by Karim Rahemtulla, Options Expert
Tuesday, December 1, 2009: Issue #1148
Take a quick glance at the share prices of certain companies today and you’d think the savage 2008 was a distant memory. But 2009 has confounded the “experts” who called for more of the same this year, with stocks rallying sharply, giving investors a chance to recoup some of their losses – and even turn a profit.
However, not everyone jumped aboard. And during the greatest destruction of wealth in our generation, few could blame them. So if you feel like you’ve missed the boat on some of Wall Street’s resurgence this year, I have some great news. Companies like Apple (Nasdaq: APPL), Google (Nasdaq: GOOG), Cisco (Nasdaq: CSCO), Dow Chemical (NYSE: DOW), and Freeport McMoran (NYSE: FCX) are all trading at multiples of their March lows.
Having embarked on such a run, you might think that the shares are now out of reach. But that’s not the case if you think they’ll go even higher over the next year or two. Actually, in some cases, you can still buy them at discounts of up to 50% or more from their current prices.
Just one thing before we start, though: You must not want to “own” these shares for more than a year or two. We’re more focused on nimble trading. So lace up your sneakers because the strategy that accomplishes what I’m talking about is referred to as deep-in-the-money (DITM) investing.
Deep-in-the-Money Investing with High Deltas
Buying options that are deep-in-the-money means they have strike prices (the price at which you can buy the shares) that are well below the current price of the stock.
This is also known as high delta investing.
Don’t be confused… it’s pretty much the same thing. Delta is an options term that simply refers to change in share price versus the change in option price. The higher the delta number, the more correlation there is between the movement in the price of the underlying shares and option.
The highest delta you can get is 100. This means the price of the option will move in lockstep with the movement of the shares. If the shares rise by $2, the options will climb by $2, too. If the shares fall by $3, the option will also drop by $3.
So, why use deep-in-the-money options, or those with high deltas?
Pay Less Money in Premiums with Deep-in-the-Money Options
Simply put, by picking deep-in-the-money options, you’ll pay less money in premiums. The option itself will be more expensive than an out-of-the-money option, only because deep-in-the-money options have more intrinsic value (the difference between the price of the underlying stock and the strike price of the call option).
Let’s say you missed the run on Microsoft (Nasdaq: MSFT), but you think Windows 7 will prove to be a resounding success and the shares may move to $40 per share in a year or so.
Ordinary investors could buy MSFT at $30 and pay $30,000 for 1,000 shares. If the stock does what you think and hits $40, you’ll make $10,000 ($40 minus $30 multiplied by 1,000 shares = $10,000). But that’s a lot of money to spend – and a lot of money at risk.
Here’s a better choice – an example of a deep-in-the-money or a high delta options trade…
Go Deep-in-the-Money with LEAP Options
Instead of shelling out all that money to buy MSFT shares outright, you do this…
- Buy the Microsoft January 2012 $20 call LEAP (WMF-AD). This means you’ll have the right to buy MSFT for $20 a share prior to expiration. The option is currently trading for about $10.70 per contract and has a delta of 100.
- Of that $10.70 price, $10 is intrinsic value ($30 current price minus $20 strike); the other $0.70 is premium for time and risk.
Here’s the difference between going deep-in-the-money and at-the-money (where the option’s strike price is at the current price of the underlying stock)…
- If you bought an at-the-money call option on MSFT (meaning a $30 strike price option), it would cost you $4.50 per contract. Thing is, though, all the $4.50 would be comprised of time and risk with zero intrinsic value.
This is important because if MSFT closes at $30 at expiration, the holder of the at-the-money $30 strike option would lose $4.50, while the holder of the $20 strike would lose just $0.70.
Let’s take it one step further and use a $40 close for MSFT…
- The holder of the $20 option would have an option worth $20 ($40 share price minus $20 strike) for a profit of $9,300 (or 46.5%). We arrive at that figure this way: $40 (stock price) minus $20 (strike price) minus the cost of the option ($10.70) multiplied by 10 contracts (1,000 shares) = $9,300.
- The holder of the $30 strike option would make $5,500 ($40 minus $30 minus $4.50 option cost) – a profit of 122%. Of course, this investor risked less money upfront, so his percentage return is higher. But so too is the risk of him losing all or most of his premium if the shares drop.
Alternatively, if MSFT moves down, the holder of the deep-in-the-money option would experience almost a penny-for-penny move down because the delta is 100. And because of stop-losses, he’d be able to control the loss, just like the shareholder.
Here’s the kicker though: The option holder can only lose what he has invested – $10.70 per contract, versus $30 per share for the MSFT stockholder.
Plus, if MSFT hits $40, the return for the deep-in-the-money guy would be about 87% ($9,300 divided by $10,700 invested = 87%). And while the regular shareholder would make $10,000, he’d have $30,000 at risk for a return of just 33%.
In sum, deep-in-the-money or high delta options are the way to go if your time horizon is known and you want to have less money at risk while not risking any upside at all.