Fischer Black
on
OPTIONS
Vol. 1, No.3
March 8, 1976
THE LONG AND THE SHORT OF OPTIONS TRADING
Suppose that you have a way to tell when a call option is overpriced
and when it is underpriced. How can you use that information? Depending
on who you are, you may use it to decide between buying the
stock or buying the option; to decide between s~lling the stock short
and writing the option naked; to write a covered option, or buy the
option and sell the stock short; to set up a neutral hedge by mixing
a long position in stock with the right short position in options, or
the reverse; or to spread, mixing long and short positions in options
on the same stock. When puts start trading, the number of strategies
will multiply further.
Of course, it's possible that transaction costs will make all of these
strategies unprofitable. If your transaction costs for getting into
a position and back out again exceed the amount by which the position
is mispriced, then it won't make sense to get into the position. Some
transaction costs, such as brokerage fees or clearing charges, are
obvious. Othemare hidden: the cost to a market maker of executing
his own trade; the cost to a customer of keeping margin money with his
broker in cash; or the cost to an exchange member of a possible gradual
decline in the value of his seat.
On the other hand, tax factors can make a position attractive even if
options seem correctly priced when tax factors are ignored. A high
tax bracket investor may be able to set up a system fer converting
capital losses into ordinary losses, or for converting ordinary income
into capital gains. He may even be able to set up a position where he
is guaranteed a profit when tax factors are counted.
Fischer Black on OPTIONS Page 2
Further, some kinds of positions involving options are attractive to
some investors even when there is no expected extra profit either
before taxes or after taxes. For example, an investor may want to
limit his possible losses by investing part of his money in bonds and
part in options, as a substitute for investing all of it in stock. Or
he may want to maximize his possible gains by investing all of his money
in options as a substitute for investing all of his money in stock.
These strategies will make sense to some investors even if options
are always correctly priced.
Option Portfolios
One way to take advantage of mispriced options is to construct a portfolio
of long positions in underpriced options and short positions in
overpriced options. The best portfolios are likely to involve long
positions in options on one set of stocks, and short positions in
options on an entirely different set of stocks. Spreads, involving
options on the same stock, are likely to have more limited profits
because more people are looking for profit opportunities in spreads
than are looking for profit ~pportunities between options on different
stocks.
In a spread, the way to reduce risk as much as possible is to keep the
right ratio of long position to short position. In a portfolio of options,
the way to reduce risk is to have a well diversified portfoliO.
This means not having too much exposure in anyone position. To some
extent, an investor will want to put more money into the most attractive
positions tnan he puts into positions that arE only moderately attr~ctive.
But he should keep this tendency under strict control. A position
may look very attractive because the market has information that
he doesn't have. If that's the case, keeping the position small will
mean he can be a small sucker, but not a big sucker. One big loss on
a big position can wipe out lots of small profits.
Fischer Black on OPTIONS Page 3
It's possible in a diversified portfolio of options to have the short
positions just about balance out the long positions. But that's probably
not a good idea, especially if the investor has most of his money
in this portfolio and doesn't have strong feelings about where the market
is headed. The market heads up more often than it heads do~'n, so
most investors will want net long positions, on aver,age, rather than
neutral or net short positions.
To tell how well diversified a portfolio of options is, it's not enough
just to look at the amount of money in each position. $1000 in out-ofthe-
money options normally amounts to a bigger position that $1000 in
at-the-money options. So both the size and the volatility of a position
count in figuring how much it makes up of the total portfolio.
To keep the portfolio diversified, positions that grow in size should
be cut back. An options portfolio that starts out diversified can very
quickly become undiversified. The money freed up can be used to increase
positions that have become small but are still attractive. When an option
becomes correctly priced, the position is no longer attractive and
should be closed out.
We shouldn't forget two other reasons for closing out a position. First,
the writer of an in-the-money option may close out his position when
the option approaches parity, to reduce the chance that he will be assigned
an exercise notice. And second, a taxable investor may close
out a position to realize a loss (or a gain) in the current taxable year.
Bettlng Uu Stock Moves
Another way to use options is in the context of a strategy that involves
forecasting which way a stock is going to move and taking a position
based on the forecast.
Fischer Black on OPTIONS Page 4
If you think a stock is going to go up, you can take a long position
in the stock, or you can take a long position in one or more of its
options. If the options ale overpriced, you may want to choose the
stock. If the options are underpriced, you may want to choose the
options.
However, there are other factors to consider, too. If you would like
a large position, and can't borrow as much as you would like at reasonable
rates, you may buy options even if they are overpriced to some
extent. If the transaction costs on an option position are lower than
they are for an equivalent stock position, that may help offset some
overpricing of the options.
Also, you may prefer the pattern of returns you get with options to the
pattern you get with an equivalent stock position. If an option moves
$0.50 for each $1.00 move in the stock (in the short run), then buying
two option contracts will be "equivalent" to buying one round lot of
stock. But you'll pay less for the options than you will for the equivalent
stock position, so your possible losses will be less with the
options than with the stock.
If there were no transaction costs or dividends or taxes, buying an inthe-
money call option selling at parity would always be better than buying
the stock. Your gains would be the same as on the stock and your
losses would be limited. In fact, though, the stock may be better, especially
if you want a long term position. An in-the-money call option
will expire, or you may decide to sell it or exercise it early because
of a dividend on the stock. To regain your position, you'll have to
buy another option or buy the stock. This involves transaction costs,
and may force you to realize capital gains that you would rather not
realize. And the dividends hurt even if they don't cause you to close
your position early. They reduce the advantage that in-the-money call
options at parity may have over stock.
Fischer Black on OPTIONS Page 5
On the other hand, if you think a stock is going to go down, you can
take a short position in the stock, or you can write naked options.
If the option is overpriced, you may want to write the options; while
if the option is underpriced, you may want to short the stock.
However, the other factors to cons ider are probably ,even more important
here than with long positions. As with long positions, transaction
costs may be higher on the stock or higher on the options. Tax
factors will be very important, since writing naked options gives ordinary
income or loss, while shorting stock gives short term capital
gains or losses. For a high bracket investor, these tax differences
generally favor writing options.
There are penalties to short positions that don't exist with long positions.
To sell a stock short, you have to borrow the stock, and the
lender usually insists on cash collateral on which he pays little or no
interest. The broker may also ask for margin in cash, and he normally
won't pay interest on cash balances. If the lender of the stock wants
it back, there may be costs in finding another lender.
To sell options short, you don't have to borrow the options from anyone,
so you don't have to put up cash collateral, and you don't have to
worry about the lender wanting them back. You may have to put up cash
margin that doesn't pay interest though. And if you receive an exercise
notice, you will have to incur the cost of buying the stock to
deliver, plus you may lose some tax benefits that you expected to get.
How all of these factors will come together will depend on the individual
trader. Ny g"C:3S would be, though, that if you avoid options where early
exercise is likely, shorting options will generally be better than shorting
stock.
(TO BE CONTINUED)
If you have any questions or comments, please call me at 617-253-6691, or
write me at 50 M8morial Drive, Cambridge, MA 02139