The Easy Option – Example BOBJ

Options Sage Submits:

Although many of our members have been trading for years and are highly sophisticated, this educational segment will build from the foundation levels recognizing that some of our members are relatively new to the options game and, while it's all quite simple when you know how – you do need to know how!  There is nowhere better to begin then with the "easy option" – the long call!

The long call option is probably the best understood of all the options because in many ways it is so analogous to stock ownership.  When we buy a stock and it rises we can sell the stock and profit. When we buy a long call and the stock rises, we can sell the call and profit too!  

Here at Phil's Stock World we tend (OK, not tend, almost always) to use options as leverage on positions.  While options are inherently risky, they do provide the advantage of allowing the average investor to be able to diversify his/her virtual portfolio across a large number of positions, limiting the capital at risk in each one (when applied with good money management techniques!).

Let's take a look a BOBJ, a stocks Phil likes for Monday.  The company has beaten estimates each of the last 4 quarters, the last by 20%, and is expected to report a strong Q4 on Tuesday (.56 vs .42 last year).  The underlying strength in Business Objects can be seen in that they have no debt and have thrown $160M of cash into the bank this year alone leaving them with $518M as of last quarter so the current p/e of 49 is deceiving on this $3.6B company.

At $38.70 they are trading well off  last year's high of $43 and 25 out of 41 analysts tracking the stock don't like it.  That plus the fact that there's been a rumor that ORCL is interested in buying them, which may have irrationally pumped up the price and the fact that the stock dropped like a rock to 19 in July on an earnings warning, makes us a little nervous about making a full commitment and buying the stock.

Here's how we can play the earnings:  :  We could take $4,000 – the most we are willing to tie up in an earnings play – of our hard earned money and tie it up in 100 (about) shares of BOBJ.  We like the stock and hope it will break over it's 5-year high at $44 but that would be a 15% move.  Realistically, let's set a goal of making 10% ($400) by holding it for 3 months.  Investors business daily counsels us to set a stop at an 8% loss but we are daredevils and are willing to risk $400 on our position so we would set a 10% stop.

However, we know this is earnings and anything could happen!  The stock could gap down past our 10% stop limit and since we have $4,000 on the table, we are at risk of losing more than our stated $400!! So let’s look at buying a long call instead.  With just $660 (only a bit more than the total capital we are willing to risk), we can purchase 4 March $40 option contracts at $165 each.  This allows us to take the other $3,340 we were willing to tie up for those 45 days and either purchase some other (hopefully diversified) positions, or simply keep it in an interest bearing account and at least be assured a 5% annual return on 80% of the capital we were willing to risk.

It is important to note here that Phil does not like an uncovered earnings play on this particular stock and would rather buy 4 April $40s for $860 and sell 4 Feb $40s for $400, automatically limiting the risk to $460 although capping the upside somewhat.  His strategy allows you to keep 90% of the money you were willing to tie up in the bank and, if earning 5% interest, this means your maximum loss for the year on this play would be 5.5% – assuming, of course, you were sensible enough to stop gambling and leave the rest in the bank after taking a beating on 5% of your capital!

As we are discussing basic strategies though, let's stick with the very basic March calls:

As we are buying the March call at a $40 strike and an ask price of $1.65. If the stock moves up $2, that long call is unlikely to increase $2.  The amount the option changes by is determined by the delta. The delta tells us the change in the price of the option for a one point move in the underlying stock. 

There is also a volatility premium that is built into the pre-earnings price, hence Phil's often stated rule: "Always sell into the initial excitement" as that premium quickly disappears once the news comes out.

The delta on this option is 0.45 – the long call changes in price by $.45 as the stock moves $1. [In practice if we already own an option we could simply click on the option symbol in our brokerage account and the delta can be easily identified].  Keep in mind our goal is to make $400, so we are hoping for about a $2.20 positive move in the stock price.

It's worth noting that the deltas vary at different strike prices. For example, the delta of an in-the-money option is higher than that of an at-the-money option which in turn is higher than that an out-of-the-money option.  This is quite intuitive when we realize that a trader who purchases an option in-the-money is taking higher risk than a trader who purchases an option at-the-money or out-of-the-money and so they are rewarded accordingly to a greater extent if they are correct.

This is also to our advantage on this trade as our call quickly goes in the money on a $2.20 gain but is already out of the money and will not lose value as fast should there be a $2.20 loss (delta to the downside is just 0.45 but decreases as the stock falls).  That means that our stop at .65 (a $400 loss) should afford us at least $2.50 of downside protection.

It is also worth noting that standard volatility models used across most option classes are generalized and, therefore flawed.  Some of our more advanced members may wish to take a look at Alan Lewis' book: "Option Valuation Under Stochastic Volatility", a fairly hard-core mathematician's thesis on volatility that will have you thinking differently about many derivative issues.

We will track this trade closely this week and you can use it as a practical example while going through our members' education section.  As we progress through the education segment we'll refer back to the delta phenomenon and we'll likely use it as a basis for explaining why Phil is not a big fan of some spread trades like bull calls/bear puts – more to come on that later!

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