OptionSage submits:
When I travel around the country to teach options trading, I have the opportunity to chat with all sorts of students, from conservative investors to the trading gunslingers! When I introduce strategies that involve stock ownership, I am often asked: "Is there a way to use options in such a way that it effectively replaces stock ownership?" Indeed there is – though there are some ‘gotchas’ to be aware of!
Stocks vs. Long Calls
As a novice options trader, one of the easiest landmines to fall into is to believe that long calls move in the same manner as stocks i.e. as a stock rises $1 so too does a long call increase in value by a $1. In fact, most long call options purchased do NOT move dollar for dollar as a stock rises.
Most options purchased in fact tend to be at-the-money (stock price equal to strike price) or out-of-the-money (stock price < strike price for call options). As a stock moves up $1, a long call at-the-money might initially increase in value by $0.50 (perhaps more if it is further out in time). Another feature to be aware of is that options at-the-money tend to have higher extrinsic value than options in-the-money or out-of-the-money. This becomes a really important factor when considering the similarities and disparities between stocks and options.
For example, if you had a stock and sold call options at-the-money you would still be profitable if the stock gapped up unexpectedly and your short calls were assigned – you always get to keep short call premium upon assignment. However, if instead you had a long call (longer term, say 6 months) covering your shorter term short call as part of a calendar trade, the massive rise in the stock could actually cause the trade to appear as a loss initially.
The reason for this is that the purchase of the long call involves the purchase of comparably more extrinsic value than is received through the sale of the short call. As the stock gaps up, both options are deep in-the-money (and most of the value of each option is intrinsic value). Since each option has the same intrinsic value and, assuming the gap is big enough, the extrinsic value of each option is negligible, the long call will not be making as much as the short call is losing.
How can we avoid paying maximum extrinsic value and still largely simulate stock ownership?
Long Calls In-The-Money
One approach we could take is to place the long call options in-the-money. The further in-the-money the long call option, the higher its delta value. The delta simply tells us how much the option moves as the stock moves. So, the more in-the-money the long call option, the higher the delta and hence the more closely it simulates a stock position.
Since the long call option is cheaper than the stock, the % return on investment is higher holding the long call when compared to simply holding the stock position as the stock rises. However, the flipside is obviously that as the stock drops, the losses are also magnified. The danger then is that if our timing is not perfect and the stock continues to drop all the way through to expiration, we never have an opportunity to recover losses and ultimately get back to profitability as the stock cycles back bullish again – unlike a stock position where we could remain patient through the bearish phase.
How do we benefit from the option simulating stock ownership while minimizing our risk in the event that the stock unexpectedly drops lower?
Calendar Strangle
One of the stocks Phil and I were discussing recently was Google. Google is a very expensive stock (at $483 per share) for most people so we were chatting about various ways of taking advantage of what we believed were strong fundamentals without using tens of thousands of dollars to do so!
As Cramer mentioned mid-week, Google has 63% sales growth and 33% operating margin while fellow Internet company, Amazon.com has 33% sales growth and a 4.8% operating margin. According to Yahoo Finance, Google trades at a forward P/E of 26 and a trailing P/E of 43 while Amazon trades at a forward P/E of 54 and a trailing P/E of 115. I like that Cramer concluded that Google was “half as cheap” rather than “half as expensive” as Amazon; obviously inferring Amazon too was worth owning! If we buy into this bullish premise, how can we take advantage of Google WITHOUT purchasing the stock?
One possibility is to purchase a long call far in-the-money while protecting much of the intrinsic value through long put options at-the-money.
For example, if we bought into the long-term bullish thesis on Google we might be willing to go out to Jan '09 and buy long call options in-the-money rather than stock. My preference when I purchase such options is to buy options with a delta of at least 0.80 – as the stock rises $1, the long call initially rises $0.80 and this increases the more the stock continues to rise. Based on current option chain figures that leads me to the strike 410 options in Jan '09 costing approximately $132. Admittedly it is expensive but it is still just about one quarter of what it would cost me to buy the stock!
The intrinsic value on this option is the difference between the stock price and the strike price ($483 – $410), $73. The extrinsic value is any value the option has over and above the extrinsic value ($132 – $73), $59. This is good to know because each and every month we would not typically just rely on the stock rising to make money but we would be proactively selling calls against the long calls to reduce risk.
Holding the calls alone would make me quite uncomfortable though – the puts out in January '09 $480 calls cost approximately $50. That’s great to know too because, once I have those in play I could, in fact, start selling shorter-term puts against my long puts while also selling short calls against my long calls.
And what is the risk in this trade? Well, I know that the long puts protect the long calls below $480. So in fact, the risk can be calculated as:
In-the-money Calendar Strangle Risk = Long Call Option Value + Long Put Option Value – Difference in Strike Prices
In-the-money Calendar Strangle Risk = $132 + $50 – ($480-$410) = $112.
This is obviously significantly less than the $483 that would be at risk if the stock were held alone. Plus the new trade has protection built-in, in the form of long puts as a hedge against long calls.
At this point we can look at short options and ask ourselves, “Is it possible to produce $112 of short option premium over the next 18 months to produce a virtually risk-free trade?” That translates to selling shorter-term options for an average of just $6 per month! With some savvy market timing, dedication and due diligence in addition to reliance on the fundamentals winning out in the end, the trade has the potential to be a real winner! Our risk is reduced with each and every month's gain and the cost basis is significantly lower than that of purchasing stock alone.
Perhaps you wouldn't consider this trade if you had to tie up $48,552 in 100 shares of stock plus another $5,000 for a protective put so you could sell perhaps calls like the July $500s for $13.25, netting $1,325 on your $53,552 investment less your time decay on the put (if all goes well). While the 2.4%, return should look sexy enough when annualized by itself, cutting your capital in play down to $18,180 simultaneously boosts that same return to an almost irresistible 7.3% for the period, although there is, of course, more upside risk as you don't actually own the stock and must settle with your caller if it breaks over $500 while taking a hit on your protective put.
To summarize, the trade we will initiate here is to buy the GOOG Jan '09 $410s for $131.80, since 1 contract costs $13,180, it is difficult to enter this trade slowly! Phil is going to take the call first and wait for a test of $490 to buy the $480 puts, now $49.95, but we're not expecting much of a discount as they are already trading at their month lows. Once we leg into the other end of this spread, we will follow up with the calls we finally decide to sell. Phil's caveat: Google must be holding $480 and the market must be positive for him to enter the leaps.
Trade Safely & Have A Great Week!
OptionSage
