Issue No. 6 – December 27, 2004
James A. Andrews
Since the site is deeply involved in options, it’s a good idea to look into their makeup more carefully for the benefit of those who may not have traded options. Requirements for a stock to have options traded for it are determined by the exchanges. Not all stocks are approved for options. There are only about 2,300 that are optionable out of a total of more than 12,000 stocks. As you may already know, options are contracts that assign their owner the right, but not the obligation, to exchange an underlying stock at a fixed price, called a strike price, on or before the contract expires.
Option names consist of a symbol for the underlying stock, the expiration month, a strike price and whether it is a put or call option. For example, ADQ GH JUL 40.00 CALL is a call option for the underlying stock symbol ADSK. ADQ refers to the stock symbol, G refers to the month and GN distinguishes the call option from SH for the put option, named ADQ SH JUL 40.00 PUT, that has the same strike price and expiration month. Months 1 through 12 are lettered A through L and then again from M through X. Conventions vary a bit on how to separate the first two elements of the name. In the examples, ADQ GH and ADQ SH, a space is used, as is the case with the Etrade.com Market Trader software application and CBEO.com. Others, Yahoo.com, BigCharts.com and Etrade, at times, do not separate them at all (using ADQGH and ADQSH), with the understanding that the last two letters distinguish puts from calls for any underlying stock represented by the preceding letters. In either case, the letters preceding the month are used to uniquely identify an option and distinguish it from all others.
One component of option pricing is its time value. The greater the amount of time prior to the expiration date, the more time value an option has. After the expiration date, the value of an option falls to zero. As a rule, options expire on the third Saturday of the month in which they expire. Practically speaking, the last day to trade an option is before the markets close on the preceding Friday afternoon. Option values decay toward zero at an accelerating rate during the last four weeks prior to expiration. It is strategically wise to take this factor into account when trading options by exiting any options trade a month or two before expiration.
The current price at which a given option is traded is known as the premium. The premium has three major components. The volatility value is proportional to the volatility of the underlying stock. The time value is proportional to the amount of time to expiration. The intrinsic value is described below.
There are two basic types of options. A call option gives its owner the right to buy the underlying stock at the strike price. Call options are bought when the price of the underlying stock is expected to increase. Call option premiums increase in value as the stock price increases. A put option gives its owner the right to sell the underlying stock at the strike price. Put options are bought when the price of the underlying stock is expected to decrease. Put option premiums increase in value as the underlying stock price falls. The strike price for a given option remains fixed, no matter how much the underlying stock price changes and this gives options their value. When the underlying stock price rises above the strike price, a call option is said to be in the money and a put option having the same strike price is out of the money. Reversing the situation, when the underlying stock price falls below the strike price, a call option is out of the money and a put option having the same strike price would be in the money. When an option is in the money, it has an intrinsic value equal to the difference between the strike price and the underlying stock price. When an option is out of the money, its intrinsic value is zero.
For practical purposes, the previous paragraphs may be all that’s needed to trade options after studying the relationship between changing quotes for option premiums and underlying stock prices for a while. So unless you are concerned that the option you are interested in may not be priced at its fair value, here are a number of things you probably never wanted to know about option pricing. The term "fair value" (also "theoretical value") means that, statistically, the stated option price favors neither the buyer nor the seller. In 1973, Black and Scholes published what has come to be known as the Black-Scholes formula. It’s purpose is to determine the “fair value” of an option. The 1997 Nobel Prize in Economics was awarded to Robert C. Merton and Myron S. Scholes for their work, along with Fischer Black, in developing the Fischer-Black options pricing model. Black, who died in 1995, would undoubtedly have shared in the prize had he still been alive.
Here's the theory behind the formula. When a call option on a stock expires, its value is either zero (if the stock price is less than the exercise price) or the difference between the stock price and the exercise price of the option. For example, say you buy a call option on XYZ stock with an exercise price of $100. If at the option's expiration date the price of XYZ stock is less than $100, the option is worthless. If, however, the stock price is greater than $100 - say $120, then the call option is worth $20. The higher the stock price, the more the option is worth. The difference between the stock price and the exercise price is the "payoff" to the call option.
The Black-Scholes Formula was derived by observing that an investor can
precisely replicate the payoff to a call option by buying the underlying stock
and financing part of the stock purchase by borrowing. To understand this,
consider our example of XYZ stock. Suppose that instead of owning the call
option, you purchased a share of XYZ stock itself and borrowed the $100
exercise price. At the option's expiration date, you sell the stock for $120,
you pay back the $100 loan, and you are left with the $20 difference less the
interest on the loan. Note that at any price above the $100 exercise price,
this equivalence exists between the payoff from the call option and the payoff
from the so-called "replicating portfolio."
But what about before the call option expires? Believe it or not, you can still match its future payoff by creating a replicating portfolio. However, to do so you must buy a fraction of a share of the stock and borrow a fraction of the exercise price. How do you know what these fractions are? That is what the Black-Scholes Formula tells you.
It states that the price of the call option, C, is equal to a fraction of the stock's current price, S, minus a fraction of the exercise price. The fractions depend on five factors, four of which are directly observable. They are: the price of the stock, the exercise price of the option, the risk-free interest rate (the annualized, continuously compounded rate on a safe asset with the same maturity as the option), and the time to maturity of the option. The only unobservable is the volatility of the underlying stock price. But volatility can be implied based on the past behavior of the underlying stock.
If the current stock price is way above the exercise price, these
fractions are close to 1, and therefore the call option’s value is
approximately the difference between the stock's current price and the present
discounted value of the exercise price. If, on the other hand, the current
stock price is way below the exercise price, these fractions are close to zero,
making the value of the call option very low.
There are many forms of the formula that I will not repeat here. I know of at least one subscriber who might be interested to know that the formula is given in several computer programming languages at the web site, http://home.online.no/~espehaug/SayBlackScholes.html.
But for those of us who may not be software engineers, an online calculator is provided at http://www.numa.com/derivs/ref/calculat/option/calc-opa.htm. A listing of fair values for an entire options chain is provided by at Etrade at https://us.etrade.com/e/t/home . To see it, type the stock symbol in the “Quotes” box at the top of the screen and press “Go”. Then click on the tab that says options chains. Open the pull down menu that is preloaded with “Calls and Puts” and use the scroll bar to scroll down to “Analytics”. In the “Month” scroll bar, scroll down to the month of interest (July in this case) and press “Go” over at the extreme right. The “Theoretical” column is the Black-Scholes “fair value” for each option, as seen in the table below for ADSK July 2005 expiration.
Symbol Strike
Price Last Bid Ask Theoretical Delta Gamma Theta Vega Rho
Calls
ADQGF 30.0 9.10 9.00 9.20 8.41 0.881 0.024 -2.003 5.558 13.712 in the money
ADQGZ 32.5 7.20 7.20 7.60 6.48 0.793 0.035 -2.620 7.994 12.945
ADQGG 35.0 5.70 5.50 5.80 4.84 0.684 0.043 -3.085 9.947 11.592
ADQGU 37.5 4.40 4.20 4.50 3.50 0.566 0.048 -3.301 11.009 9.866
ADQGH 40.0 3.30 3.10 3.40 2.47 0.450 0.048 -3.246 11.074 8.011
ADQGV 42.5 2.35 2.20 2.60 1.69 0.344 0.045 -2.971 10.295 6.234
ADQGI 45.0 1.70 1.60 1.80 1.13 0.254 0.039 -2.558 8.966 4.671
Puts
ADQSF 30.0 1.10 1.10 1.30 0.53 -0.119 0.024 -1.367 5.558 -2.774
ADQSZ 32.5 1.80 1.75 1.90 1.07 -0.207 0.035 -1.930 7.994 -4.915
ADQSG 35.0 2.65 2.65 2.90 1.90 -0.316 0.043 -2.343 9.947 -7.642
ADQSU 37.5 3.60 3.60 4.00 3.04 -0.434 0.048 -2.505 11.009 -10.742
ADQSH 40.0 4.90 5.00 5.40 4.47 -0.550 0.048 -2.397 11.074 -13.972 in the money
ADQSV 42.5 6.50 6.70 7.00 6.16 -0.656 0.045 -2.069 10.295 -17.123
ADQSI 45.0 8.20 8.50 8.80 8.08 -0.746 0.039 -1.604 8.966 -20.059
Calls are in the top half of the table and puts are in the bottom half. ADSK closed on 12/23 at $37.52. Boxes are drawn around groups of options that are in the money. Notice how for each option, the last premium price paid, and indeed the bid amount, exceeds the theoretical or “fair” value by a substantial amount. Looks like both bulls and bears are optimistic. ADSK has been in a strong trend and is now falling out of an over bought condition, according to the Williams %R.
The Greek parameters in the table are a collection of statistical values (expressed as percentages) that give the investor a better overall view of how an option and it’s underlying stock have been performing. These statistical values can be helpful in deciding what options strategies are best to use. One should remember that statistics show trends based on past performance. It is not guaranteed that the future performance of the stock will behave according to the historical numbers. These trends can change drastically based on new stock performance.
Beta: a measure of how closely the movement of an individual stock tracks the movement of the entire stock market (typically defined by the S&P500).
Delta: is a measure of the relationship between an option price and the underlying stock price. For a call option, a Delta of .50 means a half-point rise in premium for every dollar that the stock goes up. For a put option contract, the premium rises as stock prices fall. As options near expiration, in the money contracts approach a Delta of 1. Alternatively, Delta has been defined as the probability (on a scale from zero to one) that an option will expire in the money.
Gamma: Sensitivity of Delta to unit change in the underlying. Gamma indicates an absolute change in delta. For example, a Gamma change of 0.150 indicates the delta will increase by 0.150 if the underlying price increases or decreases by 1.0. Results may not be exact due to rounding.
Lambda: A measure of leverage. The expected percent change in the value of an option for a 1 percent change in the value of the underlying product.
Rho: Sensitivity of option value to change in interest rate. Rho indicates the absolute change in option value for a one percent change in the interest rate. For example, a Rho of .060 indicates the option's theoretical value will increase by .060 if the interest rate is decreased by 1.0. Results may not be exact due to rounding.
Theta: Sensitivity of option value to change in time. Theta indicates an absolute change in the option value for a 'one unit' reduction in time to expiration. The Etrade Option Calculator assumes 'one unit' of time is 7 days. For example, a theta of -250 indicates the option's theoretical value will change by -.250 if the days to expiration is reduced by 7. Results may not be exact due to rounding. NOTE: 7 day Theta changes to 1 day Theta if the number of days to expiration is 7 or less.
Vega (kappa, omega, tau): Sensitivity of option value to change in volatility. Vega indicates an absolute change in option value for a one percent change in volatility. For example, a Vega of .090 indicates an absolute change in the option's theoretical value will increase by .090 if the volatility percentage is increased by 1.0 or decreased by .090 if the volatility percentage is decreased by 1.0. Results may not be exact due to rounding.
OK, maybe this is getting a little long. Let’s file it in the archive for future reference. Next week’s discussion will be on determining the trading time frame for a given option and adjusting technical indicators accordingly.
This is a nervous period for contrarians who typically look in the opposite direction from where the crowd is headed. My limited understanding of contrarianism is that advisor survey responses are based on what advisors have already done with their money. When advisors are bullish, optimistic or complacent it means they are already invested on the long side and there is little money left to buy stocks. So stocks can not go much higher. If they are bearish, pessimistic or fearful it means they have most likely taken short positions or are out of the market entirely. This implies that there is a lot of cash on the sidelines or poised for buy to cover trades. Stocks are thereby ready to rise.
Based on http://www.vtoreport.com/sentiment/vixvxn.htm volatility indices VIX and VXN, the markets have reached an extreme of optimism not seen in over 9 years. The VIX is sometimes called the investor’s “fear gauge”. When the VIX is high, above 50 or so, it usually corresponds to a high level of fear near the bottoming of the markets and it’s time to buy stocks. When the VIX is low, below 20 or so, it corresponds to a high level of complacency and a time to be careful. It is not a time to put on new long trades. The VIX is now at 11.23.
For the NASDAQ, when VXN reaches 80 or higher that is likely to mark an important market bottom. When it drops below about 30, it is not a time to put on new long trades. The VXN is now at 16.80.
The Investor's Intelligence survey of Bullish investment advisors is at its highest level since 1987 and that peak was hit just before the crash of 1987. This is yet another indicator of complacency. As Jason Goepfert of SentimenTrader.com said last week, "We are subject to a reversal at any time, and the risk/reward is not in favor of establishing new long positions." The ratio of bullish advisors to bearish advisors is currently 62.1% to 21.1%. That’s about three to one. When fear is low and complacency is high, as it is now, it’s time to be careful about putting on long trades.
According to http://www.vtoreport.com/index.html the 5 week RSI for the three major indices is either overbought or very overbought. The CBOE put/call ratio is an excellent short term (days) sentiment indicator with a level near or above 1.0, indicating a high degree of fear in the market and a level near 0.5 indicating a high degree of bullishness/complacency in the market. The put/call ratio is now at 0.57.
Market Summary
Week ending 12/25/04:
Indices for the Week:
Dow Jones +1.5%
NASDAQ 100 +0.7%
S&P500 Index +1.1%
Russel 2000 +1.1%
Industry Leaders:
Tires
Mining
Steel
Tobacco
Toys
Heavy Machinery
Industrial Equipment
Home Construction
Lodging
Healthcare Providers
Trucking
Consumer Electronics
Pipelines
Computers
Real Estate
Recreational Products & Services
Medical Supplies
Casinos
Footwear
Railroads
Automobile Manufacturers
Oil Companies, Major
Gold for past Month:
USD -1.65%
CAD +3.10%
CHF -2.05%
GBP -3.81%
EUR -3.79%
JPY -0.98%
The industry leaders list above contains the top 10 industries for four periods consisting of 1 week, 1 month, 2 months and 3 months. Results are ranked highest to lowest based on the average percentage gain per week within any period times the number of appearances of an industry in the four top 10 lists.
The following stock screens were generated with tools from AAII. The short term trading screen used for Table 1a looks for optionable stocks whose percentage relative strength over the past 6 months is greater than 90%, EPS Growth over the past 12 months is greater than 80% and are within 5% of their 52 week high and a minimum price of $50.
Table 1a
Short Term Options Screen as of 12/25/04
|
Symbol |
Company |
Sector |
Industry |
Option |
|
ADSK |
Autodesk, Inc. |
Technology |
Software & Programming |
ADQ GN JUL 70.00 CALL |
|
CLF |
Cleveland-Cliffs Inc. |
Basic Materials |
Metal Mining |
CLF GS JUL 95.00 CALL |
|
MON |
Monsanto Company |
Basic Materials |
Chemical Manufacturing |
MON GJ JUL 50.00 CALL |
|
NUE |
Nucor Corporation |
Basic Materials |
Iron & Steel |
NUE GJ JUL 50.00 CALL |
|
POT |
Potash Corp./Saskatchewan (USA) |
Basic Materials |
Non-Metallic Mining |
POT FP JUN 80.00 CALL |
|
TXI |
Texas Industries, Inc. |
Capital Goods |
Construction - Raw Materials |
TXI GL JUL 60.00 CALL |
|
TXU |
TXU Corporation |
Utilities |
Electric Utilities |
TXU GL JUL 60.00 CALL |
|
X |
United States Steel Corp. |
Basic Materials |
Iron & Steel |
X GJ JUL 50.00 CALL |
|
AET |
Aetna Inc. |
Financial |
Insurance (Accident & Health) |
AET GX JUL 135.00 CALL |
|
MGG |
MGM MIRAGE |
Services |
Casinos & Gaming |
MGG FN JUN 70.00 CALL |
The stock screen in Table 1b was added for the potential to write covered call options. The only difference between screens for Tables 1a and 1b are that in 1b the maximum stock price is $20.
Table 1b
Short Term Covered Call Writing Screen as of 12/25/04
|
Symbol |
Company |
Sector |
Industry |
Option |
|
AKS |
AK Steel Holding Corporation |
Basic Materials |
Iron & Steel |
AKS AC JAN 15.00 CALL |
|
MXT |
Metris Companies Inc. |
Financial |
Consumer Financial Services |
MXT AC JAN 15.00 CALL |
|
OS |
Oregon Steel Mills, Inc. |
Basic Materials |
Iron & Steel |
OS AD JAN 20.00 CALL |
|
PNK |
Pinnacle Entertainment |
Services |
Casinos & Gaming |
PNK AD JAN 20.00 CALL |
|
SID |
Companhia Siderurgica Nacional (ADR) |
Basic Materials |
Iron & Steel |
SID AD JAN 20.00 CALL |
|
VIRL |
Virage Logic Corporation |
Technology |
Semiconductors |
UVB AD JAN 20.00 CALL |
|
EPAY |
Bottomline Technologies |
Technology |
Computer Services |
EEU AC JAN 15.00 CALL |
|
TIBX |
Tibco Software Inc. |
Technology |
Software & Programming |
PAV BV FEB 12.50 CALL |
Repeating the Growth Momentum and Peter Lynch screens, PVTB and CTEL dropped out and some new ones were added. The number of selections was reduced by eliminating stocks having P/E’s greater than 30.
Table 1c
Growth Momentum (Intermediate Term) Screen as of 12/25/04
|
Symbol |
Company |
Sector |
Industry |
|
ELBO |
Electronics Boutique Holdings Corp. |
Services |
Retail (Technology) |
|
FBP |
First BanCorp. |
Financial |
Regional Banks |
|
MOH |
Molina Healthcare, Inc. |
Financial |
Insurance (Accident & Health) |
|
MSA |
Mine Safety Appliances |
Health Care |
Medical Equipment & Supplies |
|
MTH |
Meritage Homes Corporation |
Capital Goods |
Construction Services |
|
TS |
Tenaris S.A. (ADR) |
Capital Goods |
Construction - Supplies and Fixtures |
|
VIVO |
Meridian Bioscience, Inc. |
Health Care |
Biotechnology & Drugs |
|
WIBC |
Wilshire Bancorp, Inc. |
Financial |
Regional Banks |
|
CEDC |
Central European Distribution |
Consumer Non-Cyclical |
Beverages (Alcoholic) |
Table 1d
Peter Lynch Value (Intermediate Term) Screen as of 12/25/04
|
Symbol |
Company |
Sector |
Industry |
|
BLSC |
Bio-Logic Systems Corp. |
Health Care |
Medical Equipment & Supplies |
|
CSLMF |
Consolidated Mercantile (USA) |
Basic Materials |
Containters & Packaging |
|
KEP |
Korea Electric Power Corporation (ADR) |
Utilities |
Electric Utilities |
|
PCU |
Southern Peru Copper Corp (USA) |
Basic Materials |
Metal Mining |
|
SHI |
Sinopec Shanghai Petrochemical Co. (ADR) |
Energy |
Oil & Gas Operations |
|
TM |
Toyota Motor Corporation (ADR) |
Consumer Cyclical |
Auto & Truck Manufacturers |
|
UGP |
Ultrapar Participacoes SA (ADR) |
Energy |
Oil & Gas Operations |
|
VLCCF |
Knightsbridge Tankers Limited |
Transportation |
Water Transportation |
A screen for Warren Buffet style stock picking was added for the intermediate to long term. Two requirements were added to include only optionable stocks in order to find LEAPS opportunities. Seven out of the 11 stocks had LEAPS written for them. The other requirement was to include only those stocks having a PE of 17 or less. More information on the Buffett screen can be found at http://www.wisertrader.com/buffettscreen.html . Although some near term options are listed, they should be viewed with caution. The Buffett screen does not include momentum stocks. These are considered value stocks due to their PEG’s in the range of 1 to 1.7. They would not be expected to move quickly.
Table 1e
Warren Buffett Value (Long Term) Screen as of 12/25/04
|
Symbol |
Company |
Sector |
Industry |
Option |
|
HOV |
Hovnanian Enterprises |
Capital Goods |
Construction Services |
HOV HJ AUG 50.00 CALL |
|
DHI |
D.R. Horton Inc. |
Capital Goods |
Construction Services |
VEI AH JAN07 40.00 CALL |
|
FNF |
Fidelity National Financial |
Financial |
Insurance (Property & Casualty) |
VWJ AJ JAN07 50.00 CALL |
|
FDP |
Fresh Del Monte Produce Inc. |
Consumer Non-Cyclical |
Crops |
VKZ AF JAN07 30.00 CALL |
|
PGR |
The Progressive Corp. |
Financial |
Insurance (Property & Casualty) |
PGR ER AUG 90.00 CALL |
|
NYB |
New York Community Bancorp, Inc. |
Financial |
S&Ls/Savings Banks |
VTD AD JAN07 20.00 CALL |
|
ACS |
Affiliated Computer Services |
Technology |
Computer Services |
ACS GL JUL 60.00 CALL |
|
HRH |
Hilb, Rogal & Hobbs Company |
Financial |
Insurance (Miscellaneous) |
HRH DH APR 40.00 CALL |
|
NFB |
North Fork Bancorporation, Inc. |
Financial |
Regional Banks |
OUN AH JAN07 40.00 CALL |
|
LNCR |
Lincare Holdings Inc. |
Health Care |
Healthcare Facilities |
OUN AI JAN07 45.00 CALL |
|
MYL |
Mylan Laboratories Inc. |
Health Care |
Biotechnology & Drugs |
OKL AD JAN07 20.00 CALL |
Table 2
Stock Trades as of 12/25/04
|
Symbol |
Buy Date |
Buy Price |
Last |
Action |
P/L(%) |
|
CREE |
11/10 |
$37.10 |
$37.45 |
Sold 11/23 |
0.9% |
|
UPL |
11/12 |
$50.80 |
$52.90 |
Sold 11/23 |
4.1% |
|
BTU |
11/23 |
$78.96 |
$74.10 |
Sold 12/8 |
-6.2% |
|
MDR |
11/23 |
$16.39 |
$15.64 |
Sold 12/8 |
-4.6% |
|
SWN |
11/23 |
$52.31 |
$48.40 |
Sold 12/8 |
-7.5% |
|
ELBO |
12/20 |
$39.00 |
$40.40 |
Sold 12/23 |
3.6% |
|
FBP |
12/20 |
$61.95 |
$63.80 |
Sold 12/23< |