber is $2.00 per month, while January is
$1.50 per month ($3.00 for two months),
and April is $0.90 per month ($4.50 for
five months).
Taking the time to expiration into
account can make a big difference in
your profitability and serve to help your
peace of mind, if trading short-term
options is a stressful proposition for
you. In addition, longer-term options
provide ample opportunity to make ad-
justments with hedges and so on, should
the trade go against you.
INTEREST RATES
How do interest rates affect the price of
an option?
Since options are derivatives, they
have a “cost of carry” that is priced into
the time value of the option itself. This
cost of carry for calls is equal to the risk-
free interest rate less the dividend over
the period of time to expiration. On the
other hand, a put contract’s time value
in part assumes the dividend of the
stock less the interest rate. The reason
calls are more expensive with rising
interest rates is that long calls are paired
with short stock (that is, the writer of the
call will be assigned short stock). There-
fore, the short sale of the stock earns
interest. This interest is factored into the
time premium of the call itself. As inter-
est rates rise, calls become more expen-
sive, since the short position in the un-
derlying will accumulate that interest in
the form of cash.
S&C

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