- Low volatility spawns new opportunity.
- The impossible becomes a reality in one simple move.
- The best way to play Apple’s coming historic moment.
- Also recommended: Blue chip stocks get small-cap makeover.
It’s getting tougher than ever to pay up for pricey stocks.
As I write, the S&P 500 is trading at 19.7 forward earnings — just below a 10-year high.
Of course, that’s not to say that bargains can’t be found in the market or that some stocks haven’t earned a premium valuation.
But as senior analyst Jonathan Rodriguez pointed out last week, the lack of volatility in the stock market presents investors a unique opportunity.
He revealed a little-known trading strategy that helps investors bypass lofty stock valuations and significantly increase their returns over stocks, too.
Today, he’ll dive even deeper and show you exactly how to grab these gains…
Ahead of the tape,
Chief Investment Strategist, Wall Street Daily
Why Low Volatility Is Your Friend, Not Foe
I’m sure you’re constantly hearing financial talking heads warning about the “dangers” of low market volatility (low vol).
Granted, it’s true that investors should keep an eye on the force of market moves.
But make no mistake, low vol offers far greater rewards than risks.
One such reward is the stock replacement strategy.
As you recall, this strategy uses long call options in place of stocks during periods of relative calm in the market.
This strategy is incredibly useful for investors who want to cash in stock gains near a market top — but still want exposure to any potential upside.
It’s also great for investors who want to forcefully multiply their returns on stock moves.
Either way, now is the perfect time to implement the strategy.
As I noted in last week’s column, there are two ways you can do it…
- An in-the-money (ITM) call option. (Current stock price is above the option’s strike price.)
- An out-of-the-money (OTM) call option. (Current stock price is below the option’s strike price.)
Here’s what a stock replacement strategy might look like on Apple Inc. (NASDAQ: AAPL), which is well on its way to becoming the first $1 trillion company in history.
Technique #1: ITM call
Right now, Apple is trading around $154.
The stock trades at about 15 times forward earnings but also at a whopping 3.5 times forward sales.
That’s a 78% premium to the S&P 500 and 14% above Apple’s five-year average.
But thanks to low market volatility, options on the stock are reasonably priced — if not a little on the cheap side.
A quick look at an options chain will show you that ITM calls are more valuable than those that are out of the money.
Without getting into the weeds of option pricing, this is because ITM calls have intrinsic value.
If you execute a call option that’s in the money and purchase the shares, you can immediately turn around and sell them for a profit.
Calls that are out of the money require the underlying stock to rise above the strike price before a trader earns a profit on the shares.
Now, you may recall that I drew your attention to an option’s “delta” last week.
Put simply, delta is the correlation between the price of an option and the price of the underlying stock. The more valuable an option is, the higher its delta will be.
Why is a high delta important for call options?
Well, the higher an option’s delta, the more closely it tracks the underlying stock’s moves…
Take a Bigger Bite out of Apple
The Apple $120 calls expiring in January 2018 presently cost about $35.
This means that one option (a contract to purchase 100 shares of stock) runs investors $3,500.
Compare that with buying 100 shares of Apple outright, which would cost $15,400.
So the option represents an $11,900 discount to owning shares and leverages investors more than four times to the stock’s gains.
But where does delta come in?
Well, the options boast a delta of 0.92. So every $1 move in Apple’s shares would generate a move of about $0.90 for the call options — a very tight correlation.
These calls break even at expiration as long as the stock remains above $155 ($120 strike price + $35 option premium).
That’s just slightly higher than the stock is trading right now.
With a move in the underlying shares to $191 — a mere 24% gain — the option doubles in value.
Better still, using a 50% stop loss on the trade risks just $1,750 of capital with the option.
Using the same stop on the stock would deliver a loss of $7,700.
Not a bad way to juice your upside on stocks and lower your risk at the same time.
OK, let’s recap…
The chief advantage of ITM calls over OTM options is that ITM calls benefit from a higher delta.
Meaning that they earn more for every uptick in the underlying stock.
The key downside is that ITM options are significantly more expensive than OTM calls.
However, investors are well compensated with a much higher reward-to-risk ratio.
Next week, we’ll break down OTM calls in more detail.
On the hunt,
Senior Analyst, Wall Street Daily