Options 02 (Oct 09 - Dec 24)

[teachme]

By the way, I am looking at the options in the US market now. Does anyone know how many days is used in the calculation of the historical volatility for the pricing of the options in the US market? Is it 21 days or 30 days or even 50 days?

Just want to make sure the market maker is giving me a fair bid/ask price.

Thank you.

[kennynah]

you should ask your brokerage this question...there's no "standardized" way of calculating HV...so you are right that depending on what data points they use, the output will be different...

[iam802]

Now, my turn to hijack this thread.

Back to Covered Calls. Why?

Because most of us are familiar with buying stocks. So, adding an option to buying or selling stock is a small step towards using options.

The question here is when you enter into a 'long' position for a particular counter, will it rally and run up in price much higher, stay in a trading range, or worst....goes into exhaustion mode and drop back down?

With Covered Calls, we have 3 options (selling calls ITM, ATM, and OTM).

If my understanding is correct, most people will focus on selling ITM or OTM CALL options.

And this lays the foundation for the next question.

When do you have a Covered Call which is ITM and when do you use OTM?

What are the key differences?

For ease of discussion, let's assume the following:

1. CROX is selling at $8
2. ITM option is $7 call, OTM is $9 call.

[kennynah]

before going into the actual discussion ...

one other considering factor, should also be :

3. Choice of Expiration Month


ok..i wait to hear from 802 first...

[b0rderc0llie]

I've been writing OTM calls, both naked and covered, without exploring writing ITM calls. Thanks to your post, I did a simple search on the internet and found out about the characteristics of writing ITM calls.

http://www.investopedia.com/articles/op ... lWrite.asp

---
For ease of discussion, let's assume the following:
1. CROX is selling at $8
2. ITM option is $7 call, OTM is $9 call.
---

Normally, I will sell OTM $9 call. This way, I earn the premium, and I get to sell CROX at $9.

However, if I am concerned about CROX going downwards and want more downside protection, I can sell the ITM $7 call. As the web puts it, "an in-the-money covered call write provides an excellent, delta neutral, time premium collection approach - one that offers greater downside protection and, therefore, wider potential profit zone, than the traditional at- or out-of-the-money covered writes."

What I understand from it is that, we will earn less on the upside than a OTM covered call. However, there is a higher chance of profit and we only lose if CROX goes very low.

I think I will still prefer to use the OTM call write, as I love to hold the underlying asset. If I am thinking of disposing the underlying, I might use the ITM call write, or just sell it directly

[kennynah]

Let's superficially address the choice between ITM and OTM Covered Calls...

We must remember that when the option is american stye, such option are exercizeable even before its expiration date. european options can be exercised only on expiration date. most stock options are american style and several indexes options are european style.

So, if CROX is at $8 and I choose to Sell $7 strike Call, an ITM Call, I risk being early exercised; which means, at any time before option expiration date, my existing Long CROX shares can be "called away"; ie, I am "forced" to sell my shares away at $7. If this happens....the Covered Call play is over even before it can reap any benefits...

The choice of any option strategy is usually decided by the intention of the trade. Thus, we must clearly understand the purposes of Covered Calls... In my mind, these are the main few :

a) Attempt to generate consistent income from existing Long stocks (this can be achieved by Selling either ITM, OTM or even ATM Calls)
b) Provide some downside cushion in stock price (the premium from Selling Calls mitigates small losses from price adverse movement)
c) A predetermined profit exit point (usually with Short OTM Call)
d) Achieve a higher Return on Investment, when the Short Call is exercised and existing stocks are "called away" ("If called" ROI is always higher essentially due to extra premium earned)

BC : briefly specified ITM Covered Calls are "neutral delta" position...conceptually, this is quite correct.

I am hoping that we can use GREEKS to explain and decide on why Covered Calls strike should be ITM, ATM or OTM ? and whether to use nearer or further dated options?

[iam802]

We must remember that if the option is american stye, such option are exercizeable even before its expiration date. european options are exercised only on expiration date. most stock options are american style and several indexes options are european style.

So, if CROX is at $8 and I choose to Sell $7 strike Call, I risk being exercised; which means, at any time before option expiration date, my existing Long CROX shares can be "called away"; ie, I am "forced" to sell my shares away at $7. If this happens....the play is over...
....

Just to add on.

The risk exists that the buyer may exercised early. However, this is unlikely to happen on a frequent basis.

Why?

Buyer buys time. Seller sells time (on top of other things).

I can't say when, as a seller, I will be assigned. However, it is fair to say that a smart option trader (or buyer) will not want to exercised this right early.

Back to Greeks. I am all ears.

[kennynah]

eh brudder....i am all ears .... waiting for your GREEKS discussion leh....

you wait for me...i wait for you.... sun rise liao loh....

[kennynah]

I can't say when, as a seller, I will be assigned. However, it is fair to say that a smart option trader (or buyer) will not want to exercised this right early.

i agree...in most ordinary circumstances, buyers wont exercise early....not unless :

a) anticipating FOMC to announce an abnormal rate cut...
b) company suddenly declares extra-ordinary dividend pay out...
c) buyer has some other motivation to switch Call for stocks (can be any reason; eg...his mother ask him to do so...)

so basically, whenever one is Short ITM option, one is at the mercy of the heavens... it is called an "OBLIGATION" becos when the buyer wants it...you cannot dont give it...if it is sex...i dont mind..but it will mess up a portfolio...so, I wont usually Short ITM american options...

[b0rderc0llie]

So, if CROX is at $8 and I choose to Sell $7 strike Call, an ITM Call, I risk being early exercised; which means, at any time before option expiration date, my existing Long CROX shares can be "called away"; ie, I am "forced" to sell my shares away at $7. If this happens....the play is over...

Next, what is the purpose of Covered Calls? Mainly these few :

a) Attempt to generate consistent income from existing Long stocks (this can be achieved by Selling either ITM, OTM or even ATM Calls)
b) Slightly cushion any downswing in stock price (the premium from Selling Calls mitigates small losses from price adverse movement)
c) A predetermined profit exit point (usually with Short OTM Call)
d) Achieve a higher Return on Investment, when the Short Call is exercised and existing stocks are "called away" ("If called" ROI is always higher essentially due to extra premium earned)

BC : briefly specified ITM Covered Calls are "neutral delta" position...conceptually, this is quite correct.

I am hoping that we can use GREEKS to explain and decide on why Covered Calls strike should be ITM, ATM or OTM ? and whether to use nearer or further dated options?

I remember reading somewhere that it does not make sense to exercise an American style option before expiry, because there is still time premium in its price. One usually just close the option position (for a profit) instead of exercising it. May I know if there is an instance which you would exercise an american style option before expiry?

Ok, lets play with the greeks then. A stock position has a delta of 1. The delta of ATM call options is 0.5, which is like half a stock. The more we move ITM, the higher the delta, until it becomes 1. The more we move OTM, the lower the delta, until it becomes 0. Since we are selling a call, the delta becomes negative.

Suppose I sell a ATM call option, my position delta will be 1-0.5 = 0.5. If I sell a ITM call, I have a lower delta between 0 to 0.5. If I sell a OTM call, I have a higher delta between 0.5 to 1. So, depending on how much delta I want, I can decide whether to sell a ATM, OTM or ITM call.

For theta, the ATM call has the most time premium and the more we go ITM or OTM, the less time premium we get. Selling nearer dated calls gives us higher theta, and selling further dated ones gives us lower theta.