Investing in stocks? Try options instead!

Friday, 9 January 2009 07:36 by The Lunatic

When people think about trading options, their first response is usually "too much risk". While it's true that options can be misused, they are often used to REDUCE risk by hedging other investments.  For example, buying a stock and selling a "covered call" is a substantially more conservative investment than just investing in the stock itself (less risk, but also potentially lower return).

And yes, I have learned the hard way what can happen if you lose your head.  After about ten years of successfully and profitably trading options, I entered into an overly aggressive position in 2006 that went south - and pretty much wiped out my entire gains of the previous ten years.  Lesson learned: stick to your strategy and stay within your limits!

But in general, even with that painful experience, I am still a firm believer that trading options is more prudent than buying stocks.

Admittedly, options are far more complicated.  With stocks, you have pretty much four choices - you can buy a stock, you can buy a stock on margin, you can short a stock, and you can short a stock on margin.  With options, you can buy Calls or Puts, sell Calls or Puts, all at different strike prices and different expiration dates. And there are literally THOUSANDS of combinations that make up bear spreads, bull spreads, calendar spreads, butterflies. It's mind boggling!

Additionally, you need to learn new concepts like "implied volatility" and figure out "the Greeks" (primarily Delta and Gamma - two measures of how an option position changes in value with respect to the underlying stock).

Among all these choices, there are two strategies that are a "replacement" for simply buying (or shorting) shares of stock. These two strategies are superior in every way to a straight stock purchase - EXCEPT if you are buying a stock specifically to get a dividend payout.  Option positions do not receive dividends.

The first strategy is buying "deep in the money" LEAP's. LEAP stands for "Long Term Equity Appreciation Position" - but it's really just an option that has a longer term than the 3 month expiration cycle that normal options are on. LEAP's expire in January of every year, and you can usually buy them with expiration dates as far out as three years. What I like about this strategy is that you have all the upside of buying the stock (the value of your position goes up almost dollar for dollar with the stock) but you have MUCH less downside risk if the stock tanks.

Here's how it works.  Let's say you were going to spend $50,000 to purchase 500 shares of some company at $100 per share. 

Instead, you can purchase 5 option lots (each lot represents 100 shares - so it's the same as 500 shares) of a LEAP that expires in two years with a strike price of $60, which will typically be priced at about $50 per share (I usually look for positions that have a delta of about .8 to decide what strike price to buy, but you don't need to worry about that for now) - so you spend $25,000 and put the other $25,000 safely in the bank.

If the stock price goes up, the value of the option will only go up 80% of the value increase at first (because of the .8 Delta) - but this will accelerate and get very close to 100% the further away the stock price gets from the strike price (this is because of the Gamma).  Once the stock price goes past around $125, the Delta will be 1 and the option will move up dollar for dollar with the stock.

If the stock goes down, the inverse happens - the value of the LEAP only goes down eighty cents for every dollar that the stock goes down - and this decelerates. So if the stock keeps going down, the LEAP will only go down 60%, then 50%, etc, as you get closer to the strike price.  So if the stock drops to $50 per share, your position is worth much more than $12,500 (depending on how much time there is left to expiration). Add this to your $25,000 cash in the bank and you'll see that the net of your investment does not go down by 50% when the stock price drops in half.

And if the stock does an Enron on you, and goes to zero, you still have half your money available since you only spent $25,000! If you had bought the stock outright, you would be wiped out. If you had bought the stock on margin, you would be $50,000 in debt and in need of a loan to pay your margin call.

The only disadvantage of this strategy is that you will be subject to a small decline in the "time value" of the premium if the stock doesn't go anywhere. Since you purchase the option so far "in the money", you are not paying for much of a premium at all - but you will lose a few percent per year if the stock stays around $100 per share and doesn't go up or down. It's a very small price to pay for the lower risk, and you can even mitigate this somewhat by rolling the position out to a longer expiration date when you get within six months of the current expiration date.

The second strategy is a little more complicated - it's called a "Synthetic Long" position. This is a very powerful concept, and you can change your leverage with some minor tweaks ... which DOES have the potential to be abused if you're not a disciplined investor. But without the "tweaks" it's the equivalent of buying the stock outright.

What you do is buy an "at the money" Call option, and pay for it by selling an equivalent Put option (same strike price and expiration date). This combination will go up and down, dollar for dollar, along with the stock. What's more, since you're selling the same amount of time value (with the Put option) as you are buying (with the Call option), you aren't even subject to time decay - so it really doesn't cost you anything!  Note that you do have a federally mandated equity requirement for the "naked" Puts, which means you do need to have about 20% of the total value in cash in your account. You still earn interest on this cash, it's just kept in reserve so you can't spend or withdraw it.

So for our example above, instead of buying the stock for $50,000 you will buy 5 lots of Call options for around $22 (assuming a one year position, and the price will vary depending on the Implied Volatility) and you simultaneously SELL 5 lots of Put options, again for $22 per share.  Your net price: zero. Keep your $50,000 in the bank and earn a few percent interest on it, which will pay for your broker commissions.

When I said that this has the potential to be abused - it's mostly because people will think "Wow, I only need to have 20% in equity - so I can really buy 5 times as much!"

DON'T DO THIS!  Only acquire the number of shares you can afford to buy if you were going to buy the stock - or if you tend to be a more aggressive investor, buy what you would have bought on margin (so you purchase the equivalent of $100,000 worth of stock). Any more is the equivalent of buying on 20% margin, and you could be completely wiped out with a small drop in price. Just don't do it!

The inverse of the Synthetic Long is the equivalent to shorting a stock, and it's called a "Synthetic Short". In this case, you BUY the Put option and pay for it by SELLING the Call. Remember when the SEC put the limitations on shorting financial institutions last fall?  Professional investors just switched to Synthetic Shorts and they were back in business.

I had mentioned a few "tweaks" you can do with this strategy. For starters, you can offset your strike prices by $5 or $10. So, for example, with the Synthetic Long, instead of buying strike $100 Calls and selling strike $100 Puts, you can buy strike $95 Calls and sell strike $105 Puts. Your net outlay is still zero (the Calls and Puts will be roughly the same cost), but the position will go up and down $2 for every $1 that the stock moves, within the range of $95 to $105. Above or below that, you are back to moving dollar for dollar. This is a good strategy if you really expect a small upward move, but you don't want to expose yourself to undue downside risk.

With both of these strategies (deep in the money LEAP's and Synthetic Longs) you can even sell "covered calls" against them, just like you could with a stock.  Again, this makes the entire position more conservative - reducing your risk but also reducing your potential gains.

If you're interested in learning more about trading options, I would recommend that you start with the book Options as a Strategic Investment by Lawrence McMillan. This is a good "nuts and bolts" tutorial that starts at a very basic level and guides you all the way through the complex stuff.

Categories:   Economics
Actions:   E-mail | Permalink | Comments (1) | Comment RSSRSS comment feed

Comments (1) -

May 6. 2011 23:56

Trading in options isn't something which I have considered of late, so I need to go back through how it works, as I am fed up missing out on shares dropping in value.


Add comment