There’s always a bargain to be found in the stock market… if you know where to look.
Senior analyst Jonathan Rodriguez recently revealed an incredible trading strategy that can unlock massive gains in stocks.
A strategy that most investors have never heard of: stock replacement.
This tactic can put exponentially greater profits in your pocket on a stock’s rise — with far less capital at risk than buying stock.
Today, he’ll finish off the series with a detailed look at the second of two ways to play it.
Ahead of the tape,
Chief Investment Strategist, Wall Street Daily
High Returns on Low Volatility
As an options trader, I love volatility.
Volatile periods marked by big swings in stocks provide traders with the fastest opportunities to book large profits.
But when the sea of stocks calms after a highly volatile period, there’s opportunity there, too.
As you recall, stock replacement — using options — offers investors the ability to profit on a stock’s upside at a significant discount to a stock’s market price.
This technique can also radically reduce risk, too.
That is because buying high-delta call options that closely follow a stock’s movement can net you serious profits — at a fraction of the cost of owning shares.
In my last two articles, I’ve gone over the use of in-the-money (ITM) call options to replace stocks.
Today, we’re going to talk about an even cheaper way to replace your stocks in a low-volatility market.
Technique #2 — OTM calls
As you’ll recall, a key factor in an option’s price is volatility. The more volatility the market expects, the higher an option’s price will be.
And vice versa: Low volatility makes for cheap options.
I previously went in-depth with in-the-money calls. With a strikes price that’s below the underlying stock’s current price, these options are intrinsically valuable. These options have value because they can be executed to buy shares at the strike price, and then you can sell the shares at the market price for a profit.
Today I want to cover out-of-the-money (OTM) calls.
These options have strike prices above where a stock is currently trading. And they’re much cheaper than ITM calls.
As with yesterday’s example, let’s assume Apple shares are currently trading around $154.
If you want to go long right now with a standard lot position, you’re looking at spending $15,400 for the shares.
On the other hand, the January 2018 $160 calls trade for about $8.55. So one option, which is a contract to potentially purchase 100 shares at the strike price of $160, would cost you $855.
That’s a discount of $14,545, or 94%, to owning shares. And it offers you leverage to the stock of about 18 times.
In fact, you could purchase 10 contracts — laying claim to 1,000 shares — for nearly $7,000 less than it would cost to buy a hundred shares.
The option breaks even when shares rise to $168.50 — about 9% higher than where Apple is presently trading.
The calls double in value with a move in the stock above $177. This means you have the potential to double your money on the calls with just a 15% rise in the stock from its current level.
And if you use a 50% stop loss, you risk just $427.50 ($855 times 0.5). Compare that with risking $7,700 using a comparable stop loss on a 100-share purchase.
Even a 50% stop loss on a 10-contract option purchase ($4,275) would be less than a 30% stop loss on a hundred shares ($4,620).
The key advantage to using OTM options over ITM is that your cost basis is much lower.
OTM options don’t have intrinsic value until shares rise above the strike price. So they’re considerably cheaper than ITM options.
The downside is that they don’t capture as much of the underlying stock’s movement as ITM calls do.
More specifically, OTM Apple calls have a delta of 0.44. Meaning they gain about 44 cents for every $1 move in the underlying shares.
You’ll recall that the ITM $120 options from yesterday’s example earn about 90 cents for every $1 move.
But if you’re willing to sacrifice a faster payoff, you can secure a far larger return thanks to a higher degree of leverage — and spend a lot less for the potential gains.
And ultimately, both stock replacement strategies offer investors a big payoff at a steep discount to owning shares.
The best strategy here for an investor comes down to risk tolerance and desired return.
On the hunt,
Senior Analyst, Wall Street Daily