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A Simple Strategy to Make Money
Last week we veered into the world of options. It wasn’t too intimidating was it!? This week, I’m going to explain a strategy that anyone can do in order to gain a bit more leverage than merely buying or shorting a stock.
Advantages of Trading Options
Options provide us with flexibility in that we can make money when stocks are going up, down or sideways. Here are the main advantages of trading options:
Control more assets for less money
Consider the implications of this and it becomes obvious how phenomenal this single characteristic of traded options is. Here’s the way it works for equity options: One option contract represents 100 shares of stock, and is only a fraction of the cost of what you’d pay for the equivalent number of shares.
For example, a stock is priced at $28.40 on 09 October, 2011.
A call option to buy shares might be priced at 2.80. Because one contract represents 100 shares, you can buy one call contract for $280.00 [100 X 2.80]. The alternative would be to buy 100 shares of the stock for a total sum of $2,840. So, in this example, you can buy calls options for around 10% of the stock price in order to control $2,840 of a stock until the appropriate expiration date of the option.
Call options are always cheaper than the underlying asset, and put options usually are, too. Options are often more volatile than their underlying instruments, therefore traders get ‘more bang for their buck’ or more action. Clearly this can also be perceived as being riskier, but in the right hands, it can also be safer and more conservative. Options will give you far greater flexibility in your trading and even give you the ability to make profit when you don’t know the direction in which the stock will move.
What is Leverage?
When we calculate a return on an investment, the numerator is the numerical return and the denominator is the amount invested. If the amount invested is lower, then our percentage return will rise.
Because our cost basis is proportionately lower with options (as witnessed above), the position becomes much more sensitive to the underlying stock’s price movements, so our percentage returns can be so much greater.
For example, let’s say that a stock rises from $28.40 to $32.40. This is a rise of $4 or just over 14%. But, the corresponding call option premium rises from 2.80 to 5.60.
Do you see how a mere 14% move in the stock has helped to cause a 100% rise in the option premium? That’s leverage! Now of course, leverage can affect us both ways, either in our favor or against us. It’s our job to take the right decisions so that leverage works for us.
Trade for income
We can structure options strategies specifically for the purpose of generating income on a regular basis. As far as I’m aware, options are the only financial instrument that we can use for this.
Profit from declining stocks
One of the most important trades you’ll ever make is when you profit from a stock that has fallen in price. If you only ever consider buying stocks then you’re bound to be looking at the stock market with an upward bias. Your analysis is therefore compromised by your desire to only see reasons for a stock to rise. Once you start making money from declining stocks as well, then you can simply look at the markets as a mechanism for making money, without a predetermined bias.
With options, we can trade puts and calls to ensure we can make money if the stock goes up, down or sideways, giving us ultimate flexibility. Even investors with wide-ranging equity portfolios can efficiently implement protective measures in the event of a severe market downturn.
Profit from volatility and protect against other factors
Different options strategies protect us or enable us to benefit from factors such as time decay, volatility or lack of volatility, etc.
Reduce or eliminate risk
Options allow you to substantially reduce your risk of trading, and in certain rare cases, you can even eliminate risk altogether, but with the trade-off of very limited profit potential.
So, with all the different benefits of options, why would traders not be curious to learn more about them? Well, for a start, options are reasonably complex instruments. Once you’re over that hurdle, however, they become more and more fascinating.
Options give traders added flexibility, potentially much greater gains for a given movement in the stock price, and protection against risk. On the flip side, used in the wrong way, options can lead traders to serious losses.
A Simple Option Strategy
So let’s say we like a stock that is trending up, forming a bull flag or about to break through a significant resistance area.
To take advantage of this in the simplest terms we would look to buy a call option.
An equity call option is defined as the right, not the obligation, to buy a share at a fixed price before a predetermined date.
There are two components to an option premium:
- Intrinsic Value
- Time Value
Intrinsic Value is the amount by which the option is “in-the-money.” For calls, Intrinsic Value is defined as:
- Intrinsic Value = [stock price – strike price]
Time Value can be calculated simply from:
- Time Value = [option premium – Intrinsic Value]
- Option Premium = [Intrinsic Value + Time Value]
Intrinsic Value is simple as you can see. Time Value is altogether more murky! It took two mathematicians in the 1970s to devise a formula that is widely used to calculate Time Value using factors such as time to expiration, strike price, underlying stock price, volatility, interest rates, etc.
From the components that go into the time value equations, volatility is the only one that isn’t certain. In reality, the “implied volatility” component of an option premium is actually decided upon by the market makers. This means that option premiums made up mainly from Time Value can be heavily manipulated.
The Secret to Simplicity
The more an option is In-the-Money, the greater the percentage of Intrinsic Value its premium will contain compared with Time Value. As mentioned, Time Value is subject to the vagaries of market makers adjusting the premiums.
So the secret to simplicity here is to buy an option that is “Deep” In-the-Money (ITM). The effect of this is that the option premium may only be made up from 10% Time Value, and 90% Intrinsic Value. Intrinsic Value cannot be manipulated.
A Deep ITM option can still give us 2-3 times leverage compared with just owning the stock, and for every dollar the stock rises, our Deep ITM call option will also rise dollar for dollar.
The other advantage of buying a Deep ITM option is that we can buy less time because the effect of the option’s expiration will only affect the Time Value portion of the option premium, and with Deep ITM options that is minimal portion of the option premium.
So let’s take an example:
Let’s say we have a stock at $50.00.
The 50 strike call options will be made up exclusively of Time Value – remember the formula for call Intrinsic Value is [stock price – strike price].
So, for Deep ITM options, in the case of calls we have to go for lower strike prices.
What we’re looking for is where the premium we’re paying will contain no more than 15% Time Value.
For example, the stock is $50, and we have a 40 strike call at 11.50:
Intrinsic Value = 50 – 40 = 10
Time Value = 11.50 – 10 = 1.50
Time Value Percentage: 1.50 / 11.50 = 13%.
This call is deep ITM enough for our purposes.
Now let’s consider the leverage:
If the stock rises from $50 to $55, this represents a 10% uplift.
Even with the effects of slippage and wide bid/ask spreads our Deep ITM option may rise around $4.00, bringing the premium to 15.50. This is a rise of around 35%, more than three times more than the stock increase.
So even with Deep ITM options we have plenty of leverage, and we’re not nearly as vulnerable to the murky forces of Time Value and volatility manipulation.
Remember, always Plan your Trade and Trade your Plan!