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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.

Index Versus ETF Option Pricing

Are there differences in implied volatilities (option pricing) between major indexes and the exchange-traded funds (ETF) that track them? In their 2011 paper entitled “The Implied Volatility of ETF and Index Options”, Stoyu Ivanov, Jeff Whitworth and Yi Zhang compare implied volatilities of SPDR Dow Jones Industrial Average (DIA), SPDR S&P 500 (SPY) and PowerShares QQQ (QQQ) to those of the Dow Jones Industrial Average (DJIA), the S&P 500 Index and the NASDAQ 100 Index, respectively. They note that ETF prices may deviate from underlying index levels because: (1) ETFs incorporate trading frictions from rebalancing and management fees; (2) ETF composition may differ slightly from that of the underlying index due to trading cost constraints; (3) ETFs accumulate dividends in a non-interest bearing account for periodic lump sum distribution; and, (4) ETFs trade until 4:15 p.m., while indexes close at 4:00 p.m. Also, index options are European, while ETF options are American. Using index levels at the close and ETF prices within one second of 4:00 p.m. during 3/10/99 through 12/29/06, and associated ETF and index near-to-expiration options price data filtered for reliability during 2003 through 2006, they find that: Keep Reading

Condor Options Newsletter Performance Review

A reader suggested Condor Options as a guru for review. To conduct a review, we evaluate the Condor Options Newsletter Performance table of iron condor trades (with a few hedging trades) available via the Condor Options Performance self-assessment. This table includes entry and exit dates, trade duration, specific positions/strike prices, initial value (credit), total amount risked (Real Risk), final value (credit), final value as a percentage of amount risked (% Return), risk-adjusted trade size, return on investment (Trade ROI) and cumulative value of a $1,000 initial investment (VAMI). The initial and final trade values account for bid-ask spread by sampling actual fill quotes, but they do not account for broker trading commissions. This evaluation accepts the basic premises of performance assessment as presented in the table. Using the Condor Options Newsletter Performance table as of the end of June 2011, covering closed trades from initial position entry on 5/11/07 through 6/10/11 (162 trades), we find that: Keep Reading

Return Versus Liquidity for Equity Options

Does the market compensate buyers of illiquid options? In their March 2011 paper entitled “Illiquidity Premia in the Equity Options Market”, Peter Christoffersen, Ruslan Goyenko, Kris Jacobs and Mehdi Karoui investigate the impact of illiquidity of equity options and underlying stocks on option returns. They consider two option expiration horizons, short-term (20 to 70 days) and long-term (71 to 180 days), segmented by moneyness as in-the-money (ITM), at-the-money (ATM) and out-of-the-money (OTM). They compute option returns using end-of-day quoted bid-ask midpoints. They define stock illiquidity as the effective spread obtained from high-frequency intraday trade-and-quote data and option illiquidity with quoted end-of-day bid-ask spreads relative to midpoints. Using daily option closing bid and ask quotes for those S&P500 components that have traded options over the entire period of 1996 through 2007 (341 firms), filtered for reliability, along with comparable data for underlying stocks, they find that: Keep Reading

Sell Lottery Tickets for (Their) Fun and (Your) Profit?

Can investors exploit greed among naive traders by selling them the most lottery-like equity options? In the March 2011 version of their paper entitled “Stock Options as Lotteries”, Brian Boyer and Keith Vorkink investigate the relationship between skewness of expected returns (a measure of prospects for extreme payouts, a proxy for “lotteryness”) and actual future returns for options on individual stocks. On the first trading day and the second Friday of each month, they create 40 option portfolios sorted first into eight expiration horizons and then into expected skewness quintiles. Based on end-of-day bid-ask midpoints, they calculate the return for each option assuming it is held to expiration (ignoring the possibility of early exercise) and returns for the 40 portfolios as the equally weighted average of constituent option returns. Using end-of-day bid and ask quotes, open interest and trading volume for options (screened for liquidity and obvious errors) and prices for the underlying U.S. common stocks during approximately 1996 through 2009, they find that: Keep Reading

Extracting a Volatility Premium with Equity Options?

Are options for volatile stocks overpriced? In the September 2010 version of their paper entitled “Cross-Section of Option Returns and Stock Volatility”, Jie Cao and Bing Han investigate the relationship between option return and price volatility of the underlying stock. The focus on delta-hedged positions in options and underlying stocks calibrated such that the combination is insensitive to stock price changes. For most analyses, they use the closing bid-ask midpoint as the option price. Using price and trading data for approximately at-the-money individual stock options about 1.5 months from expiration (filtered for reliability) on approximately 6,000 underlying U.S. stocks over the period January 1996 through October 2009 (about 200,000 observations each for puts and calls), they find that: Keep Reading

Lead-lag Relationship for Options and Stocks

Do options quote movements anticipate those of underlying stocks? In other words, are options traders systematically more informed than stock traders? In their January 2011 paper entitled “Is There Price Discovery in Equity Options?”, Dmitriy Muravyev, Neil Pearson and John Paul Broussard test the lead-lag relationship between the bid-ask ranges of equity options and the actual bid-ask ranges of underlying stocks by comparing instances when the two markets disagree with instances when they do not. Disagreement means that the stock bid-ask range implied by the put-call parity relation does not overlap with the actual stock bid-ask range. This approach is more definitive than a simplification based on the midpoint of the bid-ask range. Using tick-by-tick trade and quote data for 36 liquid U.S. stocks and three exchange-traded funds (ETF) and options on them during April 17, 2003 through October 18, 2006 (107,000 instances of disagreement), they find that: Keep Reading

Stock Price Pinning at Options Expiration?

A reader asked: “Do you have any research on the phenomenon of ‘pinning’ during options expiration? The theory is that there is a Max Pain price where options sellers stand to lose the least, and that they manipulate prices towards these levels.” A search of the Social Science Research Network (SSRN) separately for “pinning” and “expiration” yields the following studies, in descending order of number of downloads: Keep Reading

A Few Notes on Trading Realities

Author Jeff Augen describes his 2010 book Trading Realities: The Truth, the Lies, and the Hype In-Between as “designed to help investors understand the economic and political forces that drive financial markets and to invest alongside those forces instead of against them. It also provides a blunt assessment of the limitations that most private investors face. Understanding these limitations and being able to manage risk are as important as choosing the right investments.” Some notable points from the book are: Keep Reading

Selling Calls or Puts According to Trend

Are there predictable times when selling covered call options outperforms selling cash-covered put options? In his March 2010 paper entitled “Buy-Write or Put-Write, An Active Portfolio to Strike it Right” (the National Association of Active Investment Managers’ 2010 Wagner Award runner-up), George Yang investigates using trend signals to trigger switching between covered call and put writing. The test portfolio consists of: (1) a long position in the S&P 500 Total Return Index (SPTR); (2) cash (Treasury bills); and, (3) a short position equivalent to the value of (1) plus (2) in at-the-money, next-month call or put options on the S&P 500 Index. The Golden Cross/Black Cross Rule (the 50-day simple moving average crossing above/below the 200-day simple moving average) applied to SPTR triggers switches between calls (after black crosses) and puts (after golden crosses). Using daily closes for SPTR, the S&P 500 Buy-Write Index (BXM) and the S&P 500 Put-Write Index (PUT) during June 1988 through December 2009 (21.6 years), he finds that: Keep Reading

Are ETF Options Section 1256 Contracts?

Reader Jeff Partlow passed along the question of whether options on Exchange-Traded Funds (ETF) are Section 1256 contracts, qualifying for 60% long-term and 40% short-term capital gains treatment. Using applicable parts of U.S. Code Section 1256 and IRS Publication 550, we find that: Keep Reading

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