Whether you read my Wall Street Daily articles, you’re a subscriber to my Instant Money Trader or you’ve read my book, I’m sure you know by now that I’m a huge fan of selling put options.
If that’s not for you, though, there’s another strategy I highly recommend as an alternative to just buying stocks. And that’s buying deep-in-the-money (DITM), long-dated, call option contracts.
You see, option contracts are the greatest financial products ever created, since leverage lets many investors participate in trades that would otherwise be out of reach.
Now, many investors think that leverage is too risky. And they have a point. Leverage’s ability to magnify your gains can have the reverse effect, as well.
But here’s a way you can participate in the massive upside potential options offer, while reducing risk at the same time.
Buying Shares At a 73% Discount
Let’s use Wal-Mart (NYSE: WMT) as our prime example.
If you wanted to buy 100 shares of Wal-Mart today, it would cost you roughly $7,475. But by using DITM options, those same 100 shares would cost you roughly $2,020. That’s a solid $5,455 cheaper – or a 73% discount.
So what does deep-in-the-money mean? Basically, DITM options have strike prices that are set much lower than the current price of the stock.
The options chain to the right shows a partial listing of available call option contracts to trade on Wal-Mart (at its current price of $74.75).
Let’s focus on the January 2014 $55 strike price, which is around $19.75 below the stock price.
The cost to buy the option is roughly $2,020 per contract. Remember, each contract represents 100 shares of stock.
The benefits of buying the option instead of the stock are two-fold:
First, you’re only spending $2,020 instead of $7,475 to control the same 100 shares, but you’re benefiting from similar movement (more on that below).
Plus, you’re cutting your total risk in the trade by $5,455. The most you can ever lose when buying options is what you paid for them. In this case, you can’t lose more than $2,020.
Wal-Mart shareholders have $7,475 at risk. That’s a big difference.
However, DITM isn’t the only thing you need to focus on to make sure you’re getting the best deal possible.
High Delta is Key
It’s also crucial that you pinpoint the options with at least a 90% or higher “delta.”
Delta refers to how closely the option price moves in relation to the underlying stock. In other words, the higher the delta, the more the option moves in lockstep with the stock.
Since the whole point of buying options is to pocket massive gains when the stock moves in your favor, the best way to do that is to choose options with a high delta.
Have you ever bought a call or put-option contract and its value didn’t increase – even though the stock price moved a good distance in your favor? Depressing, wasn’t it? Most likely it was because you didn’t own an option with a high enough delta.
As I said, a good delta to go with is at least 90%. Just to clarify, that means the option price should move 90% in the same direction of the stock’s movement.
As you can see, the $55 strike price option boasts a 96% delta.
The screenshots of an options calculator below show this principle working in real-time.
The calculator on top shows what the options trade for at Wal-Mart’s current price of $74.75. The one on the bottom shows what the option would likely trade for if shares hit $75.75.
As you can see, the option price went up almost a dollar, just like the stock.
That’s the kind of movement you need.
What novice option traders usually do is pick the cheapest option contracts based on the actual dollar value. It makes them feel like they’re getting a better deal. But what they don’t realize is that the cheaper the option price, the lower the delta will be, which means they’ll see less cash in the end.
So what happens when the options expire in January 2014?
Well, if Wal-Mart increased like you hoped it would, you can sell the options and bank the gain. Or you can “exercise” the option and turn it into actual shares of stock.
If you choose the latter, you’ll have to pay for the stock in full at that time.
Usually, the first scenario is the best bet, since you could just sell the option and use the profits to buy another position. And you’re still participating in the move higher like you would if you actually owned shares. Only this way, you’re keeping your cost and risk low at the same time.
So do yourself a favor… If you’re ever going to buy a stock, consider buying DITM options with a high delta instead. You’ll be glad you did.
Ahead of the tape,