Seasonality and Listed Option Strategies
Listed option
strategies and seasonal strategies have two important characteristics in
common:
- Both have a starting point when the strategy is applied.
- Both have a predefined ending point when either profit taking occurs or the strategy is unwound.
Listed options are an investment tool designed either to increase or to reduce risk/potential return from an equity investment. Option strategies on equities and Exchange Traded Funds designed to reduce risk are preferred.
Gambling through the outright purchase of listed options is not recommended and is strongly discouraged. Most investors, who gamble by purchasing listed options, eventually lose most or all of their capital.
A list of Exchange Traded Funds with listed options has been posted in the report entitled, “Investing in Exchange Traded Funds (ETFs): DIAMONDS, SPDRS, Qubes, HOLDRS, VIPERs and iShares. The report is available in the Education Section of this website. Following is a link to the report:
http://dvtechtalk.com/specialreports/specialreport1.htm
Listed Options Basics
Please skip to the Option Strategy section of this report if you are knowledgeable about options.
Types of listed
options
- Stock options
- Foreign currency options
- Index options
- Futures options
- Bonds/Interest Rate options
Tech Talk primary focus is on listed equity and listed Exchange Traded Fund options.
Exercise
Characteristics
Options are either European or American style. European style options can only be exercised on the expiration date of the option. American style options can be exercised at any time up to and including the exercise date. All equity and Exchange Traded Fund options listed on North American exchanges are American style options. Currency and Index options can be American or European style options.
Last Trade Dates and
Expiration Dates
Last trade date for American style equity and index options
listed on North American exchanges is the Friday after the third Thursday in
the expiration month of the option. Expiration day is the Saturday after the
third Friday in the expiration month of the option.
Call Options
A call option gives the buyer the right to buy an asset at a predetermined (strike) price at a specified time (exercise date). The call buyer is expecting the price of the asset to appreciate prior to expiry of the call. The seller (or writer) of a call option has an obligation to sell the underlying asset at the strike price by the exercise date.
Put Options
A put option gives the buyer the right to sell an asset at a predetermined (strike) price at a specified time (exercise date). The put buyer is expecting the price of the asset to fall prior to expiry of the put. The seller (or writer) of a put option has an obligation to buy the underlying asset at the strike price prior to expiry of the put.
Long-term Equity Anticipation Securities (LEAPS)
LEAPS are long term listed put and call options. Regular listed options expire within nine months. LEAPS are listed options that expire longer than nine months. Expiration dates can be as long as three years.
Strike Prices
They are levels set by exchanges that determine the price that a listed option is exercised.
In, At and Out-of-the
Money Options
Call and put options are considered to be “At-the-money” when strike price of the asset is exactly the same as current price of the asset. For example, price of the asset and strike price of the listed option are both $50.
Call options are considered “In-the-money” when price of the asset is higher than strike price of the call. Call options are considered “Out-of-the-money” when price of the asset is lower than strike price of the call For example, a call option with a strike price of $45 is considered “In-the-money” when price of the asset is $50. Conversely, a call option with a strike price of $55 is considered “Out-of-the money” when price of the asset is $50.
Put options are considered “In-the-money” when price of the asset is lower than strike price of the put. Put options are consider “Out-of-the-money” when price of the asset is higher than strike price of the put. For example, a put option with a strike price of $55 is considered “In-the-money” when price of the asset is $50. Conversely, a put option with a strike price of $45 is considered “Out-of-the-money” when price of the asset is $50.
Premium
Premium is the price of a listed option. Premiums consist of two parts:
- Intrinsic value: value of the option that is “In-the-money”
- Time value: the difference between the premium price and the intrinsic value.
For example a three month call option with a strike price of $50 with its underlying asset priced at $52 trading at a premium of $5 has:
Part of the $5 premium that is intrinsic value of: $52-$50= $2.
Part of the $ premium that is time value of $5-$2= $3
All options have time value (with a possible rare exception just before expiry). As the expiry date of the option approaches, time value dissipates and reaches $0 by expiry.
Time values are highest when options are “At-the-Money”.
By definition, all of the premium in “Out-of-the-money” options is time value.
Implied volatility
Implied volatility of an option is calculated by examining the time value of options. Time value is based on the volatility in the price of the underlying asset. The implied volatility of options on a high tech or energy equities normally are higher than implied volatility of options on the utilities and banking equities. For example, implied volatility on high tech equities and Exchange Traded Funds frequently exceed 30% while the implied volatility on financial service equities and Exchange Traded funds frequently are closer to 15%.
The implied volatility of options on Exchange Traded Funds usually is lower than the implied volatility of most equity securities that are part of that Exchange Traded Fund.
Implied volatilities are available at www.ivolatility.com and www.888options.com for
Free education on option strategies is available at www.888options.com . Emailed inquiries on option strategies can be forwarded to options@theocc.com . Telephone inquiries on option strategies can be made on a toll free number at 1 888 OPTIONS (i.e. 1 888 678 4667). Services are offered free of charge by the Options Institute Council, a subsidiary of the Chicago Board Options Exchange (CBOE).
Option Strategies
COVERED CALL WRITES
Covered call write strategies are the optimal conservative option strategy for investor employing seasonality strategies. Investors buy the underlying equity or Exchange Traded Fund at a preferred entry points and immediately sell at or near-the-money call options against the position that expire at or near the end of the period of seasonal strength.
This strategy frequently is used by investors who are seeking higher than average income in a tax efficient way. Minimum expectation is a potential annualized return of 15% from capital gains and dividends. Opportunities with potential annualized returns in excess of 20% frequently are available.
Covered call writes are “bullish” strategies. They work best when price of the underlying equity or ETF rises above the strike price of the calls. Maximum return from a covered call write occurs when the call option is assigned and the investor is required to deliver (i.e. sell) the equity or ETF at strike price of the call. Indeed, the covered call writer’s goal is to have his/her calls assigned either before or at expiry. Cash raised from assignment of the calls can be used as funds for the next seasonal play.
Covered call writes are more conservative than straight ownership of an equity or ETF. Covered call writes offer downside protection equivalent to value of the call option premium.
Here is example
Background:
Period of seasonal strength: four months (i.e.120 days or one third of a year)
Equity or ETF price: $50 per share or unit
Price of calls with a strike price of $50 and an expiry in four months: $3.00
One quarterly dividend paid during the period of investment: $0.20 per share (Annual dividend yield: 1.6%).
Invested capital: $50,000
Transaction
Buy 1000 shares or units at $50 for a total cost of $50,000
Sell 10 calls with a $50 strike price that expire in four months at $3.00 for $3,000
Writer’s Investment
Equity Value $50,000
Plus Commission Expense 30
Less Option
Plus Commission Expense 50
Actual Cash Investment $47,080
Return If Exercised
Near Expiry
(Assumes price of equity or ETF is $50 or higher and calls are assigned by expiry)
Less Commission Expense 30
Plus Dividends 200
Net Return $50,170
Net Profit ($50,170-$47,080) $3,090
Percent Return ($3,090/$47,080) 6.6%
Annualized Percent Return 19.7%
Downside Protection (Assumes calls are not assigned)
Initial Equity Value $50,000
Less Option
Plus Commission Expenses 80
Less Dividends Received 200
Net Value $46,880
Break Even Per Share or Unit $46.88
The strategy is
particularly interesting for seasonal trades in the high tech, energy and gold
equities and ETFs because implied volatility on their
options frequently exceed 25%.
CASH SECURED PUT
WRITES
Cash secured put writes have similar risk/reward parameters similar to covered call writes. They primarily are used by investors who seek income in a tax efficient way. Most of the return comes from capital gains taxed at a lower rate than interest income. However, the strategy is slightly less attract for an investor using seasonal strategies because the investor may be required to buy the equity or Exchange Traded Fund at the end of the period of seasonal strength if not careful.
Cash secured put writes work if the investor takes a disciplined approach. The temptation is to employ the fixed income portion of the strategy in a more leveraged way. This temptation needs to be avoided.
Cash secured put writing is a bullish strategy. Maximum return is realized when price of the underlying equity or ETF exceeds the strike price of the puts at expiry.
The cash secured portion of the strategy implies that the investor has sufficient available liquid capital to purchase the equity or ETF prior to expiry of the puts. The definition of “sufficient” in this case means 100% of invested capital.
The cash secured portion is a money market instrument, Treasury Bill or money market mutual fund that can be liquidated easily if needed upon assignment of the puts. Maturity date of short term money market instruments or Treasury Bills optimally coincides closely with the expiry date of the put options.
Margin is required when completing a put write. Full margin based on the value of the underlying security is not needed but is strongly recommended.
Following is an
example:
Background:
Period of seasonal strength: four months (i.e. one third of year).
Invested capital: $50,000
Price of the underlying equity or ETF: $50
Price of four month puts with a strike price of $50: $2.70
Annualized interest rate on Treasury Bills maturing over four months: 4.00%
Transaction:
Buy $50,000 Treasury Bills
Sell 10 four month puts with a strike price of $50 for $2.70
Writer’s investment
Treasury Bills $50,000
Plus Commission 50
Less
Plus Commission 50
Actual Cash Investment $47,400
Potential Return at
Expiry
(Assumes equity or ETF is $50 or higher after four months and puts are not assigned)
Option Proceeds
When Puts Expire Valueless $2,700
Interest from Treasury Bills 666
Total Return $3, 366
Percent Return ($3,366/$47,400)7.0%
Annualized Return 21.1%
Downside Protection (Assumes assignment of puts at $50 near put expiry)
Actual Cash Investment $47,400
Less Interest on Treasury Bills 666
Less
Plus Commission 50
Plus Purchase of Equity/ ETF 50,000
Plus Commissions 30
Net Proceeds $46,814
Cost Per Share If Assigned $46.81
SELLING CALLS AGAINST
EXISTING SECURITY POSITIONS
Selling calls against existing security positions is virtually the same as a covered call write transaction. The only difference is that the investor already owns the underlying equity or Exchange Traded Fund before selling calls against the position.
Selling calls against existing security positions is a defensive (i.e. slightly bearish) strategy. Investors applying seasonality analysis use the strategy mainly on two occasions:
- When a seasonal trade has generated surprising gains during the early part of the season and price of the equity or ETF is approaching an expected price target. Frequently, the trade starts to show early technical signs of stalling (e.g. a MACD sell signal in the middle of a seasonal trade). The investor can increase chances of realizing the expected price target by selling a call option against the equity or ETF position. For example, an investor buys an equity priced at $50 with an expected target price of $57 over a four month period of seasonal strength. Price of the stock quickly advances to $55 after two months. The investor can sell a call options against the equity with a strike price of $55 and a premium price of $2. The investor will realize $55 +$2= $57 as long as price of the equity remains above $55. The strategy also provides downside protection of $2. The covered write portion of the transaction remains profitable as long as price of the equity remains above $53.
- When a seasonal trade is over, but the investor is unwilling to sell the equity or ETF at the present time. Possible reasons include timing for realization of taxable capital gains and timing of the next period of seasonal strength. In the former instance, investors with profitable seasonal trades expiring in December and January may be reluctant to realize taxable capital gains prior to the next tax year. Selling at or in-the-money calls that expire in January, February or March could defer realization of the capital gain to the following year while also providing at least some downside protection. In the later instance, seasonal trades with more than one period of seasonal strength can be combined by selling calls against security positions during the in-between period. For example, the Canadian Financial Service sector has a period of seasonal strength from the end of September to the end of December and from the end of February to the end of May. In late December investors may consider selling at or slightly out-of –money February calls against existing financial service security positions. If price of the equity is unchanged, the investor realizes an extra return on investment during the next two month period. Of greater importance, if price of the equity declines slightly, the investor has at least partially downside protection.
Following is an example (The example is almost identical to the covered write. The only difference is that the equity or ETF already is owned and therefore a commission cost for purchase of the equity or ETF is not included):
Background:
Period of seasonal strength: four months (i.e. 120 days or one third of a year)
Equity or ETF price: $50 per share or unit
Price of calls with a strike price of $50 and an expiry in four months: $3.00
Quarterly dividend paid during the period of investment: $0.20 per share
Invested capital: $50,000
Transaction
Own 1000 shares or units at $50 for a current value of $50,000
Sell 10 calls with a $50 strike price that expire in four months at $3.00 for $3,000
Writer’s Investment
Equity Value $50,000
Less Option
Plus Commission Expense 50
Actual Cash Investment $47,050
Return If Called Near
Expiry
(Assumes price of the equity or ETF is at $50 or higher at options expiry)
Less Commission Expense 30
Plus Dividends 200
Net Return $50,170
Net Profit ($50,170-$47,050) $3,120
Percent Return ($3120/$47,050) 6.6%
Annualized Percent Return 19.8%
Downside Protection
(Assumes calls are not assigned)
Equity Value $50,000
Less Option
Plus Commissions 80
Less Dividends Received 200
Net Value $46,880
Break Even Per Share or Unit $46.88
SYNTHETIC STOCK
POSITIONS
Synthetic stock positions are an attractive alternative to owning an equity or Exchange Traded Fund for a seasonal trade. Instead of buying the equity or ETF, the investor uses the capital to:
- Purchase a short term money market instrument (e.g. Treasury Bills, Money market funds, short term notes and bonds)
- Buy at or near-the money calls on the chosen equity or ETF. The calls expire when a period of seasonal strength is expected to end.
- Sell at or near-the-money puts on the chosen equity or ETF. The puts expire when the period of seasonal strength is expected to end. The money market instrument acts as the margin required for the put write.
Main advantages of
the trade are:
· Higher yield on capital portion of the transaction. Annualized yields on money market instruments (say 4-5%) usually significantly exceed the annual dividend yields on most equities (say 0%-2%).
· The fixed income portion remains constant over time as long as the put option portion of the transaction is not assigned.
Main disadvantages of
the trade are:
- Dividend income is not received. Dividends income received from Canadian based companies by Canadian investors are given a favourable tax treatment.
- Listed options have a definite expiry date. Expiry dates may or may not occur at an optimal date.
- The put portion of the transaction could be assigned earlier than expiry of the puts if the puts go “deep in-the-money”, triggering additional transaction costs.
Let’s look at an
example:
Background:
Period of seasonal strength: four months (i.e. 120 days or one third of a year)
Equity or ETF price: $50 per share or unit
Invested capital $50,000
Annualized yield on treasury bills: 4.00%
Price of calls with a strike price of $50 and an expiry in four months: $3.00
Price of puts with a strike price of $50 and an expiry in four months: $2.70
Quarterly dividend paid during the period of investment: $0.20
Equity or ETF Buyer’s
Investment
Buy 1000 Shares at $50 $50,000
Plus Commissions 30
Initial Investment $50,030
Synthetic Equity or
ETF Buyer’s Investment
Buy 10 Calls with a strike price of $50 expiring in four months: $3,000
Plus:Commission Cost 50
Less: Sell 10 Puts with a strike price of $50 expiring in four months: 2,700
Plus:Commission Cost 50
Net cost of options transactions: $ 400
Treasury Bill purchase 49,550
Commission on Treasury Bill 50
Initial Investment $50,000
If price of the
equity or ETF rises to $55 in four months and positions are sold:
Stock Holding
Value of the Equity or ETF $55,000
Less Commission Costs 30
Plus Dividends 200
Less Initial Investment 50,030
Profit $5,140
Profit per Share or Unit $5.14
Synthetic Stock Holding
In-the-money value of calls $5,000
Less Commission Costs 50
In-the-money Value of Puts 0
Plus Treasury Bill Investment 49,550
Plus Interest from Treasury Bills 666
Less Initial Investment 50,000
Profit $5,166
Profit per Share or Unit $5.17
If price of the
equity or ETF falls to $45 in four months times and is sold:
Stock Holding
Value of the Equity or ETF $45,000
Less Commission Costs 30
Plus Dividends 200
Less Initial Investment 50,030
Loss $ 4,860
Loss per Share or Unit $4.86
Synthetic Stock Holding
In-the-money Value of Calls 0
In-the-money Value of Puts -5,000
Less Commission Costs 50
Plus Treasury Bill Investment 49,550
Plus Interest from Treasury Bills 666
Less Initial Investment 50,000
Loss $4,834
Loss per Share or Unit $4.83
CAPITAL PROTECTED
NOTE STRATEGY
Capital protected
notes are a widely used investment product extensively marketed by major
Canadian and
An interesting alternative is available for disciplined investors who like the capital protected feature of an investment and enjoy using seasonality analysis when making investment decisions. The strategy is remarkably simple:
Transaction:
- Buy a one year Treasury Note at a discount
- Use the book value of the Treasury Note to purchase at-the-money calls in your favorite seasonal play.
Background:
Invested capital: $100,000
Price of a one year Treasury Bill yielding 4.00%: $96
Transaction:
Buy the Treasury Bill at a cost of $96,000
Use the remaining $4,000 to purchase at-the-money calls
Worst case scenario:
Seasonal picks that year did not work. The calls expire valueless during the year. After one year, invested capital remains at $100, 000. Tax payable on the $4,000 of interest income is partially offset by capital losses from the calls.
Best case scenario:
Seasonal picks that year did work. The investor successfully rolled through two or three trades where value of the calls increased each time. Profit from the call trades are open ended (i.e. not capped). Profits from the calls are added to originally invested capital of $100, 000 at the end of the year.
The strategy works
best when implied volatility of call options is low. The base case for
measuring implied volatility of
Chart courtesy of
StockCharts.com
www.stockcharts.com
The Montreal Exchange offers a similar volatility index for call options on the TSX 60 Index. It is available at www.m-x.ca .
AN ALTERNATIVE TO
SHORTING AN EQUITY OR ETF
Generally, Tech Talk
does not support shorting strategies. Reasons include:
- Lack of readily available negative news that can be anticipated. Corporation spokespersons tend to focus on prospects for positive news rather than negative news. Negative news occasionally comes from independent sources (e.g. a fundamental analyst who spot checks distribution channels), but these sources are rare and they frequently do not provide follow up.
- Lack of available seasonal opportunities. Seasonality studies support the long side of trades for good reason: Most stocks and sectors have a period of seasonal strength when they record a higher than average frequency of profitability and a higher than average return. A frequency of profitability of 70% or more is required for a recommended trade based on positive seasonality. Conversely, fewer equities and ETFs have a period of negative seasonality when they record a lower than average frequency of profitability and below average (i.e.negative) returns. Occasionally, stocks and sectors with a period of negative seasonality are identified, but they tend to be rare. In most cases, the performance of stocks and sectors outside of the period of seasonal strength is random. Frequency of profitability outside of the period of seasonal strength usually is in the 40%-60% range. Returns, by definition, are below the period of seasonal strength.
- The “messiness” of initiating and maintaining a short position including:
1. Gaining approval from your broker before starting a shorting program. By definition, the trade must be processed through a margin account.
2. The time to place the trade. A legal short position must be declared and processed outside of regular order flow (i.e. the market makers can see you coming) and the security being shorted must be borrowed before the transaction is completed. Both take time before the order is processed.
3. Costs of maintaining the positions. Investors must pay a “borrowing fee” when they borrow an equity or ETF to be sold. In addition they must repay dividends.
4. The risk of being called to replace the borrowed security at an inopportune time. Most securities are “segregated” and are unavailable for lending. Investment dealers can only lend non-segregated securities (i.e. “active” securities in margin accounts) to investors who short. Accordingly, the availability of securities for shorting is small relative to the total number of securities outstanding. Occasionally, the lending post runs out of available inventory and requires an investor with a short position to replace the position. The investor holding the short position is required to repurchase the security immediately. In most cases when dealing with big cap securities, the risk of an early call is small.
5. The potential risk of being required to provide additional margin to maintain the position.
6. Big brother is watching you! Short positions are monitored closely by Compliance Departments.
Despite Tech Talk’s cautious approach toward shorting equities and ETFs, the strategy has merit under certain circumstances. Equity and ETF prices do go down as well as up. Don’t be dissuaded from using the strategy if it fits your investment profile.
Synthetic short positions are an alternative to shorting when the underlying security has listed options. They essential are the reverse of a synthetic stock position. Here is how the strategy works:
- Basic assumptions: the investor has 100% of the capital needed to short a stock or ETF (i.e. the investor is able to commit to the value of the investment when the transaction is initiated). In addition, the investor has completed documentation with their broker that allows trading in listed options.
- Process: The investor holds money market instruments (e.g. a treasury bills) valued at the amount of capital needed to place the short position. He subsequently buys at or near-the-money puts and sells at or near-the-money calls based on the amount of capital applied to the short position. The money market instrument acts as margin for the calls. Revenues from the calls approximately offset cost of the puts.
- Result: Value of the combined money market instrument/listed options position will inversely track price of the underlying security. Profits rise as price of the underlying security falls.
- Simple example: Price of the stock is at $50. Invested capital is $100,000. An investor expects the stock to fall to $42 in six months. Instead of shorting the stock, the investor holds a treasury bill valued at $100,000 expiring in six months, sells 20 six month call with a strike price at $50 at $3.50 and buys 20 six month puts with a strike price of $50 at $3.25. If price of the stock is unchanged after six months, the options will expire valueless. The investor will own a treasury bill worth $100,000. If price of the underlying stock declines to $42, the synthetic short position will record a profit of $8 per share ($16,000 on 20 contracts). If price of the underlying stock rises to $55, the synthetic short position will record a loss of $5 per share ($10,000 on 20 contracts).
Advantages of a synthetic short position over a short position are as
follows:
· The time to initiate the trade is not an issue. Shares are not borrowed. The trade is not designated as a short and therefore is processed as a regular trade.
· Cost for maintaining the trade is 0. No borrowing fee is applied. Dividends are not repaid.
· The risk of an early call on the stock does not exist.
· No additional margin is required during the period of investment.
· It fits nicely for investors who have a predefined period of investment (e.g. a period of seasonal weakness). The strategy automatically ends on a predetermined date when the options expire.
Disadvantages of the synthetic short position are as follows:
·
Investors must understand the strategy before
they apply it. Although the strategy has almost identical risk/reward
characteristics of a short position, many investors are reluctant to consider a
synthetic short due to a phobia called “fear of listed options”. They associate
listed options as speculative securities. Some investment advisors, who are not
“options licensed” or who are not currently up-to-speed on option strategies
may feed on these fears in order to dissuade investors from trying the
strategy. The strategy is suitable for sophisticated investors who are willing
to learn how the strategy works.
·
The investor holding a synthetic short position
must have a well defined period of investment with a beginning and an end. The
end occurs when the options expire. If the investor is not reasonably sure how
long the position will be held, don’t enter into a synthetic short position.
·
The call sale side of the transaction could be a
problem if the underlying stock price rises significantly. Under this
circumstance, the calls will become deep “in-the-money” and time value on the
calls will decline. If their time value is at or near 0, the calls could be
assigned prior to expiry and the investor will be required to purchase the stock
at current prices for delivery to the call exerciser. Risk of an early exercise
escalates as deep in-the-money calls approach expiry.
·
Investors frequently are tempted to consider the
money market instrument section of the strategy as “a source of capital
available for other purposes”. That temptation should be avoided.
Disclaimer: Comments and opinions offered in this report are for information only. They should not be considered as advice to complete option strategies. Information in this report is believed to be accurate, but is not guaranteed.