| Author | Message | ||
     Kubang Celebrity Bewarse Username: Kubang Post Number: 39975 Registered: 09-2011 Posted From: 161.141.1.1 Rating: N/A |
Last week we talked about buying call-option contracts as a substitute for buying stocks. You might recall a throw-away line about how call options can quadruple your returns when compared to buying a stock outright. See, it’s my not-so-sneaky goal to turn you into a bona fide options trader. Once you’re hooked, you’ll forget about stock buying forever. But we learned that not all call-buying strategies are the same. In fact, I compared two strategies at the opposite ends of the spectrum, both with very different probabilities of profit. Today we’re going to take a closer look at why it's in your best interests to buy deep-in-the-money (DITM) call options. Let’s cut to the chase: these plays a have a drastically higher profit probability. Buying Microsoft At A 77% Discount Let’s return to our hypothetical Microsoft (Nasdaq: MSFT) trade. Remember, purchasing 100 shares of Microsoft would cost you $10,150. But buying the DITM January 2019 $80 call option would only cost you $2,285. That 77% discount means you’re paying $7,865 less. Here's a snapshot of the MSFT stock and its corresponding $80 call option: Image removed by sender. At a stock price of $101.50, the $80 call option had a market value of a $22.55 bid and a $23.15 ask. That equates to fair-value midpoint of $22.85 per contract. Using the $100 option multiplier, buying one contract at $22.85 would cost you $2,285. One of the greatest attributes of buying options is that you can never lose more than what it costs you, no matter where the stock might go. In this case, we would have $2,285 on the line. If MSFT goes belly up, you'll lose 100% of that option investment. So would every other stock investor… to the tune of $10,150. Their potential loss is much greater. So not only do call options cost you 77% less, but they also lower your risk by 77%. That's a huge bonus. Delta, Depth, and the Quadruple Effect Why focus on the $80 call option? And how DITM should you go? One of the keys to using the DITM strategy properly is to choose a call option with a Delta of 90% or higher. If you look at the table, you'll notice the column labeled "Delta" with a value of 0.9140. Delta values range from 0-100% and are a by-product of the option pricing formula. They give you an idea of how much the option price will change in conjunction with any move in the stock. With our hypothetical example, the $80 call option has a delta of 91.4%. That means the price will move 91.4% of whichever way the stock moves. If MSFT rallies by $1 per share, the $80 call's value should increase by roughly $0.91 per contract. That's the key: You want to buy an option that's going to respond and move almost as much as the stock does. Choosing options with a 90%-plus delta assures you of that. And remember the benefit. With that 91.4% delta, the call option still costs 77% less than the stock. You're getting the best of all worlds: high movement and low cost. To wet your appetite even more, take a look at this chart. It describes how using the call option can quadruple your returns compared to buying the stock outright. Image removed by sender. You'll see that once MSFT moves above the call option's break-even price of $102.85, the DITM strategy more than quadruples the return at every level. Even better, the call option's dollar profit is just $135 shy of the stock's profit at each level. That's practically the same in my book. Equal profit with 77% less risk? Yes, please! On the downside, we see the call option's loss is capped at the cost of $2,285. The stock, on the other hand, can lose the maximum of $10,150. So, what have we learned? DITM call options… Cost 77% less than buying the stock. Slash your risk in the trade by 77%. Quadruple the returns at any point above breakeven. And give you 91.4% of the stock's movement (bang for your buck. You can do this with any stock you choose. So, have I convinced you yet to give up stock buying? Ignorance is bliss |