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Equity Options

Can investors/speculators use equity options to boost return through buying and selling leverage (calls), and/or buying and selling insurance (puts)? If so, which strategies work best? These blog entries relate to trading equity options.

Cross Sections of Covered Call Returns

Do returns for covered calls on individual stocks vary systematically with stock volatility and liquidity? In the January 2010 version of their paper entitled “Option Returns and Individual Stock Volatility”, Jie Cao and Bing Han compare monthly returns of portfolios of short-term (formed about 1.5 months from expiration and held one month), at-the-money covered call options sorted by either total volatility (standard deviation of daily stock returns over the previous month) or idiosyncratic (market-independent) volatility of the underlying stocks. They also examine a double sort by market capitalization and total volatility. Using daily stock and option price data for a broad sample of U.S. equities over the period January 1996 through December 2006, they conclude that: Keep Reading

Moneyness and the Profitability of Shorting Equity Options

Covered Calls Advisor Jeff Partlow commented: “Selling a cash-secured put is essentially equivalent to a covered call when done at the same strike price and expiration date. But I’ve observed that cash-secured put sellers tend to select more conservative out-of-the-money strike prices, whereas covered call sellers tend to establish more aggressive out-of-the-money strike prices. Also, the result in ‘Outperformance from Mechanically Selling Covered Calls on a Stock Index’ is questionable to me because the July 2004 ‘Passive Options-based Investment Strategies: The Case of the CBOE S&P 500 BuyWrite Index’ by Ibbotson Associates and the October 2006 ‘An Historical Evaluation of the CBOE S&P 500 BuyWrite Index Strategy’ by Callan Associates show, respectively, that 2% out-of-the-money and at-the-money covered call strategies outperform a buy-and-hold approach.” Keep Reading

A Few Notes on Put Option Strategies for Smarter Trading

In his 2010 book Put Option Strategies for Smarter Trading: How to Protect and Build Capital in Turbulent Markets, author Michael Thomsett “explains all the put-based strategies [for individual stocks] in detail and shows how even a troubled market presents great opportunities to keep you in control. The worst aspect of volatile markets is a sense of not having control over events, and puts can be used to offset this apprehension. You have probably heard that astute traders can earn profits in all types of markets. Puts are among the best devices to accomplish that goal.” Some notable points about the book are: Keep Reading

Performance of Buy-Write Strategies for Australian Stocks

Do buy-write strategies, wherein investors buy stocks and simultaneously sell matched out-of-money call options, generally outperform their underlying stocks? In other words, do option premiums more than compensate for any sacrifice of capital gains? In their January 2010 paper entitled “The Efficiency of the Buy-Write Strategy: Evidence from Australia”, Tafadzwa Mugwagwa, Vikash Ramiah and Tony Naughton examine the performances of buy-write strategies on the Australian Stock Exchange for portfolios formed monthly, quarterly and yearly at different levels of call option out-of-the-moneyness. They test the profitability of buy-write strategies during weak and strong markets. They measure the effects on buy-write returns of underlying stock liquidity (turnover ratio), dividend yield, firm size, book-to-market ratio, earnings per share and price-earnings ratio. Using prices, firm fundamentals and out-of-the-money call option prices (actual and modeled) for 179 stocks over the period January 1995 through October 2006, they conclude that: Keep Reading

Anomalies for Building Very Short-term Trades?

A reader asked: “I am interested in finding a strategy to day-trade around the opening of trading. I would prefer the first half hour but would not be opposed to looking at strategies holding until the close or even the next day. With the high-frequency traders becoming the new liquidity providers, day traders like me aren’t left with much of an edge. I think the first half hour may still hold some opportunity. Do you know of any first half hour plays that I might start to build from?” Keep Reading

ATM or OTM Index Puts for Portfolio Hedging?

A reader asked: “I have been looking into portfolio hedging using index put options, but I cannot find any analysis on the efficiency of using at-the-money (ATM) versus out-of-the-money (OTM) puts. Do you know of any research focusing on this question?” Keep Reading

Are VIX Options Mispriced?

A reader asked: “Today (12/04/09), the Dec 27.5 VIX put options had a negative extrinsic value [option price – (strike value – VIX level)] of $-0.36 with bid-ask spread $0.50. Is there something about VIX that makes this situation not abnormal?” Keep Reading

Passive and Active Collar Strategies for ETFs and Mutual Funds

An investor can collar (bound) a long position in an asset by simultaneously purchasing a put option at one strike price (lower bound) and selling a call option at a higher strike price (upper bound) on the asset. How does this strategy perform? In the September 2009 version of their paper entitled “Loosening Your Collar: Alternative Implementations of QQQ Collars”, Edward Szado and Thomas Schneeweis evaluate the performances of passive and active collar strategies for the PowerShares QQQ (QQQQ) Exchange-Traded Fund (ETF) and for a small cap equity mutual fund. While a standard collar employs put and call options with the same expiration date, the study also considers puts with longer durations. The passive collar strategy follows a fixed set of rules regardless of market conditions. The active strategy varies collar specifications according to three market/economic conditions: (1) momentum of the underlying; (2) broad market volatility; and, (3) a macroeconomic measure combining unemployment and the business cycle. Using data covering the period from the introduction of QQQQ options on March 19, 1999 through May 31, 2009 (122 months), they conclude that: Keep Reading

Bear Spreads on Leveraged ETF Pairs?

A reader wondered: “After reading ‘Shorting Leveraged ETF Pairs’, I’m wondering whether there is any other way to play a leveraged ETF pair — perhaps writing bear spreads on both funds simultaneously.” Keep Reading

A Few Notes on Day Trading Options

In his 2009 book Day Trading Options: Profiting from Price Distortions in Very Brief Time Frames, author Jeff Augen argues that individual investors operate at material informational and analytical disadvantages whether focusing on fundamentals or trend-based technical indicators. He has written this book”for investors who are seeking a different approach and are willing to work very hard to perfect new trading strategies.” This different approach seeks to exploit “well-characterized pricing anomalies and distortions… [that] exist, in part, because contemporary option pricing models assume continuous trading… Today’s option market [responds to market down time] by varying the implied volatility priced into option contracts [thereby presenting a] profit opportunity [that] can become very large under certain circumstances.” Also, “news events often introduce brief distortions that take many minutes for the market to digest. During these brief time frames the market becomes inefficient…[as detected by] a new technical indicator that can be used to quantify rising or falling volatility.” Some notable points from the book are: Keep Reading

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