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Supply and Demand of Options

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Editors note: This is the fourth in a six-part series. Click here to read part one, here for part two and here for part three.

The relative prices of options are constantly changing, reflecting the dynamic nature of market sentiment. In fact, relative option prices over time and strike are an excellent indicator of market sentiment as I'll discuss in a later piece. As in any fluid financial instrument, prices are dictated by supply and demand. The nature of sellers of options (supply) is very different from that of buyers (demand) of options.

Most of the supply of options (sellers) comes from longer term investors who employ a strategy called over-writing. When an investor who owns stock, which may have been owned for a while or just purchased, sells call options on that stock in an amount equal to or less than the number of shares he owns, the transaction is referred to as covered call writing. The seller of the call options is receiving income from the buyer in the form of option premium in exchange for giving away to the buyer the appreciation in the stock above the strike price of the calls. The strike prices of the calls sold in covered writing programs tend to be higher than the price of the underlying stock; such options are referred to as out-of-the-money. When the strike price of the option equals the strike price of the stock, such options are referred to as at-the-money.

An over-writer (seller of options) must have a longer term time horizon than a buyer of options to effectively capture the time premium of the options sold. There must be an underlying willingness to either retain the stock if the option expires out of the money or to sell the stock if the option expires in the money in order to realize the objectives of the strategy. The first objective is to lower risk (as measured by the variability of returns) by reducing the carrying cost of the stock by amount of the option premium sold. The following graph illustrates an example of selling a six-month at-the-money call option for 10 on a stock trading at 100.


Total Return Graph: Long stock at $100 and Short 100 strike calls at $10




By netting the slopes and options above and below the strike price, we arrive at the combined position represented by the dashed blue line of long stock and short call. The upside in the stock is sold away in exchange for the price of the option. The premium sold reduces the effective cost of the stock by 10 points to 90 and thus cushions the negative impact of declines in the share price. In exchange for this reduced risk, all the appreciation above 100 is surrendered to the option buyer. The second objective is to efficiently capture the time premium of an option, which is the portion of the total price of an option minus the intrinsic value (the amount the stock price exceeds the strike price). The time premium represents the amount a speculator is willing to pay for potential price appreciation in the stock and reflects the expected volatility of the stock over the life of that option. The price of at-the-money or out-of-the-money options consists entirely of time premium.

This strategy performs best in moderately appreciating markets with volatile trading ranges where the market tends to overpay for options. Covered writing returns should outpace those of straight equity positions during such periods and will also outperform in declining or stagnant markets due to the premiums that are being captured from selling the calls. In addition it's important to note that covered writing may outperform straight equity on a risk-adjusted basis in many environments, even in periods of high price appreciation if such periods are accompanied by high volatility. During such periods equity investors tend to act emotionally and make mistakes in timing that reduce their absolute returns. By allocating funds to a more conservative asset class such as a covered writing program, an investor can control risk and achieve a discipline that helps avoid such mistakes.

The objective of any investment portfolio is to achieve the optimal combination of return and risk. Return is in most cases indeterminate, as it is an independent variable of future performance, while risk is a dependent variable determined by an investor's tolerances and requirements. Asset allocation decisions are the most important in the investing process and too often they are made on the basis of uncertain returns rather than on manageable risk. A covered writing portfolio consists of equities along with a managed program of calls that are sold against these equities. This portfolio can be considered a separate asset class that normally exhibits truncated returns with lower risk than a straight equity portfolio. The portion of the portfolio consisting of the calls that are sold has a negative correlation with the stock portfolio and this is what reduces the risk relative to a straight equities portfolio. For example, if a stock declines from 100 to 90 over a three-month period, a six-month at-the-money call sold for 10 might decline to 4. So the loss from the 10-point drop in the stock is cushioned by the 6-point gain from the sale of the call. Introducing leverage into a covered writing program will increase risk and tends to negatively affect decisions in managing the process. The primary attribute of the asset class is lower risk and leverage is not recommended.

An effective covered writing program ultimately depends on an investor's ability and desire to own a stock outright at lower prices and to sell it at higher prices. For example, if an investor is long-term bullish on a stock at its current price of 100 with an ultimate price objective of 200 and the stock were to decline to 80, the investor may choose to refrain from writing (selling) calls against it until it rallied back toward 100. In other words, the strategy of "rolling down" and selling lower-strike calls on weakness in the stock can be a mistake unless the investor wants to sell the stock (if that is the case, the stock is not really a candidate for over-writing and should just be sold). Rolling down has the effect of over-trading volatility which manifests itself in the classic case where an investor sells 100-strike calls and when the stock declines from 100 to 80 he closes out his 100-strike calls and replaces them with 80-strike calls. The stock then rallies back to 100 and the investor has now lost money on his covered writing transaction on no net movement in the stock. On the upside, the investor should continue to sell medium correlation calls against an appreciating stock until at some point he is selling 200-strike calls and he ultimately sells his stock to the 200-strike call buyer as his price objective has been achieved.

A classic mistake made by covered call writers is to allow the calls they have sold to move too deeply into the money as the stock appreciates. Consider the 6-month, 100-strike, at-the-money call we referred to earlier, which we sold for a premium of 10. If the stock were to appreciate to 120 over the next month this option might be selling for 22, which means that it now has a mere 2 points of time premium (22 less its intrinsic value of 20). At this point we are no longer efficiently capturing time premium and this option has an almost total negative correlation with the movement in the stock. Any additional appreciation in the stock will be almost completely negated by appreciation in the short option and despite the stock being far from the target price.

One approach in such a situation would be to cover the 100-strike option position when the delta (defined in my earlier column) reaches .8 (only 20% chance the option will expire out of the money) and roll up by selling a higher strike call (the 120-strike or perhaps higher). Selling an at-the-money or slightly out-of-the-money option (with a delta of .5) would help optimize time premium capture and this higher-strike option would have a much lower correlation with the stock. The over-writer runs the risk that the stock price appreciates too quickly. The investor must ultimately be prepared to sell the stock at the current strike in these situations. Large debits paid in the rolling process determined by how quickly the stock has appreciated can be minimized and managed by the duration and strike of the new option chosen. These nuances have several variables and are dependent on the investor's risk profile.

There are several variables other than implied volatility that affect option prices. Lower dividend yields result in higher relative time premiums for call option prices; mathematics will illustrate this, but essentially a call option will become increasingly more attractive as an alternative investment to owning the stock. For example, a four-month call on a stock with a 1% dividend yield will trade 8% higher than it would if the stock yielded 4%. So the relative attractiveness of covered call writing has increased in the recent low dividend yield / high volatility environment.

The predominant source of demand for options comes from hedgers and to a smaller extent, speculators. Hedgers naturally want exposure to stock movement, but for some reason want limited risk of adverse movement for some specified period of time. The reason may be stock-specific (unsystematic risk); perhaps the holder of stock is concerned about a nearby earnings report, in which case they will buy an option on the stock itself. Or the concern may be for the entire market (systematic risk), in which case the investor may buy an index option on the market. In either case, the most important implication is the strike that these buyers normally purchase. Almost all option purchases for hedging or speculation are done on out of the money strikes. A holder of stock who is worried about a negative short term earnings surprise will tend to buy out of the money puts for protection. A speculator looking for a positive announcement on a stock will tend to buy an out of the money call option. This is due to the relative low premium level in relationship to the potential payoff; this results in high leverage or as the English call it, gearing.

By far there is normally a higher supply of out of the money calls from over-writers and a higher demand for out of the money puts by hedgers than anything else. Most mispricing of options occurs here and creates what arbitragers call "skew." Measuring the skew in options often provides insights into market sentiment. When the skew as measured by implied volatilities is dramatic, meaning there is a heavy supply of out of the money calls and heavy demand of out of the money puts, market sentiment is negative and the underlying stock may grind higher from a contrarian point of view.

Click here to read Part V: Futures, the Easy Derivative

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No positions in stocks mentioned.

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