options theory/strategy question

[tede02]

On occassion, I'll buy a LEAP contract on something that looks extremely cheap. I bought a call about 18 months ago that expires on January 15th. In December I sold the call after it had moved solidly back into the money on the back of the market recovery (for a decent profit). But of-course, had I held, the option would have been worth about 50% more as I write this. The reason I sold in December was the contract was sitting in a profitable position and I viewed the risk of a sharp pull-back as increasingly high because of the speculative fervor and rich valuations in the markets.

 

Is there any theory around the wisdom in holding options as close to expiration as possible? I understand this to be Buffett's favored approach based on remarks he made about the warrants BRK receieved from BAC and others in the past. Maybe there is no answer but when I think about this, it seems like the risk of holding an option increases as expiration nears because you can get caught in a sudden pull-back (broadly or narrowly) that wipes you out with no time to recover.

 

 

[SharperDingaan]

It's a black art.

 

In most cases - to get rid of an option before expiry, the premium has to be less than the equity required - were the buyer to simply buy the stock and margin at the current price. Hence in a run-up you can easily end up deep in the money, but with no liquidity - and unable to pledge the gain as collateral.

 

Typically the more volatile the underlying, the more a preference for a shorter term, and an exchange traded option. As the expectation is monetization via expiry, you need a short term and a solid counterparty. What's optimal? depends on the overall strategy.

 

SD

 

[Pelagic]

On occassion, I'll buy a LEAP contract on something that looks extremely cheap. I bought a call about 18 months ago that expires on January 15th. In December I sold the call after it had moved solidly back into the money on the back of the market recovery (for a decent profit). But of-course, had I held, the option would have been worth about 50% more as I write this. The reason I sold in December was the contract was sitting in a profitable position and I viewed the risk of a sharp pull-back as increasingly high because of the speculative fervor and rich valuations in the markets.

 

Is there any theory around the wisdom in holding options as close to expiration as possible? I understand this to be Buffett's favored approach based on remarks he made about the warrants BRK receieved from BAC and others in the past. Maybe there is no answer but when I think about this, it seems like the risk of holding an option increases as expiration nears because you can get caught in a sudden pull-back (broadly or narrowly) that wipes you out with no time to recover.

 

There are a couple components from which your option derives value. Primarily there's its sensitivity to the underlying asset (delta), time value remaining (theta), and a volatility component (vega). Ignoring volatility for now, as a long dated option approaches expiry you're going to see it become a lot more sensitive to changes in the price of the stock because more of its total value is a function of its sensitivity to the underlying. Perhaps a better wording is that an option's time value (theta) is always decreasing toward 0 at expiration. 18 months ago theta probably represented a meaningful % of the option's total value and now it represents very little, meaning price changes in the stock will have a lot more effect on the option's value.

 

This is a highly simplified explanation and assumes volatility remains relatively constant throughout the life of the option (unlikely). If you're simply wanting to replicate a stock purchase with LEAPS while tying up less capital, a deep in the money call will best approximate the underlying for the least premium in terms of time value and volatility.

 

Likewise, options themselves can be over/undervalued, especially in longer time frames. You can get a rough approximation of what the market is predicting for the stock price by looking at the implied volatility of the option where for example a 25% implied volatility means the market expects the underlying to trade in a +/- 25% range from its current price 68% (1 standard deviation) of the time. If for some reason you think that the likelihood of the stock trading more or less than 25% of its current price is higher than 68% then there might be a trade to be made.

 

To answer your question, I guess it comes down to how you value the option. As a seller in Dec. you might have viewed the option as expensive and sold whereas a buyer had a different take on it. There's no easy answer and rarely are you going to see options that stand out as glaringly cheap/expensive. At the end of the day you still need some insight as to the market price of the option vs. its value.

[mwtorock]

side question here: for long term puts, what strike to pick to be more cost effective?

 

I usually buy leaps with strike around the spot to lower cost as compare to far out money options.  Long term puts should be more or less the same? but put premiums are so high at the money, so i am thinking i should think about optimizing.

[lnofeisone]

side question here: for long term puts, what strike to pick to be more cost effective?

 

I usually buy leaps with strike around the spot to lower cost as compare to far out money options.  Long term puts should be more or less the same? but put premiums are so high at the money, so i am thinking i should think about optimizing.

 

IV is the lowest at or near strike price. You could go through the exercise of plotting Strike Price vs. Implied Volatility delta (in 99% of cases IV will increase as you go down the strike price). Usually, you'll see what's known as a volatility smile or +/- volatility skew. Every so often the option at lower strike prices will be mispriced a tad (e.g., 400 SP with IV of 55% and 395 SP with IV of 54.9). You also have to balance that with how far up/down you expect the stock to go. 20% up/down rule is as good as any.

 

When I hold LEAPs, calls or puts, I balance it by way of a diagonal (so different SP) where the front-month option (the short option) would have a higher IV than the LEAP. If I am right on timing and direction, the front-month option expires worthless and I keep riding the LEAP. If I'm right on the direction but wrong on timing (say stock plunges 90% overnight), I can eventually convert the front-month option to make this a spread. If I'm wrong on timing and direction, I'm at least better off than just holding straight up LEAPs.