Investing In Options

The Smart Profits Report: Issue #377
Friday, December 8, 2006

Investing In Options: 3 Powerful Option Strategies That Make More Sense Than Stocks
By Lee Lowell
Futures Options & Commodities Specialist, Mt. Vernon Research

As a professional investor and someone who spent six years as a market maker on the floor of the New York Mercantile Exchange, there’s one question that my friends and associates seeking the ultimate investment ask me all the time:

“What’s the best strategy you recommend for investing in options?”

Alas, I wish there was an easy answer… but there isn’t. The truth is… no single options strategy can be perfect for every situation because each person’s outlook and financial situation is different.

But right off the bat, there are three great reasons why it makes sense to invest in options instead of stocks:

Lower upfront cost

Less downside risk

Greater leverage

After all, why pay full price for a stock when you can spend half as much money and get all the same rewards? The question is… how do we do that?

Here’s a quick and easy breakdown of three different option strategies, which will cover most of the bases.

Investing Deep In The Money

I’m talking about deep-in-the-money options. And your first job is to buy and invest in options that have a high delta. Delta is simply a figure that tells you how much the option price will change in relation to a corresponding move in the underlying stock. Delta values range from 0 - 100, so you want to buy an option with at least a 90 or greater delta.

Let’s take a look at an options chain, showing Walt Disney Co (NYSE: DIS) calls that expire in April 2007:

Option chain DIS calls that expire in April 2007

As you can see, the “Delta” column shows the delta for each option strike in the chain. And although there are quite a few that have a 100 delta (the highest you can get), we like to choose the one whose breakeven is closest to the current price of the stock.

Since DIS closed at $34.10, it would cost $3,410 to buy 100 shares of stock. But we can buy one April 2007 $20 call for $14.10 (splitting the bid/ask prices) and only pay $1,410 for the same play. This is a deep-in-the-money option, because the strike price is well below the underlying share price.

With a 100 delta, the $20 call will move point for point with the stock. The breakeven for the call is the same as the stock ($20 strike + $14.10 premium = $34.10). The bottom line here is that you spend $1,410 instead of $3,410 ($2,000 less!) and reap the same rewards.

Far Out Options, Man

Far out-of-the-money options, that is. This option investment strategy is the opposite of in-the-money - and is one for gamblers and high speculators. Buying deep-out-of-the-money options gives you the ultimate leverage. You pay pennies on the dollar for the options, and if your market prediction is right, you can hit a grand-slam-mac-daddy of a winner.

Let me give you an example, using the same Disney options chain above:

You can buy the April 2007 $45 call for $0.15 (splitting the bid/ask prices) and spend $15 per option while retaining the right to buy 100 shares of DIS at $40 per share if it ever gets profitable to do so.

Since one option contract represents 100 shares of stock, you could buy 227 call options for the same price that it would cost you to buy 100 underlying shares of DIS outright. (227 x $15 = $3,405). Your 227 option contracts are the equivalent of owning 22,700 shares.

If your prediction is right and DIS moves up to $40 by April 2007, you’ve got a whopper of a winner.

While the owner of the 100 shares would make $1,090 and see a tidy return on investment of 32% (1090/3410 = 32%), the owner of the 227 call option contracts would see a dollar gain of $110,095 and a ROI of an astounding 3,233%! ($110,095/3405 = 3,233%). That’s sweet!

Spread ‘Em With Credit Spreads

Credit spreads is one of my favorite strategies when investing in options - one where you become the option seller and receive the money from the buyer.

Specifically, you sell one option at a certain strike and buy another option at a different strike, forming an option spread. You just want to make sure the options are out-of-the-money, as that gives you extra cushion if your directional assessment is incorrect.

Let’s say you’re bearish on DIS and you think there’s no way that its share price will get above $35 and stay there by April 2007 option expiration.

You could sell the $35 call option for $1.25 (splitting the bid/ask prices) and simultaneously buy the $37.50 call for $0.50 (splitting bid/ask). This would give you a credit of $0.75 on the trade ($1.25 - $.50 = $0.75).

When you sell the more expensive option and buy the less expensive option, you get to receive that money from the spread buyer. So you get to receive $75 per option spread.

As long as DIS stays below $35 between now and April 2007 expiration, you’ll get to keep the $75. And the great thing is that DIS doesn’t even need to go lower to reap the reward. DIS only needs to stay below $35 the whole time, and you win.

If DIS ends up going above $35 by expiration, you can rest easy knowing that when you do a call spread, your risk is always capped and known ahead of time. In this case, the maximum risk will be $1.75 per spread. You calculate the maximum risk by subtracting the money you received by the width of the strikes. Since the spread is $2.50 wide ($37.50 - $35 = $2.50), you subtract $0.75 from it to give you your $1.75 risk. That means the most you can make on the spread is $0.75 and the most you can lose is $1.75.

The reason why I like this type of spread is because it gives us three ways to win:

If DIS goes lower, the strikes can expire worthless, allowing us to keep the whole $0.75.

If DIS stays at $34, the strikes will still expire worthless, allowing us to keep the money.

And even if DIS goes up slightly - let’s say to $34.85 - the strikes will expire worthless, allowing us to keep the money.

So there you have it: Three great ways to invest in options and play the options market - ways that truly allow you to use your money in a different fashion and put it to work for you.

Good trading,

Lee Lowell

P.S. There are two ways for you to grab much more information on these options strategies. First, I’ve talked about all of them in my upcoming debut book, “Get Rich With Options: Four Winning Strategies Straight from the Exchange Floor,” which will be available on January 8. We’ll send you more information about the book as its release date gets closer… so stay tuned.

Today’s Smart Profits Cribsheet

Want to beat stocks and lower your risk at the same time? Simply dig deep to maximize your profits by harnessing the power of deep-in-the-money options - one of the most dynamic investing tools you’ll find anywhere. Let Investment Director Karim Rahemtulla fill you in on all the details in Smart Profits #180, Deep-In-The-Money Covered Calls: How to Beat Stocks with Less Risk.

I use the trading strategies I talked about in this issue regularly in my VIP commodity option advisory - The Triple-Zone Profits Trader. If you’d like to find out more about this service - one that recently chalked up gains of 32% and 30% on wheat put options and 26% on a natural gas credit spread find that information here.

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