Options as a Risk Management Tool

In the last article, I discussed the basics of options: what they are, their classification, properties, and the different types that exist. I also mentioned how options allow you to speculate on the most expensive stocks at the price of a penny stock. This can make the prudent investor uncomfortable, as penny stocks are classically known as very risky because of the percentage swings and general lack of knowledge about the underlying company. With options the latter issue with penny stocks is solved, because everyone knows who JNJ is, but the swings in market value of options absolutely exist. This article describes how to manage your options to actually control your risk. But before we get there, we will start explaining the pricing of options. 

Who determines how much premium an option has? 

Ultimately the market does. If there is a high demand for a particular option, it will be more expensive. If there is lower demand, it will be cheaper. The CBOE originates a lot of options, so supply is actually not too much of an issue. The CBOE uses something called the Black-Sholes model to determine their pricing for options. The mathematician in me looked up the formula once and punted. Just know that it is based on historical movement of the underlying, and the volume and open interest just increase the demand for the option (also called implied volatility, or IV for short).

Wait, what is open interest? 

My colleague Tony Pelz explained it well a few years ago, and nothing has changed since then. Why reinvent the wheel?

The other basic information included in an Option Chain is Volume and Open Interest. Volume is easy to understand: it represents the total number of options traded for each Strike during a day (just as the volume for a stock represents the total number of shares traded during a day). For example, the SEP 16.0 Strike Call volume as of this day, June 2, was 564 contracts (see Exhibit below). This means that 564 contracts (options) were bought/sold during the day. On the same day the SEP 18.0 Strike Call traded 2,192 contracts, the most active strike for this Series. Volume is a very useful metric as it shows where most of the trading action for the day is occurring. Many possible inferences can be made reading daily volume data.

Exhibit: Option Chain for XYZ Stock
Stock: XYZ @ $16.35
Today: June 2, 2010
SERIES: SEPTEMBER

CALLS                                           PUTS
BID      ASK      Volume      O.I.      STRIKE      BID      ASK      Volume      O.I.
2.83      2.88      10              2,114     SEP 14.0     0.59     0.61      455              3,144
2.08       2.13      242           1,071     SEP 15.0      0.83    0.86      247              7,365
1.44      1.48       564           1,389     SEP 16.0      1.19     1.22      306              6,256
0.92     0.96      576            2,267    SEP 17.0      1.68      1.71      1,103            3,633
0.55     0.57      2,192         4,435    SEP 18.0      2.30     2.34     482               1,594

While volume represents the daily activity for each option, Open Interest represents the net increase or decrease in the total number of options traded (opened and closed) since the inception of the Series. For example, the Open Interest for the XYZ SEP 18.0 Strike Calls in the Exhibit is 4,435. This means that a net total of 4,435 option contracts have been opened/remain open since the Series inception.

It is important to note that daily Volume does not always equate to Open Interest – that is, just because a day’s Volume was, for example, 500 contracts, it does not mean that Open Interest will increase by 500 contracts. To expand this point, the Exhibit below shows daily Volume, Open Interest and Net Change for the ABC 5.0 Strike Calls. On Day 1, Open Interest was 10,000 contracts – a net total of 10,000 ABC 5.0 Strike Calls have been opened (and remain open). During Day 1, 500 contracts traded. On Day 2, Open Interest is now 10,500 contracts, which means all of the Volume on Day 1 was from new (initial) contracts. On Day 2, contract Volume is 300. On Day 3, Open Interest is now 10,700, a net increase of 200 contracts. This means that of the 300 contract Volume during Day 2, 100 were closing positions and 200 were opening (initial) positions. During Day 3, 1,500 contracts trade. On Day 4, Open Interest declines by 1,500 contracts, the entire Volume experienced on Day 3.

Exhibit: Open Interest and Volume
ABC 5.0 Strike
Calls                Volume      Open Interest       Net Change
Day 1 (open)   – 0 –           10,000
Day 1 (close)   500
Day 2 (open)   – 0 –           10,500                   (a) +500
Day 2 (close)  300
Day 3 (open)   – 0 –            10,700                  (b) +200
Day 3 (close)  1,500
Day 4 (open)  – 0 –             9,200                    (c) -1,500

Open Interest is a very useful metric as it gives you a snapshot into the money flow in the various Strikes of both Puts and Calls. This can at times allow you to gauge general sentiment in the Underlying shares. In some situations, it is extremely important to actively monitor and interpret Open Interest.

I will add to Tony’s description only one more use of Open Interest, and that is to understand the option’s current liquidity state.  If an option has an open interest of 0, that doesn’t mean that you cannot trade it; but the only buyer and seller is the CBOE… and they know it. 

How do I use this information to manage risk better?

Let’s piggyback off of Tony’s example above. You expect stock XYZ will go up to 18 by the expiration day in September. Currently the price is $16.34. You also notice the SEP $16 Calls @ $1.46 (midpoint is the usual mark). So you are faced with a dilemma. Should I buy the 100 shares of XYZ and pay $1634 total, or should I buy the call for $146? 

If you are right, and stock XYZ moves up to $18 at a constant pace (never happens) and ends at expiration at exactly $18… you exercise your options and you just made the same amount of money (minus $146) at a fraction of the margin it took you to just buy the shares. 

If you wake up one day and the CEO was arrested overnight spending company funds on hookers and cocaine, your loss was $146 with the call. With the actual stock purchase, you have lost up to the full $1634. It could be less, and probably is, but the risk is disproportionate to the reward. With options, you can greatly manage your risk but not putting up any more money than you are willing to lose while having the ability to make a comparable amount of money as stocks at the expense of a small premium.  

Granted, it isn’t as simple as that since there are a few more things to consider with options that will be explained in the next article. But think about this when making a move on catalysts, earnings, technical plays, or even longer term plans. Options greatly increase your available margin and allow you to make more with less. 

A quick note about commissions

One other downside to options is that the commission structure is much more expensive than trading stocks. Talking babies peddling E-Trade boast $7 stock trades, while options commission structures look like $10/trade plus $1.50 an option. This can add up really fast, but the returns are worth it. Between trading, exercising, expiration, and settlement, you are getting a lot more service for your trade with an option than you do with stocks, so it does make sense. Personally, my favorite platform is thinkorswim.com, and the cheapest commissions with a decent platform is optionshouse.com.