Tag Archives | stock replacement

The Truth About Stock: It’s a Call Option with a Zero Strike Price

Originally posted at The Options Zone


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When it comes to investments, most people have the idea that owning stock is a sound and prudent thing to do.  In fact, the Prudent Man Rule tells us that not investing a significant portion of one's assets in a diversified stock portfolio is imprudent.

Owning options is different.  Hardly anyone considers the strategy of buying options to be less than speculative.  To some, it's outright gambling.  In this discussion, I only mention call
options.  Why?  Traditional investors buy stock and probably never
consider selling them short.  Thus, a post relating to investing in
stocks must be from the stockholders perspective.  And that means owning
calls, not puts.

I don't like the idea of owning options as an investment, and never suggest that anyone invest that way.  The rationale behind my stance is that the vast majority of option buyers pay far too much in time premium, in effect placing a wager that the specific stock will move sharply higher soon, or before the option expires.  That is gambling and not investing.  A stockholder can afford to wait for his/her reason for buying the stock to be recognized by the market.  The individual investor who buys options cannot afford to wait as time erodes the value of those options.

For the small minority who have proven skills as a market timer, owning at-the-money or out-of-the-money options may prove profitable.  But buying those options is a trap for the average individual investor.

On the other hand, if a trader buys call options that are already in the money by several points, the picture is entirely different. These options have a high delta (75-85) and increase in value at a pace that almost matches that of the stock.  Obviously owning calls is less profitable when the hoped-for rally occurs. However the profit from that rally is 'good enough' when you consider that there is a big benefit that comes with owning these options.

In return for paying time premium, the call buyer gains a big advantage.  Specifically, loss is limited to the price of the call.  In a market downturn, instead of being exposed to a large loss (example, a $42 stock declining to $25), the owner of the call with a $35 strike price can lose no more than the option premium.  That amount varies depending on the stock's volatility and the remaining lifetime in the option, but it's likely to be in the $1 to $2 range, plus intrinsic value).

It's a trade-off that is not suitable for every investor.  But if you are willing to sacrifice a little upside potential in return for additional protection in a down market, these calls are suitable investments.  See a recent post on stock replacement.

If you heard of the strategy referred to as buying 'protective puts,' this is an identical approach.  Buying one put per 100 shares of stock is a method that is equivalent to owning the call option – with the same strike and expiration date.  When you consider trading costs, it's more efficient to buy calls than to buy stock and puts.

I am not trying to convince investors with long-term investment objectives to switch from stock to options.  My purpose is to compare stock with options and be certain that you recognize what you get when buying stock. 

Let's consider that $42 stock mentioned above.  It pays no dividend.  The table indicates the value of a 6-month call option, assuming the options trade with an implied volatility of 35.



Table 


Buyers of the 6-month 35 call option pay $148 per contract in time premium. Investors who hate paying anything for time premium may prefer the 6-month 25 call, which carries a time premium of only $29.  By buying this call with a lower strike price, you accept an additional downside risk of $1,000 per option.

For investors who insist on paying zero extra premium, and who are willing to take even more downside risk (but it's a small risk.  There is little likelihood that this stock can move below $25 – but it is possible) there's the 6-month call option with a strike price equal to zero.  Such options don't trade on any of the option exchanges, but they do trade on the New York Stock Exchange.  These options with a strike price of zero come with a bonus.  They never expire. They are called stock.

The point of this exercise is to illustrate that buying ITM options is not so different from buying stock.  I've seen brand new investors buy low-priced stocks for the simple reason that they cannot afford to buy higher priced stocks.  That's a big mistake.  It's much better to buy a few shares of a stock you truly want to own than being forced to choose from the universe of low-priced stocks.  That trader ought to understand that buying ITM $8 call options on quality stocks is better than buying $8 stocks.

A recent discussion with a reader prompted this post.  He is willing to invest cash in a stock position, but considers his option purchases to be speculative and uses far less cash when buying options.  That makes sense – from his perspective.  Without so-stating, it's clear: this trader buys low-priced ATM or OTM options.  The thought of owning deep ITM options instead of stock was not considered.  This post is dedicated to him and other stock owning investors.  Please keep in mind that call owners do not collect dividends and this discussion is targeted to non-dividend paying stocks.

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The two Mark's disagree over the idea of 'playing with house money" in the     Pro & Con column.

Tyler Craig contributes a guest column and offers his take on the popular strategy of writing covered calls.


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Owning Stock vs Owning Calls

Hi Mark,

I think you taught me a lesson on not to get fixated on cost
basis. I have to tell you that cost basis is the thing I am obsessed
with since day one of investing and still is at the moment. It would
take a long way to move away from it but I’ll take your advice to focus
more on risk/reward.

However, I disagree with you on one thing, which is when you compared
the risk of holding stock vs long calls/call spreads. It is obvious
that I can easily lose 100% of my call/call spreads. It is also possible
to lose 100% if I’m long stock, but the possibility is very remote. In
terms of absolute dollars, the amount I can lose in a short period of
time is going to be a little more than the maximum loss in options, but
it is very unlikely that I’m going to lose all my money in DFS.

Long calls to me is a short-term speculative play and long stock is
for a longer term, and I am comfortable with my stock positions not
hedged. The amount I allocate for stocks is a lot more than I allocate
to options (since I’m still a relative rookie in options). The amount of
money I am willing to commit to one option position can only buy
some very OTM calls (which normally don’t end up ITM) but can buy
spreads that are more profitable. That should explain why I’m
comfortable with long stock but not the long calls.

F

***

Hi F,

1) It's my opinion that being obsessed with P/L is non-productive.  I cannot provide evidence that it's true.  The final choice depends on how you decide to manage your portfolio.  From my perspective, I own a position as it exists right now:  Do I want to hold it, sell it, add to it?  That's the decision.  Why should my original cost play any role in that decision?

2) I NEVER recommend owning long calls as a directional play.  I did suggest owning high delta calls as a stock replacement for investors who want to reduce downside risk.

I NEVER will recommend owning OTM calls for anything except protection – and I really don't like owning OTM options for any reason. So, if you took anything I said as a recommendation to buy such calls instead of stock, there was mis-communication.

NOTE:  This conversation refers to owning single options as a directional play.  [The kite spread uses OTM options, and that play is not relevant to this discussion]

3) If you feel comfortable owning stock, then by all means, own stock.  The idea of substituting high delta call options apparently does not appeal to you. 

It's good that you disagree.  Blindly agreeing with someone else is a bad idea.  Don't abandon your methods unless you are sure you are doing what is right for you.

Nevertheless, DFS offers an ideal scenario for stock replacement.   DFS Jun 13 calls carry very little time premium (20 cents).  For that small premium plus the 2 cent dividend, you can own insurance.  If the stock drops by 5 points, that's a lot worse than losing $3 on a call option. 

However, If you consider that time premium to be too much to pay, then your decision is based on complete knowledge of your choices.  That's ideal.

4) This is never mentioned, but stock can be thought of as a call option with a strike price of zero, and an infinite expiration date.  You prefer to own this zero-strike call.  There is an alternative: the Jun 13 call (an 8-week option) has a time premium of ~ 20 cents. 

5) You consider calls to be a short-term speculative play.  That's because you think in terms of which calls you would buy to gamble.  Those calls are very speculative and you are right to commit only small amounts to such plays.

Consider this:  You are willing to commit cash to owning the zero strike call.  And you are willing to speculate with a small sum on an ATM or OTM call.  But, you ignore the possibility of owning a high delta call. 

I know it seems as if I am trying to confuse you and take away your cherished beliefs.  But I find this philosophical discussions fascinating.  Analyzing a position and turning it into something safer, at a reasonable cost, is always worth considering.

But if you can even think about – as you say you plan to do – looking at risk/reward for positions after you own them, then perhaps you can consider stock substitution – especially when the cost is so little.  I agree that it is a more painful decision when the time premium of a 2-month 80 delta call is several dollars (obviously on a much higher priced stock).

6) I recommend owning high delta (~80) call options under these conditions:

a) You want to own stock
b) You believe the stock is headed higher, but don't want to take much risk

Under those conditions, selling the shares and replacing them with high delta calls solves the problem.  Solid participation on the upside and limited losses.

FYI, this trade is exactly equivalent to buying a put option to protect a stock position.

d) I never recommend buying calls.  But if you are a directional player who buys stock, high delta calls are a very reasonable alternative.  I never recommend buying protective puts.  But if the conditions stated above obtain, then stock replacement is an equivalent choice.

Regards

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Coming in the May, 2010 Issue of Expiring Monthly:

  • Interview with Dr. Brett Steenbarger – trading coach and psychologist
  • The CBOE Benchmark Indexes
  • Pro and Con: Trading with House Money

and much more


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Delta Neutral Stock Replacement

Hi Mark,

If wanted (roughly) the same potential return of a stock with limited
risk, and the ITM option's delta is 80, would raising my position
size by about 25% do that?

To be clear, I'm thinking in terms of options' implied leverage and
their implied stop loss as an alternative to buying stock and entering a
stop loss order. So if I would have bought 1000 shares of stock, I
would be buying 10 options instead, and am wondering if buying 12 or 13
would bring the delta up to 1000, as it effects my account.

Hope that makes sense.

Thanks

Josh

***

Yes Josh it makes sense. Owning 12 or 13 options with an 80% delta gives you almost the same 1000 long deltas.  Most stock replacement strategies replace 100 shares with a single call.  Your plan provides the obvious benefits on a rally or a big decline, but there is an added benefit (the 'implied stop loss').

So to have
'roughly' the same return (measured in dollars not in
percentages), you can substitute the calls for stock.

I'm sure you recognize that these deltas change as the stock price changes, due to positive gamma.

Rallies

Every so often, on a rally, the plan should be to sell one call to reduce delta back to 1000.  Obviously, you would have only 10 calls remaining when the delta reached 99 or 100.

Declines

But it's not quite the same on the downside.  If you buy calls on a decline – to get back to 1000 delta, you will fare poorly when the stock continues to go lower.  I would not buy extra calls.

Is this a smart idea?

The negative:  you must pay for time decay. 

The positive: That time decay is your cost for reducing downside risk.  Only you know the value of that risk reduction, but it seems to be a good idea to me.

There is one HUGE advantage to using a long call option instead of a stop loss order.  With the stop, you are out on a decline.  With call options, you are still in the game if the stock suddenly reverses direction, after ticking the stop loss price.  And there is no whipsaw and no extra cost.  You bought the calls – and this is one of the benefits of owning calls in place of stock.

This advantage makes it worthwhile to pay that theta decay.  And this is truly much better than the traditional stop loss.  I'd be willing to pay a bit extra in daily decay to own this position.

Good question.

Thanks

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