While searching for an options topic that I thought might appeal to both newer and more experienced traders, I was looking for hypothetical trades. I thought I might include a profit-and-loss graph of the hypothetical trade, and we could talk about what the hypothetical trader hoped would happen next in that trade. How would the position reach profit? What combination of time, price movement or stability, or implied volatility movement or volatility would bring that profit? How much profit was even likely, no matter how much the expiration graph showed was possible?
I didn't want any preconceived ideas of what the stock's price would do, so I chose a less used vehicle than the typical stocks du jour such as AAPL. Here's the expiration profit-and-loss chart I chose.
I was going to tell you that this was a low-beta stock, with a beta of 0.39. So that the discussion didn't get too technical, I was going to say that a low beta means that the stock isn't too jumpy. Its price movement is usually rather sedate.
Moreover, I was going to say, the stock had a low short float of 2.95 percent. What does that mean and what does a short float have to do with our trades? The trade I showed above depended on the price staying within a certain range. If the short float is too high--if there are too many market participants shorting the stock--than any little movement upward could produce a short squeeze. Shorts might scramble to buy-to-cover their short positions and send price rapidly higher. Short squeezes are sometimes responsible for those rabid rallies we get. For comparison, homebuilder Lennar (LEN) had a short float of 20.91 percent as this article was first roughed out.
Then I was going to look at the price chart, to see where we thought prices might wander for KR and what our profit or loss would be if it wandered too far out of the expiration tent. The trade that produce that tent was a theoretical November all-put butterfly formed by selling 2 NOV 24 puts to form the body of the butterfly and then buying 1 each of the NOV 25 and NOV 23 puts to form the wings. It wasn't a trade I was suggesting. It wasn't a trade I tried. I have no idea what the best width for a KR butterfly would be. This was supposed to be like a cold call, a sight reading, if you will, for learning purposes.
Before I checked KR's price chart, however, I happened to look again at the option montage.
NOV Options Prices for KR:
This was the montage about 3:09 pm ET Friday, October 05, 2012. The setup includes columns for volume, open interest, bid and ask prices. Do you see what I see when you move just a strike or two away from the current KR price, which was 23.77?
No or low volume and open interest. Zero bids. What does this mean to the options trader? There is no liquidity in those options and not that much in the at-the-money ones, either. To employ a little hyperbole--but only a little--if you wanted to trade these options, you'd have to call a market maker or another trader from where that market maker or other trader was resting in a back room somewhere, and wait for that person to make his or her way back to the floor or the computer to trade with you. You'd pretty well have to give that other person whatever was asked when you needed to buy and you'd have to sell at whatever price was offered.
If you owned or were short KR stock and wanted to hedge against a movement one direction or another that you expected to take place after October expiration but before November expiration, there's a good reason to trade in these options. But for a month-after-month income trade that you might want or need to adjust, and in which some options strikes were either far out of the money or deep in the money? Maybe it's not quite as good a vehicle for that.
So there's our lesson, discovered along the way to another article that I thought I was writing. That trade was a butterfly, and our hypothetical trader obviously hoped that KR would stay in a tight range over the course of the trade or had some adjustments planned if it didn't. A look at the short float and the beta showed that maybe KR could be trusted to stay in a tight range, as much as traders can trust anything. However, that non-existent volume and open interest at anything more than a point away from the current price showed that the stock is a little too good at staying in a range. Everyone knows it's likely to stay in a range. There's no one piling into those options, no one for you to trade against.
You'd like to find a fairly sedate stock, but unless you intend to put these on and never adjust them and know that you might even have trouble selling them once you've bought them, this isn't the trade for you.