Over the last couple of months, I've written two segments on
options trading for Cabot Wealth Advisory.
In my first article
, I discussed the basic strategies of buying a call and buying a
put, and how to write options and collect the premiums.
, I wrote about using a put-writing strategy to "name your own
price for stocks."
Today, I'm going to show you how you can use options as
investment vehicles rather than trading vehicles.
So far I've only written about short-term trading strategies, but
there are also long-term options. You have probably heard the
term LEAPS mentioned when discussing investment ideas and
philosophies. The term LEAPS is an acronym that stands for
Long-term Equity AnticiPation Securities. As the name implies,
these are options that expire in a year or more.
LEAPS work in the same way other publicly traded options work. If
you think a stock is going up, you want to buy a LEAPS Call. If
you think it is going down, you want to buy a LEAPS Put. Like
short-term options, LEAPS have expiration dates, they're just
further in the future than average options.
As with any option-buying strategy, LEAPS have numerous strike
prices from which to choose. You can be aggressive and buy
out-of-the-money options or you can be more conservative and buy
in-the-money options. The principle is the same with LEAPS as it
is with all options: The deeper in-the-money an option is, the
more conservative it is. The more out-of-the-money an option is
it is, the riskier the trade.
In options trading, there are a number of risk measures, price
change measures and so forth where the terminology is expressed
with letters of the Greek alphabet. I won't go through all of
these with you today, but I do want to explain the term "delta"
to you and how it applies to buying deep in-the-money options.
The delta of an option expresses how much the price of an option
will change based on the change in the price of the underlying
stock. For instance, if the delta of a call option is 1.0 and the
underlying stock goes up $1.00, the option should go up by $1.00
as well. The higher the delta, the more closely the price of the
option will track the price of the stock. The delta works in both
directions (up or down) and applies to both puts and calls.
Let's look at a real world example. If you are bullish on
Merck Pharmaceuticals (
and think it is going to move higher for the next few years, you
have two choices: buy the shares or buy a LEAPS, in this example,
let's use the January 2013 Call. The strike prices available in
the 2013 LEAPS are $25, $30, $35 and $40. With the stock
currently trading around 32 the 25 strike is the most
conservative option and the 40 strike is the most risky.
To buy 100 shares of MRK will cost $3.285. The current price of
the January 2013 25 strike Call is $8.20. Remember that because
the option represents 100 shares, it will actually cost $820. The
delta on this option is 0.74, so you can expect the option price
to change $0.74 for every dollar the price of the stock changes.
Should MRK shares rise to the recent high of 37.50, the gain on
the stock would be $4.65 per share. By buying the shares, you
would make $465 on a $3,285 investment for a percentage gain of
But if MRK shares rise to 37.50 per share, the option would move
up 3.44 (the delta of 0.74 times the $4.65 move in the stock). By
buying the option, you would gain $344 on an $820 investment for
a percentage gain of almost 42%.
As with all forms of leverage, it applies to both sides. Should
MRK drop to $30 over the next few months, an investment in 100
shares would be down $285. Applying the delta calculation to the
options, you would theoretically lose $210.90 (0.74 times $285).
The loss on the stock would be 8.7%, while the loss on the option
would be 25.7%.
In both instances-when the stock goes up and when the stock goes
down-the percentage gains and the percentage losses are greater
with options than they are with the stock. However in both
instances, your total investment amount, total dollar gain and
total dollar loss, are lower with the option trade than they are
with the stock trade.
Bottom line: Options give you the chance to participate in an
upward move in a stock with a smaller cash outlay, a lower total
dollar loss if you are wrong and a smaller total dollar gain if
you are right.
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I think walking you through how I decided to treat a recent trade
will serve as a good example.
In my personal IRA, I buy Exchange Traded Funds (
) or options on ETFs. I received a recent bullish signal on the
Wisdom Tree India Earnings Fund (
, this ETF attempts to replicate the performance of the Wisdom
Tree India Earnings Index by investing in the same stocks that
are in the index. India has one of the fastest growing economies
in the world, growing at a rate of 8.9% per year. But, despite
the growing economy, EPI is down almost 20% in the last three
This is the type of long-term investment opportunity I look for
in my IRA. The fundamentals of the Indian economy look strong and
the recent selloff presents a buying opportunity. I can buy the
shares of the EPI for 23.19. The EPI doesn't offer LEAPS, but
there are October options available on the ETF. Right now the
October 19 strike Calls cost $5.90 ($590). The delta on this
option is 0.93.
So my choices were to buy 100 shares of the stock for $2,319, or
buy one October 19 strike Call for $590. In this instance, I
actually went with the shares of the ETF because I don't like the
fact that almost 33% of the option's price is time premium and I
wanted to buy more time than eight months. If there were LEAPS
available or if the premiums had been down around the
$5.00-level, I would probably have gone with the options. In
instances like this, is to best to weigh both choices.
For Cabot Wealth Advisory
P.S. Leverage your investments to make money in all markets!
Cabot Options Trader Editor Rick Pendergraft uses the market's
volatility to bring his subscribers huge profit-making
opportunities. Just check out these gains from the last three
months: a 128% gain on Maxim Integrated Products Call in 15 days
… a 70% gain on a Linear Technology Call in only 11 days … and a
164% gain on a Cisco Put in ONE day!