Q: During the course of your seminars you talk about the “risk free rate of return” and its impact on options when comparing them to stock, long calls and married puts…could you help me understand how the “risk free rate of return impacts the comparison?
A: Let’s take a look at a comparison between the Jan 2012 $60 call, and the Jan 2012 $60 married put.
The $60 call is trading at $6.00 X $6.50. You could probably get ‘in the spread’ with a limit order, but you probably won’t get it low as $6.00… maybe more like $6.20 or $6.30. With me so far?
The risk, then, will be that you could lose as much as $6.20ish.
Now let’s look at the married put. ESRX is trading at $53.15, and the Jan 2012 $60 puts are $12.20 X $12.60. Again, if you get in the spread, you may be able to pick up the put for $12.40 or so.
Now let’s do a little math:
| ESRX shares trading at $53.15 | |
|---|---|
| Plus Jan 2010 $60 puts | +$12.40 |
| Total Investment | $65.55 |
| Minus Strike price | -$60.00 |
| Total amount AT RISK | $ 5.55 |
See that? You’ll pay more for the married put than for the call, but the AT RISK amount is different. $5.55 versus $6.20 or so.
Here’s why that is significant: there are many, many self-proclaimed options gurus out there that say that a trading a long call is IDENTICAL to trading a married put… but the call is cheaper and therefore ‘more efficient’.
Hmmm… strange to say that two ‘identical’ things are the same but different… but I digress from correcting their math to correcting their English. Ahem.
The reason that there is a different dollar amount AT RISK is that the options’ pricing reflects what the rest of one’s capital is doing. The Black-Scholes equation ASSUMES that someone trading a long call HAS the capital to buy the stock; he just declines to do so. Instead, he buys a call AND..! This is important! He takes his remaining capital that WOULD be used to buy that stock and instead deposits it at interest.
Enter the risk free interest rate. The difference between the AT RISK amounts in the married put and the long call is what the same money could earn at risk free interest.
Here is where understanding the impact makes a difference: Position Sizing. If one has, say, about $10,000 of capital to trade and has a bullish expectation on a $45 stock, he may get 200 shares of XYZ plus 2 $50 put options and now his capital is spent. Of course, he can only lose the time value portion of the puts, which make his AT RISK picture pretty conservative, while retaining unlimited upside potential.
On the other hand, the temptation is to take that same bullish expectation, look at the pricing and leverage of long calls, and pick up twenty contracts because, after all.. that’s what we have the money to buy. It’s this human nature problem that gets folks into trouble: using the highly leveraged instrument that a long call is, without respect to the fact that it’s intended to be accompanied by a corresponding amount of capital that we DON’T put AT RISK.
Got it? The risk free interest rate affects pricing of these two instruments. Some will argue “but that can’t be… because in an efficient market, you can’t have that kind of disparity in pricing.” Yes you can. You COULD buy a married put, short the same month and strike calls, and make an ‘arbitrage’ profit… but in the end all you have done is solve Black-Scholes for the risk-free interest rate. The same result is attainable by buying T-bills.
Why do I advocate using married puts over long calls? Because position sizing is figured out FOR you… plus you have the opportunity to sell calls and spreads against that arrangement with a lower trading clearance.
About Kurt Frankenberg
I'm Kurt Frankenberg, and I have discovered how to truly put the odds on the side on the individual investor. It uses a principle that has been in front of our eyes all along, but is rarely used or understood. Other systems advocate treating the stock market like a business. My system really does.
I don’t understand your last paragraph – what do you mean by “sell calls and spreads against that arrangement with a lower trading clearance.”?
Hi Neville! Sorry about the late reply; I’ve been MUCHO busy helping out folks that got burned trading covered calls.
Here’s what I mean by “sell calls and spreads at a lower clearance”:
The vast majority of ‘civilians’
that trade options are only cleared to trade covered calls. Their experience level and broker’s policies don’t permit them – ironically – to do spread trades that are actually a lower risk than the covered calls.
Trading clearance is more a function of brokers trying to cover their own butts than actually allowing their clients to manage risk. If someone is relatively new to options, they might NOT have the clearance to sell a call against a call… much less sell a bear call spread against another call… even though this might be a very safe and lucrative play.
A trade set up RadioActively does not have this limitation. Even in a trading account that’s only cleared for long calls and puts and covered calls, here’s what’s possible:
You might buy the ESRX stock above and a far-out protective put. THEN, to reduce your cost basis on the stock you might sell a near term call, but at the same time pick up a near term long call. After all, you are cleared to buy long calls and puts, and sell covered calls. The short call is “covered” by the stock. The long put is part of your permissions. The long call is also part of your permissions.
Result? A hybrid of a calendar spread and ratio call spread… that a low trading clearance or stodgy broker would NEVER allow against a long call position… but even Scottrade will let you do against a married put.
In this case, if EXRX goes up or stay flat, the bear call spread that you have ‘legally’ put on will expire worthless, reducing the cost basis of your stock and bringing you another step toward bulletproof.
(‘BULLETPROOF’ is the term I use when your net cost basis for both the stock and the put are LOWER than the strike price of the put. You can’t lose but still have unlimited upside potential)
On the other hand, if ESRX goes up to the moon, your bear call spread will go against you, yes… but you also OWN the STOCK. So you are protected, can take income, AND still have unlimited upside potential.
Pretty cool? Yeah, I thought so. And you can do this just by owning stock and having Level 1 trading clearance, not even a margin account. That’s why I introduce married puts to so many people.
Happy Trading,
Kurt
At this moment I can buy Intel (INTC) plus a Jan 2012 $25 put with a net entry of $27.07 and net risk of $2.07, or I can buy the Jan 2012 $25 call for $1.51. Why risk an extra 56 cents? I suppose you would argue that repeatedly writing near-term bear-call spreads against it allows me to bulletproof it.
I see the advantage in an account with limited option-writing privileges, or for people who don’t have the discipline to size positions correctly. I think the benefit is less clear for accounts with full trading privileges, since there are so many ways to profit from selling premium rather than buying it.
Cameron,
GOOD QUESTION! Why risk the extra .56?
Well, the answer is that I wouldn’t. INTC happens to NOT be on the list of stocks that I would trade Radioactively.
You have discovered a stock that, because of the put/call ratio, favors the purchase of a call instead of a married put. That is, the pricing of the call vs. the AT RISK amount in a stock purchase plus the same strike put risks a greater amount.
The stocks that I play nearly always have the reverse situation: ESRX, for example, will allow me to pick up stock plus a Jan 2012 put with .50 LESS risk than if I bought a call at the same strike. This “puts” the edge in the hands of the married put holder more than the call buyer.
Since call prices for ESRX are inflated and INTC’s are not, I would filter out the INTC trade and be more likely to take the ESRX one. SHorting calls against ESRX will promise a higher premium and the protection will cost less. Better all around
Those other advantages you mentioned are still in place of course. For people that already own stock but are only cleared to trade covered calls and long calls and puts… the RadioActive style of protected trading fits like a hand in a glove.
Thanks for your comments!
Happy Trading,
Kurt Frankenberg
I notice on all of your videos, you don’t mention the villain of the Radioactive trade being time erosion of the protective put as it approaches expiration and no where did I see any methodology as to what to do with it…also, I take it that stocks with low betas are not a friend of the RadioActive method…I wonder what you look for in trade-able stocks using your method?
do you have an advisory letter or publish recommendations
We publish all of the trades that Kurt makes in a subscription service called FISSION. The subscription is available on the site… https://www.radioactivetrading.com/portorder.asp?pid=1
I did some research about the pricing differences between married puts and long calls. There are cases long calls are cheaper than married puts and vice versa. If you are trading large cap stocks or etfs, buying long calls is cheaper while if you are playing with growth stocks, married puts is better. I think risk free interest have some effect in options pricing that’s why long calls cost slightly more for the kind of stocks that Kurt trades(mainly growth stocks). Another factor that affects the pricing is dividend yield. Usually deep in the money married put is used as a strategy to capture dividend. Therefore the dividend is priced in to the puts. That’s why dividend paying stocks/etfs(mainly large cap) costs more if you trade radioactively.