Investing Strategies - Part VII

Long Options

To understand this post you need to have a decent understanding of options, in particular the concept of the strike price. For a refresher go to my post on options or to the CBOE website and look for the education section.

Remember, options carry special risks and are not for everyone. Before trading options, talk with your broker about them and also make sure that you meet your firm's option trading requirements.

Towards the end of my brokering career, I dealt with hyper-traders. These guys were trading at least fifty times a year - most of them were in the 150-200 trades a year range (one per day, roughly) and a few were into the multithousands of trades annually. To a person, they almost all liked the idea of trading options and most could make money playing spreads or writing covered calls, but very few every made money trading long options. Most of the hardcore options traders I dealt with in fact wouldn't trade long because they thought it was impossible to make money that way. They saw it as a sucker's game.

And to a point, they're right. But there are others that make huge amounts of money playing long options. So what's the difference between the suckers and the moneymakers, if they're both playing the same game?

Remember, options are leverage. It is possible to make huge amounts of money on a small investment. Most option players hear stories about the guy who bought XYZ options at 3/4 and sold them a week later at 10 after an 8 point move in the stock. And this can happen. It does happen. It just almost never happens.

When an option is selling at 3/4 ($75 per contract not taking commissions into account), it tells me that either it is way out of the money (the stock is selling below the strike price) or it has a short time to expiration.

Now option prices are determined by the strike price-stock price relationship (is it in the money or out?), by the time to expiration, and by the volatility. In the XYZ example above the stock obviously became more volatile and went from out of the money to in, and there is still some time left to expiration. Hence the greater move in the option price than the stock price.

But situations are rare. More common is someone buying, say, an XYZ Jun 50 call in mid-May with the stock trading at 48.25 and paying 3/4. What almost always will happen is that on the third Friday in June the stock will close around 49.75, meaning the option expires worthless - hence the sucker's game.

A quick and dirty rule of thumb that you can use to avoid playing the sucker's game is as follows:

XYZ
Calls
Strike	Price	OI
50	.75	1000
55	.70	2500
60	.50	1250
65	.25	500
70	.10	75

If you're looking at the above listings in the WSJ, you'll notice that the open interest peaks at 55. Chances are, XYZ will be just under 55 on that third Friday in June. Usually the highest open interest will represent an expected cap. This system isn't perfect and often times you're going to find that the next couple of strike prices before the highest open interest aren't going to offer huge profit potential. Options are risky enough by themselves, the goal of this rule of thumb is to avoid playing the sucker when you don't have to.

Most of the folks I saw making money on playing the long options game wouldn't even be looking at that part of the listings. Instead they would be looking at the deep in the money, long time to expiration options. If you have faith that a company is going to make a move one way or the other, this can be an excellent way of increasing your profit from that move.

When you're buying a deep in the money option, even with LEAPS, there is usually very little time value built in to the option price. Say XYZ is trading at 50. You may be able to buy a LEAP for two years out with a strike price of 25 for around 26 or 27.50. If XYZ goes to 75 over the next two years your option would go to 50.

If you buy the stock, you make $2500 over those two years for a $5000 investment (50% in two years). If you buy the option at $27.50, you would make $2250 on a $2750 investment (an 81% profit in two years). Same move in the stock price, but the option is more profitable to buy.

One thing that is important to keep in mind is that because of the time value depreciation, the option will almost never gain dollar for dollar with the stock. But when the stock starts to go down, it almost never loses dollar for dollar, either.

Deep in the money options are one of the simplest and most effective money makers in the options market. You pay more, but you buy time and a cushion in case the stock goes down. It's kind of like buying insurance of a sort.

And therein lies the difference between the money makers and the suckers. The old adage it helps to have money to make money holds true even in the options market. Think of it as the difference between playing keno or taking 1.5:1 odds on a bet. Take consistency over percentage every time.

Options are one of the most powerful, most misused, and most misunderstand tools of the stock market. The lack of options knowledge is one of the few pockets of true market inefficiency that is still out there. Take advantage of that inefficiency to help you make money.

This posting is not intended as nor should it be construed as market advice. Consult your broker before undertaking any trading with which you are not familiar, experienced or comfortable with. The author assumes no liability for any actions you may take.