Take a LEAP
Analyzing a Possible Trade for my IRA
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.
Last month, 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 (MRK) 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 14%.
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 (ETF) or options on ETFs. I received a recent bullish signal on the Wisdom Tree India Earnings Fund (EPI), 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 months.
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
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