calls

Last week we described a simple way to achieve roughly double investing returns on some asset class like an S&P 500 stock basket, or a narrow class of stocks such as semiconductors, or on some commodity like gold or oil. That way is to buy one of the many exchange-traded funds (ETFs) which use sophisticated derivatives to achieve a 2X or even 3X daily movement in their share prices, relative to the underlying asset. For instance, if the S&P 500 stocks move up by 2% on a given day, the SSO ETF will rise by 4%.

Of course, these leveraged funds will also go down two or three times as much. They also have a more subtle disadvantage, which is that when the markets go up and down a lot, they tend to lose value due to their daily reset mechanism.

In this post we describe a different way to achieve roughly double returns, which does not suffer from this volatility drag issue. This way is to buy long-dated deep in-the-money call options on a stock or a fund.

Say what? We have described how stock options work here and here. The reader who is unfamiliar with options should consult those prior articles.

A stock option is a contract to buy (if it is a call option) or to sell (if it is a put option) a given stock at some particular price (“strike price”), by some particular expiration date. Investors generally buy calls when they believe that the price of some stock or fund will go up. For a call option with a strike price far below the current market price of a stock, the market price of the option will move up and down essentially 1:1 with the market price of the stock.

For instance, as I write this the market price of Apple is about $230. Suppose I think Apple is going to go up by say $40 in the next six months. One way for me to capture this gain is to invest $230 in buying Apple stock. The alternative propose here is to instead of buying the stock itself, buy, say, a call option with a strike price of $115 and an expiration date of January 17, 2025. The current market price of this option is about $119.

Other things being equal, we expect that the market value of this call option will go up by $40 if Apple itself goes up by $40. But we have invested only $119, rather than $230, so our return on our investment is roughly double with the option than by buying the stock itself.

There is a subtle cost to this approach. At a stock price of $230 and a strike price of $115, the intrinsic value of this call option is $115. But we pay an extra $3 of extrinsic value when we buy the option for $118. This extrinsic value will gradually decay to zero over the next six months.

Thus, if Apple went up by $40 within the next month or so, we could turn around and sell this call option for nearly $40 more than our purchase price. But if we wait for six months before selling it, we would only net $37 (i.e., $40 minus $3). This is still fine, but it illustrates that there is a steady cost of holding such options. This annualized cost is about equal to or slightly higher than the prevailing short term interest rate (5% /year). This option pricing makes sense, since an alternative way to control this many shares would be to borrow money at current interest rates (5%) and use those borrowed funds to buy Apple shares. Options and futures pricing is generally rational, to make things like this equivalent, or else there would be easy arbitrage profits available.

As a side comment, the reason I am focusing on deep in the money calls here is that the extrinsic premium you pay in buying the call gets lower the further away the strike price is (i.e. deeper in the money) from the current stock price. A deeper in the money call does cost you more up front, but net net its dollar movements up and down more closely track (1:1) the movements of the underlying stock. So, if I am not trying to guess right on any market timing, but simply want to get the equivalent of holding the underlying stock but tying up less money to do so, I find buying a call that is about 50% in the money generally works well.

How I Use Deep in the Money Call Options

I consider the technology-oriented stock fund QQQ to be a core holding in my portfolio, so I would like to stay exposed to its movements. But I might as well do this on a 2X basis, to make better use of my funds. I do hold some of the 2X ETF QLD. But if we experience a lot of market volatility, the price of QLD will suffer, as explained in our previous post.

As a more conservative approach here, I recently bought a deep in the money call on the QQQ ETF. As usual, I went for a call option with a strike price roughly half of the market price, with an expiration date 6-12 months away. When this gets close to expiration (May-June next year), I will “roll” it forward, by selling my existing call option, and buying a new one dated yet another 6-12 months further out. This takes little work and little decision making. I will pay the equivalent of about 5% annualized cost on the decay of the extrinsic option premium, but I come ahead as long as QQQ goes up more than 5% per year.

This is a little more work than just holding the 2X QLD ETF, but it gives me a bit more peace of mind, knowing I have done what I can to smooth out some of the risk there. Of course, if QQQ plunges along with the markets in general, I will be looking at double the losses. For that reason, I am taking some of the money I am saving by using these leveraged approaches, and stashing it in safe money market funds. In theory that should give me “dry powder” for buying more stocks after they drop. In practice, I may be too frozen with fear to make such clever purchases. But at any rate, I should not be appreciably worse off for having used these leveraged investments (2X funds or deep in the money calls).

Disclaimer: As usual, nothing here should be considered advice to buy or sell any investment.

Put simply, a stock option is a contract to buy (if it is a call option) or to sell (if it is a put option) a given stock at some particular price (“strike price”), by some particular expiration date.

Example: Buying Apple Call Option Instead of the Stock

In a little more detail: if you buy a call option on a stock, that gives you the right to buy that stock at the strike price (“call” the stock away from some current stockholder).
For most American stocks the option holder can exercise this right at any time, up till the end of the expiration day. (For so-called European options, you can only exercise the option on the expiration date itself.)
Let’s jump into an example. As of late morning 11/27/2023 when I am writing this, the price of Apple stock is $190 per share. Suppose I have a strong conviction that within the next month or so, Apple will go up by 10 dollars (5%) to $200/share.

One thing I can do is plunk down 100 x $190= $19,000 to buy 100 shares of Apple, and wait. If Apple does indeed reach my target price of $200 in some reasonable timeframe, and I sell it there, I will make a profit of 100 shares x $10 / share = $1000 on my initial investment of $19,000. That represents a 5.3% return on my investment.

But suppose because of some unexpected factor (Taiwan invasion?), that the price of Apple plunges by say 30% to $133/share, and remains there for the indefinite future. If I want to get my money out of this affair and move on, I would face a huge loss of 100 shares x (190-133)= $5,700 dollars on my large $19,000 investment.

Instead of buying the stock outright, I could buy a call option. There are a number of specific strategies and choices here, but to keep it simple, I could buy an Apple call option with a strike price of 190 (the current price of Apple) and an expiration date of say December 29, 2023. At the moment, that call option would cost me $3.80 per share, or $380 dollars for a standard options contract that involves 100 shares.

If Apple stock hits my price target of $200 sometime in the next month, I could exercise this option and purchase 100 Apple shares for $19,000 dollars, (100 x $ 190 strike price) and immediately sell them into the market 100 x $200/share = $20,000 dollars. That would give me a net profit of: (profit on stock buy & sell) minus (cost of call option) = 100 x ( ($200 – $190 ) – $3.80 ) = $620. That is a return of 163% on my $380 investment. Woo hoo!
(If I did not want to actually exercise the call, I could have sold it back into the options marketplace; the value of the call would have risen by somewhat less than $10 dollars since the time I bought it, so I could take my profit that way, without going through the cycle of actually buying the shares and immediately selling them.)

If Apple stock fails to rise by more than the $3.80 dollars a share that I paid for the call option, I will lose money on this trade. If Apple stays at or below 190, this call option expires valueless, and I will have lost 100% of my option purchase price. (If say two weeks goes by and the share price is hovering just below 190, this call option might still be worth something like $1.90/share, and I might choose to sell it and bail on this trade, to recover half of my $3.80 instead of risking the loss of all of it; there are many, many ways to trade options).

Now, in the event that Apple shares plunge by 30% and stay low indefinitely, I would only lose the $380 that the options cost me, instead of the $5,700 dollars I would lose if I had bought the stock outright.

This example demonstrates some of the benefits of buying stock options: You can make a huge return on your invested/risked capital if your stock price thesis plays out, and you can be shielded from any losses other than the cost of the option. The big weakness of this approach is that your hoped-for stock move must occur within a limited timeframe, before the expiration date, or else you can lose 100% of your investment. Folks who trade options for a living make lots and lots of small trades, knowing that they will lose on a significant percentage of these trades, hoping that their wins will outweigh their losses.

Buying Put Options for Hedging and Speculation

This has been a somewhat long-winded explanation of one way of utilizing options, namely, buying calls. Buying a put option, on the other hand, gives you the right to require that someone will buy a stock from you at the strike price (here, you are “putting” the stock to the person who sold you the option).

Puts are often used as for protective hedging. Suppose I own 100 shares of Apple stock that is currently valued at 190 dollars a share, and I want to protect against the effects of a possible plunging share price. As an example, I might buy a March 15, 2024 put with a strike price of 175, for $2.80. If Apple price falls, I would absorb the first 15 dollars per share of the losses, from 190 to the strike price of 175. However, that put would protect me against any further losses, since no matter how low the share price goes, I could sell my shares at $175. (Again, instead of actually selling my shares, I might sell the puts back into the market, since their value would have increased as Apple share price fell).
Buying puts in this manner is like buying insurance on your portfolio: it costs you a little bit per month, but prevents catastrophic losses.

Buying puts can also be used for speculative trading. Suppose I was convinced that Apple stock might fall well below $175 in the next three months. Without owning Apple shares, I might buy that March 2024 175 put for $2.80 per share, or $280 for a 100-share contract. If Apple share price went anywhere below (175 – 2.80 = 172.20), I would make money on this trade. If the price went back down to its recent low of 167, my net profit would be around 100 x (172.2 – 167) = $520. This would be nearly doubling the $280 I put into buying the puts. But again, if Apple price failed to fall as hoped, I might lose all of my $280 option purchase price.

Where to Find Options Prices

There are lots of YouTube tutorials on trading stock options. Here is quick ten-minute intro: Stock Options Explained, by The Plain Bagel. If you want to check out the prices of options, they are shown on websites like Yahoo Finance, Seeking Alpha (need to give email to sign in; you can ignore all the ads to make you purchase premium), and your own broker’s software.

I usually prefer to sell options, rather than buy them, but that is another post for another time. As usual, this discussion does not constitute advice to buy or sell any security.