Posted by Our main The Monthly Income Machine mission at SaferTrader.com is reliable, significant monthly income no matter which way the market goes… but,
SaferTrader community members do sometimes want to take a “directional” position because they see an opportunity to snag a nice profit on a potential move up (or down) in a particular stock, index, or ETF, i.e. to make an investment for capital gain rather than income.
Once again, the PROPER use of an option strategy will often be far superior to an outright long or short position in a given security, especially if it’s a pricey stock like Google, Apple, Netflix, etc.
A Better Way: How To Multiply Your High Priced Stock Profit Potential Without Increasing Your Risk.
Let’s say you expect a nice up-move in Google during the next couple of months. Most investors looking at options as their vehicle will buy “cheap” out-of-the-money call options to implement their idea.
And, statistically, most of them will lose all or much of their investment because the anticipated move up (1) doesn’t occur and the option expires worthless; or (2) the move up occurs, but too late and the option expires worthless; or (3) the move up occurs, but not enough to make the option profitable at expiration and it expires worthless.
In short, buying an out-of-the-money option is a risky proposition because you are buying the hope that a positive move in the underlying stock or index will occur fast enough, and far enough, to offset the inexorable negative effect of time decay on out-of-the-money options.
In each of the above negative outcomes, the main culprit is the time decay that ALWAYS works against the buyer of out-of-the-money options.
Remember: The value of an option is a function of intrinsic value (how far the option is in-the-money), plus its extrinsic, or “time” value (which reflects how much time remains before option expiration).
Intrinsic Value + Time Value = Option Price (the “premium”)
When one buys an out-of-the-money option, ALL the value is time value (i.e. extrinsic value) because there is no intrinsic value when the price of the underlying stock or index has not moved beyond the option strike price.
But, if we look instead at in-the-money options, especially deep in-the-money options, everything changes for the better!
At first glance they are much more expensive than out-of-the-money options, but that first glance is deceiving. Almost all the price you pay for an in-the-money option is real (intrinsic) value. The value of the option changes pretty much dollar for dollar with the change in value of the underlying security.
The mere passage of time does NOT greatly erode the value of your deep in-the-money option… and that makes all the difference in the world. You will make or lose money on the trade based on whether you are right about direction; time decay doesn’t enter into the matter significantly because you are dealing almost entirely with intrinsic (real) value only.
Consider the following three approaches to investing in expensive XYZ, looking for a move up in the stock. (We’ll ignore commission since it’s a pretty trivial component of the example transactions.)
In each of these examples, assume XYZ is currently trading at 600, and it moves up to 660 over the following two months.
Step 1: Buying the Stock.
Assume XYZ is currently at $600.
You buy 100 shares of Google for $60,000.
Two months later XYZ is at $660 and you have a profit of $6,000.
Rate of return on investment = $6,000/$60,000 = 10% in two months.
Step 2: Buying 2 Month Out-of-The-Money Call Option (Strike Price 660)
Assume: XYZ is currently at $600.
One XYZ call option (for 100 shares) expiring in 2 months with strike price of 660 costs $580.
You could buy 1 call for $580 (all the value is time value since it’s an out-of-the-money option).
Two months later XYZ is at $660 and your 660 call expires worthless (it only has intrinsic value if XYZ is HIGHER than the strike price at expiration).
Rate of return on investment = none, (a loss of total $580 investment, even though the underlying stock rose 10%).
Step 3: Buying Deep In-The-Money Call Option (Strike Price 550)
Assume: XYZ is currently at $600.
One XYZ call option (for 100 shares) expiring in 2 months with strike price of 550 is trading at 54 and therefore costs $5,400. ($5,000 of this cost is actual (intrinsic) value; only $400 is time value).
Two months later, at expiration of the option, XYZ is at $660, so the 550 call is now trading at 110 and is therefore worth $11,000 on expiration day, reflecting a $5,600 profit.
Rate of return on investment = $5,600/$5,400 = 103.7%
Summarizing: XYZ Stock Rises from 600 to 660
Buying 100 shares of XYZ stock outright, when trading at $600, costs $60,000 and delivers a $6,000 or 10% return during the 2-month rise of $60/share in XYZ stock. (You could get the nominal return up to 20% if you bought the stock on 50% margin, but you would have had to pay interest on the borrowed funds).
Buying one deep in-the-money (550 strike price) call costs $5,400 and delivers a $5,600 or 103.7% return, based on the same 2 month increase in the price of XYZ stock!
That’s a very big difference, to say the least.
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Again: super article, Lee!
One note: this SHOULD be obvious, but for newbies like me it might not be.
In order to capture the profit, you have to SELL the option at the end. BEFORE it expires!
I bought a deep-in-the-money call on MU, since it was pretty well guaranteed to shoot up. And so it did. Even with the disastrous 7% drop on Friday–after a positive earnings report!–I still made about $800… but only on paper. And that paper is now worthless!
Brokerage firms typically exit automatically from options that expire in-the-money, i.e. when expiring options have value at expiration, that value is added to the investor’s account. Thus the investor should receive his proceeds and not have to place any order to exit from an option that expires in-the-money. You can confirm this by checking with your brokerage firm (phone or email to Customer Service).
Right you are, Lee. The broker did indeed exit the option. But since it was a call, they didn’t credit the account with the profit; instead, it loaded 200 shares of MU into my account, bought at the strike price. I sold them Monday morning for about the same profit.
Hi Lee,
Super article. I’m thinking of doing this with MU, Micron Technologies.
Comments:
1) Why “deep in the money”? Why not buy a call right at the money?
2) This strategy would work just as well with inexpensive stocks. Just buy more contracts, to achieve the same reward. Is that correct?
3) You didn’t mention another possible result: after two months, XYZ had a surprise tumble and is now at $550. Instead of a huge profit, one faces a huge loss. This is why some people say the best strategy for options is to never use them. You really should warn people of the dangers of trading options, especially without the safety net of the Monthly Income Machine strategy.
Thanks for your help!
4) Assuming the stock goes up as hoped: is there a chance of not finding a buyer for an option which now is WAY far from the current price, and is now VERY expensive? I see the volume goes down considerably once you reach the outer limits.
Thanks again for your help.
It is VERY hard to imagine that the option – once in-the-money as in your example – would not find a buyer if the owner of the option offered it for sale at the true, intrinsic value. Keep in mind that with an in-the-money option, the owner always has the right to exercise the option and buy the stock at the strike price.
So if an in-the-money option failed to reflect its true value based on the price of the underlying, an investor could buy the option, exercise it to acquire the stock at the option strike price, and then immediately sell the stock at its true (higher) value, i.e. he would have a guaranteed profit. (Needless to say, the markets do no grant guaranteed profits!)
1) You want a deep in-the-money strike price when using option as a lower price surrogate for owning the underlying stock. This is because you want your vehicle to move up and down as closely as possible with the stock. An at-the-money or out-of-the- money option has extrinsic (time) value as part or – in the case of the out-of-the-money strike price – all of the premium. Consequently, it will not track the movement of the stock dollar for dollar. A deep out-of-the-money will more closely move the same amount up and down as the underlying.
2) yes.
3) You are correct that a “surpise tumble” in the underlying stock can greatly lower the price of a deep in-the-money option. However, keep in mind that you are using a deep in-the-money for the express purpose of tracking as close as possible the dollar movement of the underlying.
But with the option, the most that can be lost is the premium paid for the deep in-the-money option. With the stock itself, it is theoretically possible for the stock’s value to drop to zero.
Hi Lee,
I’m still on the question of buying deep in the money call, or close to the money call.
For my latest trade, I bought a call on TXRH, because I am reasonably sure they will increase over the next few months.
When looking at the option chain, I made these observations:
TXRH @ $63
Stock price premium
$35 28.55
$40 23.50
$45 18.50
$50 13.80
$55 9.20
$60 5.15
1) The closer the strike is to the current price, the lower the premium. It becomes more affordable that way.
2) The closer the strike is to the current price, the greater the increase in profit for every move in the stock price. From $40 to $35 price, the change in option value is $5.05 (28.55-23.50), about 21% of 23.50. From $60 to $55 price, the change in option value is $4.05 (9.20-5.15), about 78% of 5.15
The risk is greater: if the stock falls, the option close to the money will be close to worthless; the deep in the money option will still retain some value.
Anyway, I bought 1 contract at $60. So my total risk is $515. I’ll let you know how it goes!
TXRH is now at $68.25. The premium for the July 20 $60 call is 8.55, a 66% increase in value from 5.15 when I wrote the above comment!
The premium for the July 20 $35 call is now 33.45, a 17% increase in value. Nice, but nowhere near as nice as 66%.
However… TXRH went for a swim shortly after I wrote the above comment, and has been slow to pull back up. When my $60 call expired on June 15, it was only worth 4.40, so instead of a nice profit, I took a 14% loss. Rats!
That’s the thing about buying options vs. selling them: the buyer has to have everything perfect: the timing, the direction, the amount.
Now if you would have bought deep Itm option you wouldnt have lost as much as you did with atm. Is that simple. You dont make much but you also dont lose much
Wow. Thanks for the insight Lee.