08/26/2022

Or, I could have titled this why call options make dollars and cents.

Does it make sense to put a little money in Call Options?

The story I will tell today, hopefully, will convince my readers that it does.  Let’s first look at the chart I’ve put together on Devon Energy Corp. (DVN).

While talking to my buddy, Bill Stark, on the phone the other day he and I decided DVN may be a good stock (with inflation and rising gas prices) to put a little money into.  Of course, no one knows what the future holds and if they tell you they do they are a liar.  Now Bill is not an investment guru and has never been trained in investments as I have.  He worked his entire life (as far as I know) for the U.S. Postal Service.  His #1 passion is golf … but on rainy days (as we have had for quite a while in Mississippi now) you can find him in front of a computer trading in the market or playing computer games.

Take a look at the chart as we saw it on the day, we were looking at it:

This is part of a 30-day chart for DVN.  What we saw was stock that was trying to trend up but we could not predict that it would continue that way.  If you look at the Red Line, the 50-day Simple Moving Average (SMA) we see that it seems to be trending down.  However, the Green Line, the 100-day SMA is trending up slightly; while the blue line, the 20-day SMA is in a strong trend up.  When you want to invest in options it is important to “Make the trend your friend” no matter if the stock is trending up or down.  If up … Call options … if down … Put options.

Does it make sense to look at Options rather than the stock?

On August 12^th when we were looking at this stock you will see that it opened (take my word for it since you really can’t see the values) at $64.12.  The stock, on that day, went as high as $65.80 and as low as $63.68 … but eventually closed at $65.55.  Now I have no idea where it was when I actually purchased the options contracts that I will tell you about, but it’s safe to assume it was somewhere between $63.68 and $65.80.  As you will see in the next chart, when I started to write this article, the stock had hit a price of $74.56.  Therefore, it grew from a closing price of $65.55 on 08/12/2022 to a price of $74.56 in just 10 trading days (14 calendar days).  That is an overall increase of $9.01 per share (or an increase of 13.75%) in a period of 14 Calendar Days.  That, in and of itself, is not a bad return for a stock investor.

If I would have bought the stock (using an average price of $64.74) it would have cost me $6,474.00 to purchase 100 shares.  Rather that doing this I purchased 3 Call contracts with a $60 strike price and an expiration date of 10/21/2022 for a total cash outlay of $2,221.99.  Imagine that … controlling 300 shares of stock that could have cost me as much as $19,422 (300 x $64.74) for only a fraction of the cost ($2,221.99).  Had I purchased the stock and it fell by only 11.44% I would have lost a total of $2,221.99 (the cost to purchase the options).  Remember, on the 12^th of August my buddy, Bill, and I had no idea which way this stock was going to go.  This is a major reason we chose not to invest $19,422 into 300 shares of the stock.

Why would I look to “In the Money Options?”

Remember the stock was trading at around $65 per share and the options I purchased had a strike price of $60.00.  This means the options were already $5.00 per share in the money.  So, the premium I paid per share to purchase these options was $7.41 per share ($2,221.99 ÷ 300 shares).  Of this $7.41 a total of $5.00 was known as “intrinsic value” and the remaining $2.41 was extrinsic (or time) value.  In an option it is time value that depreciates or melts away daily.  The Intrinsic value will be there – and can even grow – as long as the stock remains the same value or grows in value.

Another reason I look at “In the Money” (ITM) options is because they provide a higher Delta.  The Delta of this option (one of the Greeks in options you need to know) was probably about 0.60.  At the Money (ATM) Options have a Delta of about .50 and the deeper you go in the money the Delta becomes larger.

Delta tells us two things:

First, for every dollar the underlying stock increases in value the option increases in value by the Delta.  So, a Delta of 0.60 means that if the stock goes up $1.00 the option premium you paid to purchase the option goes up about 60¢ in value.

Second, the Delta tells us the likelihood of the option expiring “In the Money” on the expiration date.  A delta of 0.20 has only a 20% chance of expiring ITM whereas a delta of .060 has a 60% chance of expiring ITM.  When you hear someone say that all options “expire worthless” don’t believe it.  Many options expire worth their “Intrinsic Value.”  Intrinsic value is simply the stock price minus the option strike price.  In this case of a $60 call option … if the stock was valued at $61 at expiration the option would be valued at $1.00.  If the stock was $75 at expiration the option would be valued at $15.00.  Since the is no NEGATIVE Intrinsic value … if the stock was at $60.00 or less at expiration of the option … the option would be worthless.

Keep your position sizes manageable:

What do I mean by that?

I recommend that you never invest much more than 2% of your total portfolio into one option position.  My portfolio is a little more than $100,000 in value.  Therefore, I try to keep my options positions at roughly $2,000.  Sometimes you may go a little over or under to get the number of contracts you need to have.  This literally gives me room to have up to 50 options positions in my portfolio knowing that the most I can lose for any one position is 2% of my portfolio value … and I know that I am not going to lose on all positions.  I have also never held 50 positions in my portfolio at one time.

To mitigate losses even more – use Profit/Loss lockers:

I’m of the opinion – when it comes to options or any investing – that “Pigs get fed while Hogs get slaughtered.”  Being piggish is fine … but when you get hoggish you are probably on a fast track to trouble.

Knowing this I will always do the following:

First, I will always look for options that have an expiration date at least 60 days in the future. Some say the “sweet spot” for options expiration is 60 to 120 days.  However, I’ve had some fortune actually going out as long as a year in the future on many options.  Keep in mind the further you go out … the more expensive the premiums become.  This is why many foolish investors look for options that are only a week to a month out in time.  They are looking for lower premiums and greater rewards – though 90% of them will lose more money than they make.  Take a look at this chart below from Investopedia.com:

Notice that while it takes a long time for Theta to rob you of 50% of an option “Time Value,” the remaining 50% is lost in the last 30 to 45 days of the options life.  It’s kind of like a block of ice.  The longer you let it melt the faster it will melt.

Second, once I have purchased an option, I will immediately set a bracket order.  That bracket order can be for a gain of 50%, 100%, 150% or 200% … but it will also include a “Trailing Loss” of 50%.

A trailing loss works off the options Bid Price.  It will trail the Bid Price up but never down.  For example:

• If the Bid Price of an option is let’s say $5.00 when I set the Trailing Stop … the “Trigger Price” for the stop loss is $2.50.  This means that if the option price drops to $2.50 per share it will be sold at the next available “Market Price” which may be higher or lower than $2.50 per share.  The more Open Interest you have on the option the closer you will be to the $2.50 per share.
• If the bid price moves up to $15.00 per share the new Trigger Price has moved to $7.50 per share (50% of $15.00).
• Then if the bid price drops back to say $13 per share, the Trigger Price does not get lowered to $6.50 per share (50% of $13) but remains at $7.50 until the Bid Price moves back above $15 per share.

So, with multiple contracts per option, I will start with a gain of 50% of the original cost and a Trailing Stop of 50%.  Then I may move some other contracts to a gain of 100% of the original cost with a trailing stop of 50%.  If I have more contracts left, I may move to a gain of even 200% of the original cost and a trailing stop of 50%.  Allow me to illustrate using one of my holdings on Apple Computers (AAPL).

As you can see, I have 6 contracts on AAPL $175 Strike set to expire on 01/20/2023.  I have two of these set with Profit/Loss lockers of 50% gain and 50% Trailing Stop.  Two are set for 100% gain and 50% trailing stop and two are set for 200% gain and 50% trailing stop.  Regardless of whether these prices are hit or not rest assured I will be closing all these options that remain no later than 12/20/2022 since that would be 30 days before expiration.

Now let’s get back to the DVN story:

I bought 3 options with a strike price of $60 and an expiration of 10/21/2022 – which at the time was about 70 days into the future.  I paid $7.41 per share.  Since that purchase this is how the underlying stock (DVN) has performed:

I set two of these contracts to close at a 50% gain or a 50% trailing Stop and the other 1 contract to close at a 100% gain or a 50% trailing stop.

Just 5 trading days later (7 calendar days) the first two contracts got sold at the 50% gain.  Then 5 days after that, the last 1 contract got sold at the 100% gain.  Would it have been better to target them all for a 100% gain … sure … but remember:  We cannot see into the future and we know that “Pigs get fed and Hogs get slaughtered.”

This is how it worked out in the end:

I made $747.31 on the first two contracts that were closed (50.45% gain) in 7 days … that’s an equivalent annualized return of 2,630.55% assuming I could replicate that every 7 days.  I made a $751.66 gain on the last contract that was closed today (101.49%) in 14 days … that’s an equivalent annualized return of 2,645.86% assuming I could replicate that every 14 days.

This all happened as the stock itself only returned 13.75% in 14 days (for an equivalent annualized return of 358.48%.

The bottom line:

No matter how you analyze it … options can provide greater percentage returns than can the underlying stock in a shorter period of time with less money to lose.  This, to me, makes options less risky and more profitable than investing in the stock.

Does this mean a person should never buy and hold stock.  Not in the least bit.  I have a portfolio of stocks in addition to a portfolio of options.  I personally think a person will do better, long-term, investing in multiple areas.  All I’m trying to make you understand is that it makes sense to have some of your money in options along with other investments you may be participating.

Things to remember when buying call options:

1. Consider buying options At the Money or In the Money rather than Out of the Money.
2. Look for options that have Open interest of at least 100 so that you know it is more liquid and will be able to be closed at a price more satisfactory to you.
3. Look for Delta’s of between 0.50 and 0.75 to give the option a 50% to 75% chance of going in your favor.
4. Buy options in a stock that is up in value on the day you buy the option and appears to be trending higher in value – unless it is a put option … then purchase opposite.  An option on stock that is down in value on the day you buy it and appears to be trending lower in value.
5. Look for options that have an expiration date (in most cases) of 60 to 120 days out to “put time on your side.”
6. Look for options on stock that have an earnings announcement at least 30 days in the future.  Earnings announcement can ruin an options value.
7. Get out of options contracts at least 30 days before expiration regardless of gains or losses.
8. Try to keep your options contracts to an average of about 2% of your total options portfolio value at time of purchase.
9. Always set profit/loss lockers to lock in gains and mitigate losses to less than 2% of the portfolio value should the option go against you. 
10. Stay positive and have fun …