Why Buying in-the-Money Call Options Is a Smart Move

03/31/2010 12:01 am EST

Focus: OPTIONS

Although options should be part of any balanced portfolio, when it comes to buying stocks that you don't plan to keep in your account for the long haul, nothing beats using call options as a short-term surrogate. Not only can you close the position at any time (or simply wait until expiration, when it gets closed for you), but you can bank similar returns for a fraction of the cash outlay.

In fact, you can be making even more money on the capital you'd originally planned to allocate to stock buying. So, when someone tells you that you have to spend money to make money, you can show them the fat returns you're making by saving money instead of spending it all in one place!

In fact, you can greatly reduce your risk if you take your 500 shares of ABC stock, sell it, and then buy five ABC call options that are in the money by a few strike prices.

(I'll explain which expiration date the call options should have in a minute—and yes, that's important.)

If ABC is trading at $60 per share and you pull up the option chain and look at the 2009 January calls, you might see the following call options available:

* ABC Jan 60 calls trading at $9 (These are at the money)
* ABC Jan 55 calls trading at $12 (These are in the money by one strike price.)
* ABC Jan 50 calls trading at $15 (These are in the money by two strike prices.)
* ABC Jan 45 calls trading at $18.50 (These are in the money by three strike prices.)

Make Money By Spending Less

It makes more sense—instead of buying 500 shares of ABC stock at $60 (for $30,000)—to buy five of the ABC Jan 45 calls at $18.50 (for $9,250). Then, put the remaining $20,750 in a money market account and earn a 5% return on that "extra" cash.

In this case, the intrinsic value of the Jan 45 call is $15 (because the stock price of $60 minus the strike price of $45 = $15) and the extrinsic value of the call option is the remaining $3.50 (because the call costs $18.50 minus $15 intrinsic value = $3.50).

This means that during the life of the call option (especially in the last few months leading up to the January expiration), that $3.50 extrinsic value (i.e., "time value") deteriorates. So, if your ABC stock trades flat at $60 for the next few months, the option would lose $3.50 and be worth $15.

Keep in mind that the $3.50 loss (assuming that you actually held on for the next few months) is a loss of $1,750. But, since you put the rest into a risk-free money market account, you would have earned $1,383.33 in interest.
So, the loss is reduced to $366.67. (And that would equate to 73 cents of the call option instead of $3.50 per share.)
So, what are you getting in return for your willingness to lose 73 cents during the course of a few months on a $60 stock that really only equates to 1.21%?

Number One: Broader Market Downtrends are Less Nervewracking

You know that your absolute maximum downside risk is the $18.50 (or $9,250) that you invested in the call option, instead of the $60 (or $30,000) on the stock that likely wouldn't lose all of its value. But, as we know, a loss of anything between one cent and $30,000 is possible.

There are many benefits here that one wouldn't consider at first. One of them is the psychological gain. I mean, you would be a lot less worried about the stock market crashing, and this would allow you to feel more confident about buying when people are fearful. That means that you would be buying when things are down.

Also remember that you should usually play both sides of the market. So, you can also buy in-the-money put options to bet on the downside. That means if the stock is at $60, and you were betting that it would trade lower, you would buy the in-the-money Jan 75 puts.

Number Two: Similar Gains to Buying the Stock

If your stock moves higher, you are making almost the same amount that you would have made on the stock.

Number Three: Smaller Losses

If your stock moves lower, you are probably going to lose much less than you would have on the stock. A very basic hypothetical example is that if the stock trades up ten points, you will probably make nine to 9.5 points, but if the stock trades down ten points, you will probably lose about seven points.

So you see, the downside-versus-upside ratio is less than par. You only get the downside-versus-upside ratio benefit if you do two important things:

1) Buy the options that are in the money by a few strike prices, and…
2) Buy an option that has a long while to go until expiration day. This "long while" should probably be one year or more.

So, in the example used above, January can be the furthest-out available LEAP. The ultimate goal is to be out of the position at least three months before the option expires.

By Chris Rowe of The Trend Rider

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