I'm a bit surprised at the speculative stocks M* is recommending as potential options trades.

What do you think of this options trade from M*? 

I'm a bit confused by the math they use to calculate returns. It would help if they would show the equations in algebra. One of their equations uses a number that's apparently out of thin air. 

[thinkingoutloudmode]Pardon me while I try to understand this and think it through.[/thinkingoutloudmode] 

Key graphs from M*:

[quote user="Morningstar"] You can investigate the option opportunity for yourself by clicking on Morningstar's options chains for Keryx. After examining the call options expiring March 21, 2008, we can see that the call spread between call options with strike prices of $10 and $15 per share costs $1.50 at the midpoint of the bid/ask prices, as of Oct. 15. Doing a little basic math, we can calculate that the option market is pricing a 30% (1.50/5) chance that the stock will move from $10 (slightly below where it's trading today) to above $15 by the expiration date. However, we think there's a 60% probability that Keryx will see positive data before the expiration date, and if it does, we think the value of the stock should approach $20 per share. By our estimates, the market is serving up a bet at half of what it is worth.

That said, we estimate that this investment has a 40% chance of going to zero, so it is only for the risk tolerant, and only for a small percentage of a portfolio. Also, the bid/ask spread can eat into the edge on this bet, and executing at the ask produces a less attractive return. Each option would pay roughly $1.60 (a $5 payoff if the stock moves to $20 and the strike price is $15, minus the $3.40 cost at ask price), so the expected value of the bet is $0.96 (60% * $1.60), which is a 28% return (0.96/3.40) over five months, or 68% annualized. One way to improve this situation is to place a limit order to buy the call spread for a nickel or a dime more than the midpoint, and wait to see if your order is filled by the market maker.

On my Thinkorswim.com option trading screen, the possible vertical spreads for KERX are  10/12.5, 12.5/15. That suggests to me that the market doesn't expect many 5 point spreads for a stock at this price.

A bigger question, why would you buy such expensive options? The historical volatility is only 66% and the implied volatility on options for all three strikes is about 150%. This means all of the options prices could fall sharply even if the stock's price doesn't change. That would make the trade a quick and sure loser.

The logic, of course, is that you are expecting the price of the stock to move to $12.5 or so from about $10. This would give you a 2.5 loss on the 15 strike and a 2.5 gain on the 10 strike. To make money, you'd need to see the stock rise to at least $13, giving you a 50 cent profit. See M*'s math in the previous post.

For me, this suggested trade is a great case history of what makes a good vertical spread. You're expecting a news event that will cause the stock to rise. You limit your risk by buying a 10 strike and selling a 15 strike. As the trade nears the March 21 maturity, assuming the stock holds at $10, the price of the 15 will fall, giving you a profit. If the stock falls to $9 or $8, prices on both options will drop, and you'll probably lose money, because the higher-priced 10 call will lose more than the shorted (written, sold) lower priced 15 calls will make. You have to watch the trade like a hawk, by the minute or hour, not by the week or month.

M* is assuming that if the stock rises to $20, you'll call the stock and pay $10 for it and hold it, making this a long-term investment.

Most traders, however, would take their profit on the spread and move on rather than put up the money to buy the stock. If you're sophisticated enough to do this trade, wouldn't you be sophisticated enough to continue to leverage your cash doing spreads rather than use your money to buy a stock?

I wonder why M* doesn't call this a "vertical spread," which is what it is?

 

Here's another way to look at M*'s creative trade:

M* says:

"After examining the call options expiring March 21, 2008, we can see that the call spread between call options with strike prices of $10 and $15 per share costs $1.50 at the midpoint of the bid/ask prices, as of Oct. 15."

So you're taking a 15% risk on a $10 stock, if the stock is below $10 when the options expire.

If you want to play but not do options, you can cut your risk in half. Buy the stock at $10. If it falls 8%, or 80 cents, sell it. You've taken a flier and limited your risks, living to play another day. Taking a 15% haircut on a trade seems foolhardy to me. 

You also could do the trade recommended by M* and cut your losses at 75 or 80 cents, provided there is enough options market liquidity, which may not be there when you need it.
 

Yes, I looked at this situation and decided against it. I just didn't like the risk/reward, and the options are so expensive! I like LEAPS, but to get the Jan9 LEAP at strike 10 would cost me over half of the stock price anyway, so why not just get the stock, or even sell a far OTM covered call? Seems like buying such expensive options is not a great strategy. Even the March calls are too expensive. And yet M* expects important product decisions in March and still recommending a March call, when any delay at all would require a roll out? Not for me on this one.

Steve

Good discussion,

We're looking at options with a very fundamental lens, and as an investment.  Let me run through a few of the questions.

 
Why not call it a vertical spread?:

1) Because we are writing these articles to be approachable by beginners, so we're minimizing the options lingo.

2) We're trying to get away from some historical accidents in options terminology.  Vertical is named as such because of the way the prices are quoted on an option pricing board in a pit.  It doesn't explain things well to a beginner.  We'll be calling those strike spreads.  Similarly, we'll be talking about time spreads, not horizontal spreads.  Experienced option users will understand what we're talking about, and beginners should be less intimidated.

Why buy such expensive options?

1) Keep in mind that implied volatility is simply a plug value for pricing options.  There are no "rules" that implied volatility must follow any relationship across strikes, or relative to historical statistical or historical implied volatility.  I'll be publishing an article shortly about the probability distribution view of options prices.  This will start to lay out the way we will think about option pricing, implied probability from the options vs. our estimates of probability.  To illustrate this point in a framework implied volatility users are more familiar with, what is the right volatility skew across strikes to price a bi-modal outcome?  In yet another lingo, options on the fat tails are often too cheap, even if volatility is high.

2) Any option investment we make will be assuming you can hold the position until after the time event you're expecting, and the desirability of the investment is always
measured by expected return..our expected payoff if the option position is held to after that time period, divided by the cost of the investment.  Imagine you're the house in Las Vegas and you own a Roulette wheel.  Any one bet might have a small chance of paying out for you, but it's the average edge of the bets that matters in the long run.

 Keep the good discussions coming,

Philip Guziec
 

I first subscribed to M* mutual funds reports back in the early 1990s (or was it the late 80s?), and what I've always liked about M* is its ability to bring the latest scholarly ideas to the trading screen. That's what I see happening in M*'s options articles.

 
What I'd like to see are some citations and even links to articles that would provide greater understanding of where the ideas are coming from and where M* is trying to take readers.

I wonder about the wisdom of trying to change the industry's lingo, however. It's hard enough to keep it straight as we go from information source to information source and read articles outside of M*. WSJ style is to use the industry lingo, then add a short definition or explanation. For example, " When bond prices rise, interest rates on bonds fall." It's in almost every credit markets story and column.

If beginners don't learn the trade lingo, they'll be lost.

I also think it would be helpful to explain at the beginning of each trade the objective of the trade and how risks and returns will be measured. For example. Experienced option traders will recognize this trade as a "vertical spread." We see it as a way to lower the lower the price of entering a long-term position in a highly speculative stock. The chances this will work are 60%. The maximum risk is xx%, and you can cut your risks by taking your losses if the position loses 10% from your purchase price. If a long-term investment loses 10% from the purchase price, it should be abandoned in favor of other opportunities.