The Big Question for Traders: Option Volatility Versus Risk

The big issue for options folks is the unending struggle between wanting to be in options positions in volatile stocks because that’s where the profits happen quickly; and wanting low-volatility stocks to reduce risks.

The consequence is that we tend to end up with highly volatile stocks and “safe” strategies like covered calls. Two risks are thus in play. First, the stock’s price rises so far that the call is exercised and shares are called away. (Then, rather than happily taking those capital gains plus option premium, the trader bemoans the profits they coulda, should, woulda had if only …) The second risk is that the volatile stock’s price falls and the call expires or is closed at a profit, but the stock’s net value now is well below the adjusted basis.

And that’s why so many covered call writers end up with yet another paper loss sitting in their portfolio.

Among the solutions: limit your options action to less volatile stocks, use collars instead of covered calls to add downside protection, or avoid holding long stock and instead, use synthetic long stock or synthetic short stock positions. These set up options to act exactly like stock, so profits are the same as long or short positions in 100 shares. The big difference, though, is that the net cost of a synthetic stock position is at or near zero.

(Synthetic long stock consists of one long call and one short stock opened with the same strike and expiration; and synthetic short stock is made up of one long put and one short call.) To truly get a handle on the volatility trend in a quick and easy way, check volatility edge

The synthetics solution is the most intriguing and offers great potential for limited risk and potentially exceptional returns. The short options pose a risk, but this should be compared to the risk you undertake with any position in stock.

To see how it works, check out short-term synthetic long stock positions on the Caterpillar (CAT) 105 options. With the stock at just under $107, the May 105 call is at 5.65 and the put at 4.55. So a synthetic long stock position yield a credit of $110 before transactions fees, and a synthetic short gets you a debit of the same amount.

Another one: IBM was at $205.50 on March22’s close. The May 205 call was at 5.65 and the put at 5.55. A synthetic long on IBM gets a credit of $10, and a synthetic short costs you a debit of $10.

In either case, the net cost or small credit is much lower than CAT’s $10,700 for 100 shares or IBM’s $20,500 …

Michael C. Thomsett