Options can get complicated

August 17, 2016 01:00 PM
In our feature presentation on options, we start with a conversation with Bill Brodsky, the long-time leader of the Chicago Board Options Exchange (CBOE), who is now chairman and will retire from CBOE next year.

In our feature presentation on options, we start with a conversation with Bill Brodsky (see “Listed options: A brief history,” page 16), the long-time leader of the Chicago Board Options Exchange (CBOE), who is now chairman and will retire from CBOE next year. It is important to understand the history because listed options are a relatively new tool (1973) for investors and traders.

In terms of investing, stocks and outright futures contracts are somewhat rough tools. How often have you heard a trader say, “I was right on the move, but wrong on the timing?” It happens all of the time. Options allow investors and traders to perfectly calibrate a position. Options can be used to trade an outright position — where you think the underlying will go or where you think it will not go — hedge existing positions or to trade volatility in an underlying market.

We could do nothing but write about options every issue for the next five years and still not cover all there is to be covered. The unique benefit of options is that they are multidimensional. This makes them very useful, but sometimes risky for a newbie. While, generally, options are a great way to reduce risk, if you are not well-versed in the Greeks and what they mean, they can get dangerous. We speak to options trading legend Anthony Saliba (see “New tips from an old options pro,” page 32), who has a new book out that we would recommend to anyone looking for a greater understanding of options.

As mentioned, options can be dangerous if not completely understood. One risk that can occur in rare instances is when out-of-the-money calls are exercised against you (pin risk) and in-the-money call are not. In “Zombie puts & calls” (page 28), Robb Ross explains pin risk and what traders can do to prepare for these rare occurrences.

Options are traded on both equities and futures, and while the underlying principles are the same, there are some differences. In “Futures vs. equity options,” (page 34), Carley Garner breaks down the key differences.

In “Are buy-writes the right strategy?” (page 20), Keith Black and Edward Szado highlight the benefits of six option writing strategies that CBOE has created indexes on. Wrapping up our extended options coverage, contributing editor Steven Lord profiles a manager using a covered call approach (see “An institutional approach to cover call writing” page 26).

In our cover story, we take a look at Tesla Motors (TSLA) and the disparity of opinion on its stock outlook. Tesla is an innovative auto company that has caught the imagination of market analysts and consumers. Features editor Garrett Baldwin presents many views on the high-flying stock. The funny thing about Tesla is that despite the disparity of views, generally, everyone could be correct. But it is important to remember that most investors and retail traders can’t withstand the type of volatility the stock continues to experience and maintain a position. This is something futures and options traders know due to the leverage allowed in those instruments. It is why certain options strategies have been created. It is not enough for retail traders to know that a certain stock has long-term growth potential. If a stock loses half its value — which Tesla did from late 2015 to February 2016 — on the way to doubling, tripling or even growing tenfold, it doesn’t do much good for the trader who was stopped out. Some analysts like to be able to claim they recommended a certain stock back when it was trading in single digits. But if a majority of folks listening to your advice were not able to take advantage of the recommendation because their long position was stopped out, then you really didn’t help them.

The problem with Tesla is that it isn’t a penny stock; it is an extremely high-priced stock of a company that has yet to make a profit. The success or failure of such investments has less to do with the long-term performance and more to do with the ability of investors to withstand volatility. Such information should be included in any analysis. Speaking of analysis, this month’s market focus is the auto sector. Our contributors provide an auto outlook that goes beyond Tesla. 

In June, the United Kingdom voted to leave the European Union causing a massive sell-off in stocks as well as the British pound. U.S. equity markets have since recovered and set all-time highs. In “The Brexit fate debate” (page 38), we include the reaction to the vote by a large cross section of key players.

About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange.