Stocks have been trading in penny increments for more than six years and options are following suit. This shift is now providing new opportunities for option traders.
The Penny Trading Pilot program started in January 2007 with all option exchanges supporting penny-priced increments on the options of 10 stocks and three exchange-traded futures (ETFs). Penny pricing existed before this but mainly via price-improvement systems, not at the exchange market level, and this is a significant advancement.
Penny-priced options, rather than options priced by nickels and dimes, provide new trading opportunities; help to increase liquidity, and benefit both the option buyer and seller with tighter bid/ask spreads. Penny pricing also will create opportunities and allow for more efficient rollout trades.
A rollout in an option-selling strategy is simply buying back a previously sold option and selling it again, but with an expiration date further out in time. Because more time premium is being sold, a credit for the transaction is normally received. As shown in “Rolling for premium” (below), a rollout can be done to the same or lower strike for a credit.
Though a seemingly simple concept, it works well in real market conditions when used in the right trading vehicle with appropriate characteristics. Desired characteristics for rollouts are:
1. Liquidity and tight bid/ask spreads
2. Strikes in increments of one
3. Penny-priced options
To demonstrate, we will discuss an actual trade that involves selling naked options that are about 10% out-of-the-money (for safety’s sake) and using the rollout strategy for damage control.
If the trade starts going in the wrong direction and the safety factor is reduced from 10% to 5% or less, a rollout to the next month is performed. When done, a credit is normally received for the trade and the safety factor can be returned to approximately 10%.
In a market that is in a controlled decline, say 6% a month, the rollout can be performed month after month. In such a scenario, when the market stops its decline, the naked position would expire worthless and the trade finally would become a winner.
For sharp market declines, this strategy may not work and the position might have to be closed. It’s important to remember that rollouts of only a single month are preferred. The goal is to collect premium every month and limit the risk exposure to one month.
THE USUAL SUSPECTS
We will explore this strategy looking at McDonalds stock, a semiconductor exchange traded fund (ETF) and the QQQQs:
Stock or ETFPrice Avg.
(Symbol)on 4/5/07BetaVol.
McDonalds
(MCD)45.781.46,000,000
Semiconductor
ETF (SMH)34.242.213,000,000
Nasdaq 100
ETF (QQQQ)44.561.5134,000,000
The vehicle’s beta is a measure of a stock’s price volatility in relation to the rest of the market. This is shown because it is related to the option’s price. High beta implies high option premium.
In eliminating candidates, we first need to accept that options on stocks that have strikes in increments of 2.5 or 5 are not great for rollouts. “Too much spread” (below) shows how a credit rollout for MCD is not possible (buy it back for a nickel and sell it for a nickel). MCD also has much less volume than the ETFs.
With strikes in increments of 2.5, the options on SMH also leave little room for a credit rollout and, perhaps more damaging, are clearly less liquid than the QQQQ. Here, the option must be bought back at 11¢ and sold at 9¢ for a debit. In an attempt to get a better price, a limit order can be used. For example, buy it back for 10¢ and if that gets filled, try to sell it for 11¢. However, in a fast moving market, waiting for limit orders to be executed may not work and the market can run away from you. By contrast, the QQQQ options have all of the characteristics required for selling naked puts and making the rollout strategy profitable:
1. The QQQQ is normally the most active ETF or stock on the New York and Nasdaq exchanges. The bid/ask spreads are tight.
2. Strikes are in increments of one.
3. The options are priced in penny increments.
ROLLING THE QQQQs
With all the right attributes, the QQQQ provides an excellent example of selling naked options using this technique. With the QQQQ trading at 45.40 on March 20, 2007, the bid/ask for the 40-strike put option was 0.02/0.03. This bid/ask would translate into 0.00/0.05 using nickel increments.
The March 40 puts are 11.9% out-of-the-money (meeting our safety factor criteria) and were sold for 2¢.
Selling puts on this ETF has an advantage versus selling an individual stock option. First, ETFs are safer than individual stocks. Also, the QQQQ strikes are in increments of 1.0 versus increments of 5.0 or 2.5 for strikes on stock options. This permits the QQQQ to be rolled out to a safer strike price when the market moves against you and approaches the strike price of the sold put.
Indeed, this example trade did go in the wrong direction, with the 400-point drop in the Dow on Feb. 26 and the subsequent correction. The rule of thumb that we’re working with here is that if the safety factor is reduced to about 5% or less, then roll to the next month. The goal is to increase the safety and receive a credit for the roll-out trade.
The rollout must be performed before the underlying is below the strike price (safety factor goes negative). With the QQQQ at 42.8 on March 2, “Safety net” (below) shows how the QQQQ put can be rolled-out to the next month for a credit.
The March 40 puts are repurchased for 13¢, and the April 38 puts are sold for 17¢. After the rollout, the safety factor was increased to about 7% again and a credit of 4¢ was received. More time premium is being sold in hope that the QQQQ will be above $38 at the April expiration. If the QQQQ continues to decline, say from $42 to $40, after a few weeks, another rollout (to May) can be performed.
This rollout can continue to work as long as there is not a sharp decline in the QQQQ. At the time this article was written, with April expiration approaching and the QQQQ above $44, the trade looked like a winner.
Trading options with a bid/ask spread of a nickel or more is often not worth it just because of the breakeven risk. Both buyers and sellers benefit from tight bid/ask spreads. Probably, the marker maker who makes a profit from the bid/ask spread isn’t too happy, but the increased trade volume from the more active retail participants should make up the difference.
Tony Elenbaas and David Tsou are software engineers and independent option traders. E-mail them at elenbaas@verizon.net and d_tsou@hotmail.com.
