Matt Kerkhoff's Intro to Options: Part 11 and 12

12/15/2017 5:01 am EST


Matthew Kerkhoff

Chief Investment Strategist, Model Investing

Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational series on understanding options and their role in investment portfolios. This series will run each Friday on throughout December, moving from the basics through increasingly more sophisticated strategies.

In the last segment of our series, we began discussing the use of covered calls as a way to generate monthly income from a stock portfolio. In today’s installment of our ongoing monthly options series, we’re going to put the finishing touches on this strategy and discuss how to exit these types of positions.

If you missed any of the prior installments or just want a quick refresher, they’re linked below.

Part 1 and 2: Understanding Put Options

Part 3: Understanding Put Options

Part 4: Factors that Affect Options Prices

Part 5: Portfolio Insurance (Part 1)

Part 6: Portfolio Insurance (Part 2)

Part 7: Rent out Your Stocks for Income (Part 1)

Part 8: Rent out Your Stocks for Income (Part 2)

Part 9 and 10: How to Get Paid to Buy Stocks

Before we get into the meat of today’s strategy, I want to point something out. If you’ve been following along thus far, you may have noticed that two of the three strategies we’ve discussed have involved us being the sellers of option contracts. The only one in which we are buyers had to do with acquiring portfolio insurance.

The strategy that we will discuss today also involves being the buyer of options (this time calls) … but generally speaking, these are the only two scenarios/strategies in which it is advisable to be an option buyer.

Why is this? Because by now you should recognize that puts and calls are really just forms of insurance, and who typically always comes out ahead … insurance companies? Or the insurees? Every once in a while an insuree will get the best of an insurance company, but in aggregate, insurance companies always come out ahead. Insurance is priced that way.

That’s why, generally speaking, you want to be a seller of options. You want to be selling insurance contracts that have a low probability of requiring payout, collecting premiums along the way as the time value component of the contracts you sell erodes to zero. Few people will tell you this, but being an option seller is really the key to making money consistently using options. You need to think of yourself as an insurance salesman …

But … as mentioned, there are two situations in which it is advisable to be a buyer of options: when you need to acquire short-term portfolio insurance, and when you want to buy a stock or ETF at half price. As you’ll notice shortly, we’re going to take some very special steps in this strategy to minimize the downside of being an option buyer – which generally comes as a result of time value decay.

Okay, let's get into it.

Let’s say you’re bullish on a stock like Amazon (AMZN), but with a share price of $955.40 today, you realize that buying 100 shares will cost you $95,540. That’s a lot of spare change.

Is there a way that you can take part in a rise in AMZN shares the same way a general shareholder would … but without this immense outlay? The answer is yes, and it’s accomplished by purchasing deep-in-the-money calls.

We’ve talked about in-the-money options and out-of-the-money options (the former being an option contract that has intrinsic value – value if it were exercised today – with the latter being an option with no intrinsic value that is comprised only of time value), but what is a deep-in-the-money call?

The answer is a deep-in the-money call is an in-the-money call that has A LOT of intrinsic value. Not a little bit … a lot. And guess what, because this type of option contract has a lot of intrinsic value, it’s going to cost a lot … but not as much as purchasing the stock outright. And in exchange for paying up for this type of contract, we’re going to see a couple of big benefits.

Using my online desktop trading platform, ThinkorSwim, this is what the option chain for AMZN currently looks like. I’ve selected the December expiration to give us time for AMZN to rally into the holidays. These December calls will expire in 74 days, on the third Friday of December.

chart 1

We’re going to spend a few minutes studying this option chain because there’s a lot to learn here. The first thing I want to point out, to get you acquainted with the table, is the purple shading that extends down to a strike price (rightmost column) of 955.

As you probably guessed, the purple shaded area marks in-the-money options (those that currently have intrinsic value), while the black area denotes out-of-the-money options. The further we move up in this table in the purple section, the “deeper” in-the-money the call options become.

In order to compare and contrast the pricing dynamics of these calls at various strike prices, we’re going to focus on two specific contracts: the $960 strike, and the $750 strike (at the very top). This will allow you to see the enormous difference between buying out-of-the-money calls and deep-in-the-money calls.

First, notice that the December call option with a strike price of $960 costs $41.00 (I’m going to use the Bid prices just to keep things simple). This means that if you purchased that contract, you’d pay $4,100 plus commission.

Now, how much of that $4,100 is time value, and how much is intrinsic value? The answer is that it’s ALL time value; for your $4,100 you’re receiving NO intrinsic value. If AMZN stays near its current price all the way until December, that $4,100 worth of time value will erode to zero, and you’ll have lost the full investment.

Generally speaking, when you are a buyer of options, you’ll want to MINIMIZE the amount that you are paying for time value. How do we do that? With deep-in-the-money calls, of course.

FREE 14-part guide to options: The Basics to In-Depth Portfolio Strategies

Okay, now let’s look at the $750 strike near the top of the table. Notice that its bid price is $209.00. If we purchase this contract, it will cost us $20,900. That’s a lot more than $4,100! So what are we getting in exchange for paying so much more?

In order to answer that, we have to break this option into its two components: intrinsic value and time value. We do this by calculating the intrinsic value, and then whatever value is left over is attributed to time value.

Here’s how that works:

With AMZN currently trading at $955.40 per share, the $750 strike price call already has an intrinsic value of $205.40 per share ($955.40 - $750). Since the option contract represents 100 shares, this means that there is $20,540 of intrinsic value in the $750 call.

Since we could currently purchase that option for $20,900, it means that we would only have to pay $360 in time value ($20,900 - $20,540) to control AMZN shares until mid-December.

Since we know that time value erodes exponentially over time, doesn’t it make sense to pay as little in time value as we possibly can? You better have said yes!

So here is the first benefit. By purchasing deep-in-the-money calls, we have to put more money up front, but by doing so we are able to spend WAY less on time value, which we KNOW WITH CERTAINTY will erode over the course of that option contract’s life. Pretty cool, right?

If we bought the out-of-money $960 strike, we would be paying $4,100 for time value, whereas with a deep-in-the-money call, we only have to pay $360 to “own” 100 shares of AMZN for the next 74 days. That’s less than 10% the total cost paid for time value!

Quick aside: Flip the script around, and as a seller of options, do we want to sell out-of-the-money or in-the-money options? Out-of-the-money of course, because then we collect more time value premium that will erode over time, leaving us with bigger profits. Starting to all make sense?

Okay, now that we see the first major benefit of buying deep-in-the-money calls as opposed to in-the-money, at-the-money, or out-of-the-money calls, we need to explore the second benefit.

For this, I need to introduce a new term to you, and it’s called Delta. If you study options, you’ll eventually come across what are known as the option “Greeks.” Option Greeks give you insight into how the price of your option contract will change based on changes in the underlying. There are four Greeks (delta, gamma, vega and theta) but the only one we truly need to understand for this strategy is delta.

Delta is a number between -1 and 1, and it tells us how much the value of an option contract should change when the price of the underlying stock (or ETF) rises by one dollar.

Notice that I’ve included the column “delta” in the table above. It’s the third column from the right. Going back to our example, also notice that the $960 call option has a delta of 0.51, while the $750 call has a delta of 0.95.

Here’s what that means. If you own the $960 call, and AMZN shares rise by $1 per share, the value of the $960 call would rise by 51 cents. On the other hand, if you own the $750 call, and AMZN shares rise by $1 per share, the value of that call option would increase by 95 cents.

In other words, the higher the delta of the call option we buy, the more the price of our option contract will represent an actual investment in the stock. With a delta of 1.0, we’re receiving the exact same benefit as if we were actual shareholders of AMZN … that is, with a delta of 1 (or very close), if AMZN goes up by a buck per share, we make a buck per share.

 This is very important and here’s why. If you bought the $960 strike, and AMZN went up by $10 per share, your call option would only increase by about $5.10 per share ($510 gain). On the other hand, by owning the $750 call, a $10 rise in Amazon’s share price would result in an increase of $9.50 per share in the price of the option contract ($950 gain).

So buying deep-in-the-money calls really provides two benefits: They reduce the amount of money we “waste” paying for time value (and the position overall), and at the same time, they position us to receive a larger benefit from moves in the underlying stock’s price. Together, these benefits make buying deep-in-the-money calls pretty much the only type of call option you’ll ever want to buy.

Let’s begin to wrap things up by comparing our hypothetical purchase of the December $750 strike call to what most investors would do, which is just purchase 100 shares of AMZN.

If we purchase 100 shares of AMZN, our outlay would be $95,540. In exchange for that, we’d control 100 shares of AMZN that have a delta of 1.0 (that is, for every dollar that AMZN increases, it adds $1 of per share value to our holdings).

Now, if we went with the $750 call option, our outlay would be $20,900. In this scenario, we would also control 100 shares of AMZN (until the third Friday in December) and that investment would have a delta of 0.95, meaning that for every $1 that AMZN rises, our option contract would increase in value by 95 cents per share.

As you can see, a deep-in-the-money call allows us to experience almost the identical upside benefit that regular owners of AMZN stock receive, but for (in this case) almost 80% less cost! Tell me that’s not rather amazing.

There’s another benefit here, and it comes down to risk. Do you realize that in this scenario, purchasing the deep-in-the-money call results in substantially less risk? Think about what would happen if something catastrophic occurred and AMZN took a path like Enron, or more recently, Valeant Pharmaceuticals.

If AMZN stock dropped to zero, or close to zero, an owner of 100 shares of AMZN would lose roughly their entire investment of $95,540. The owner of the $750 call, however, would only lose $20,900. And yet, both would have received essentially the same upside on the investment, had there been any.

That’s pretty amazing if you think about it … same upside but roughly 80% less downside? Why would anyone ever buy regular shares of stock!? That last comment is a joke, but as they say, all jokes are half truth …

Okay, we’re running long here, and as always we’ll do a follow-up next month on this strategy to explain some of the nuances and how to close out the position. But I want to mention one last thing.

This strategy is called “How to Buy Stocks at Half Price” and yet I just walked you through an example that showed you how to essentially buy AMZN stock for 74 days for way more than half off (almost 80% off). What gives?

The key takeaway here is that deep-in-the-money calls allow you to control shares of a stock or EFT for a significant discount. That discount can vary based on a variety of factors, including volatility and time to expiration, among others.

If you had wanted to use a deep-in-the-money call to exactly approximate being a shareholder of AMZN (find a call option with a delta of 1), then per this example, you would need to look at strike prices of 600 and below. This is where delta rises to 0.99. As you might imagine, these options are more expensive, with the 600 strike costing $35,865 and the 500 strike costing $45,805 (as of today).

Also, this example only looked at a holding period of 74 days. Often, if you want to own a stock, your desired time period will be longer than a few months. Moving to deep-in-the-money calls with longer-dated expirations will increase the amount of time value that you pay for, resulting in a higher overall cost for the option.

These two factors are the primary ones that will drive up the cost of your upfront investment. In some cases, with high volatility and a long time to expiration, the cost of these deep-in-the-money calls will approximate roughly half of what a typical stock purchase would entail.

If you managed to read through all of this, and understood most of it, take the rest of the night off! As I’ve said before, this is not easy stuff. But hopefully, even if you’re still fuzzy on some of the concepts we’re discussing, you’re starting to realize that options open up a whole new world of investment possibilities.

They allow you to restructure risk and reward in a way that accommodates YOU. In this case, we didn’t have to pick between only the $750 strike or the $960 strike, we just used those as examples. The interplay between time value and intrinsic value, and the notion of delta, exist on a continuum.

Buy the $850 strike and you’ll receive a benefit package that lies in between that of the $750 and $960 strikes. Buy the $600 strike, and you’ll get even more of the benefits (pay less in time value, closer approximate the upside of being a shareholder). Ultimately, the decision is up to you.

When you restrict your investment options to only buying or selling shares, there is really only one price that you can transact at, at any given time. But with options, the possibilities are endless. You get to choose exactly how much you want to pay, and for what.

Now, before we continue I should point out what has happened to AMZN stock since we initiated our hypothetical position back on October 2nd (vertical blue line in chart below). As you see, Amazon recently gapped higher due to a very strong earnings beat.

chart 2

While this is going to make our hypothetical trade look very lucrative, and work great for our example, keep in mind that this is atypical price action. It’s not often that a thousand dollar stock rallies by more than 10% in a day.

With that disclaimer out of the way, let’s see exactly what has happened to the two positions we discussed last month.

First, let’s examine the details regarding the deep-in-the-money call we opted for, which had a strike price of $750. Recall that this option contract had an initial price of $209, which means we paid $20,900 in total. Of that premium, $20,540 was intrinsic value and $360 was comprised of time value.

Okay, how do things stand as of today? In the updated option chain below we can see the latest pricing for AMZN calls. The two strike prices of interest are highlighted below, with the $750 strike in orange and the $960 strike in blue.

chart 3

The first thing to notice is that the most recent bid price for the December $750 strike is $358.20 (Note: we used bid prices in the previous article to keep things simple, so we’ll continue to do so today).

This means that the price of our deep-in-the-money call has increased by $149.20 ($358.20 - $209). In dollar terms, this represents a gain of $14,920 or 71.4%. Our original position, which cost us $20,900, is now worth a juicy $35,820 as of today. Not bad for one month’s work!

Next, I want to point out what happened to the “Delta” of this contract. Remember that Delta is one of the option “Greeks” that tells us how the price of a contract will change based on changes in the underlying. Back on October 2, when we initiated this trade, the $750 strike had a delta of 0.95. As you can see in the table above, the delta has increased to 0.99.

Why is this?

The way option prices work, the deeper in-the-money an option is, the higher delta it will have. In this case, while our strike price remained the same ($750), the share price of Amazon rose substantially, pushing our option contract further (deeper) into the money. As a result, this option contract now almost perfectly represents an investment in the stock itself (if AMZN shares rise by $1 per share, our option contract gains 99 cents per share).

While the move from a delta of 0.95 to 0.99 is not all that substantial, I point it out to once again reinforce the concept of delta. When it comes to deep-in-the-money calls, tracking and making sure your position has a high delta is very important.

Okay, now that we’ve seen what a stellar job we did by choosing the $750 deep-in-the money call, let’s see how we would have done if we had approached this as an amateur, and gone with the $960 out-of-the-money call.

Referencing our table above once again (this time looking at the blue box), we can see that the $960 strike has a bid price of $151.25. When we looked at this contract back on October 2, it was trading for $41, so let’s do the math on the hypothetical gains.

Had we gone with this contract instead, our position would have increased from $4,100 to $15,125. That represents a gain of $11,025 or 268.9%. As you can see right of the bat, even choosing a suboptimal contract can be very lucrative if the stock moves heavily in your favor …

Now, you might be quick to point out that using a deep-in-the-money call generated a 71.4% return while the (not recommended) out-of-the-money call delivered a remarkable 268.9% return. Based on those figures alone, it would appear that the out-of-the-money call was the way to go.

But the percentage gain doesn’t tell the whole story, and in fact this is one of the primary reasons why amateur option traders tend to favor out-of-the-money calls … the returns look amazing! But in reality, this is just a gimmick – a math trick based on having a low denominator (cost of the initial contract). As we’ll see, looking at these two trades from a holistic perspective will tell the whole story.

The first thing to point out regarding these gains is that while the out-of-the-money $960 strike saw a higher percentage gain, the deep-in-the-money $750 contract realized a larger total gain ($14,920 vs. 11,025). Any idea why that is?

If you said it was the result of the $750 contract having a higher delta, take the rest of the night off and go grab a beer … you nailed it.

Recall that one of the primary reasons we went with a deep-in-the-money call was because of the higher delta. This told us that the value of our contract would increase more for every $1 rise in the share price of Amazon. And as you can see, that’s exactly what happened.

But that’s not the only reason we went with the deep-in the money call. We did this from a risk management perspective as well. Sure, it’s great that AMZN blew through the roof during the last month, making us lots of money on both our hypothetical contracts, but as I mentioned before, this is atypical price action.

In many cases the underlying security will either not move very much, or it will move against us. And in both these situations, deep-in-the-money calls provide a substantially better risk-reward profile, due primarily to the tradeoff between intrinsic value and time value.

Let’s say that between now and when these contracts expire in December, AMZN shares move back down and end up trading exactly where they were when we initiated this contract ($955.40). In this case, the deep-in-the-money call would have lost $360 worth of value while the out-of-the-money call would have lost all $4,100 of its value. Big difference, right?

The investor who purchased the deep-in-the-money call would live to fight again, while the investor who purchased the out-of-the-money call would suffer a 100% loss.

As a quick aside, this reminds me of something Richard Russell used to always say: “The worst thing an investor can do is take the BIG LOSS.”

Whether it’s in the stock market or the bond market or in this case, the options market, taking a big loss not only sets you back financially, stifling the benefits of compounding, but it also has a big psychological effect. It can quickly lead to more risk taking to “get back to even,” and it can leave your courage and ego shattered, which is a dangerous place for any investor.

That’s why even when it comes to options, we must consider all aspects of the trade, and not try to constantly hit home runs.

Before we wrap things up by discussing how to close out these types of positions, I want to address one more question that may be hiding in the back of your mind.

If you’ve been paying attention so far, you may present the astute argument that buying a deep-in-the-money call, as opposed to an out-of-the-money call, entails more risk because we are putting more capital in harm’s way. After all, if AMZN stock collapses, we stand to potentially lose $20,900 whereas a buyer of the $960 out-of-the-money call can only lose $4,100.

This is a valid argument, but there are a couple of caveats to keep in mind. First, as buyers of the deep-in-the-money call, AMZN shares must fall much further for us to sustain a max loss than for the out-of-the-money buyer to sustain his or her maximum loss. This means that the probability of that occurring is much lower.

In this example, even if AMZN had already fallen by $205.40 per share (to trade right at $750 per share – the same level as our strike price), our $750 call would still not be worthless. The price of our contract would no longer contain any intrinsic value, but it would still have an element of time value representing the possible price action over the next two months.

The other thing I’ll mention is that even if AMZN did collapse in price, the buyer of a deep-in-the-money call still has a lot less capital at risk than a simple owner of AMZN shares. A regular owner of AMZN common stock would have had $95,540 at risk vs. our $20,900 (based on the prices when we initiated the trade).

Okay, now that we’ve covered some of the subtleties regarding deep-in-the-money calls, let’s talk about how to close out these types of positions.

Since we are dealing with in-the-money options here, this tells us that we will need to close out our trade prior to expiration. If we don’t, our call option will be assigned and we’ll end up owning 100 shares of AMZN at a buy-in price of $750 per share.

Chances are you don’t really want to own AMZN shares, after all part of the reason we went with a call option as opposed to buying common stock was to avoid the big capital outlay. Therefore, the easiest thing for us to do here is simply close out our trade and capture the profits.

In this example, we could choose to let this trade run until expiration in December, or we can close it out now. For the sake of wrapping things up, we’re going to close it out today, but the process would be the same if you wanted to wait until closer to expiration.

Okay, so how do we exit this trade?

Closing out an option position simply requires that we perform the opposite transaction(s) that we did previously. For this example, since we purchased one December $750 call option, we’ll close out the position by selling one December $750 call option.

In this particular case, since the bid-ask spread is so wide (bid is $358.20, ask is $362.00), I’d suggest that you go with a limit order toward the higher end of that range. The trade won’t be executed immediately, but once a little bit of volatility kicks in, your order will most likely be completed. If not, you can always cancel that order and set your limit price a bit lower.

The one thing you wouldn’t want to do here is sell your position as a market order. That would be fine if you were trading a highly liquid stock where the bid-ask spread was a matter of pennies, but in this case the spread amounts to $380. So you might as well try to capture some of that spread on your way out of the position.

Alright, that concludes our discussion on how to buy stocks for half price (or less) using deep-in-the-money calls!  At this point we’ve covered four of the five strategies on our road map. The only one left is our final strategy: How to Make Money Even When You’re Wrong.

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