3 Opportunities to Put Smart Option Strategy Into Action

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Includes: ABB, CORN, FXF
by: Bob Rubin

Option strategy can slash your investment risk by 50% or more. You’ll learn how in this article on the Stock Replacement Strategy, and get three suggestions for immediate action.

Most people think options are for speculators. They couldn’t be more wrong. Options were created to cut risk. That’s what the pros call “hedging.” Smart option strategy lets you keep all the profit potential of buying stock with much of the risk removed. Interested?

The Stock Replacement Strategy is a great example of smart option strategy. Instead of buying shares of stock, you buy deep-in-the-money call options. This is simpler than it sounds.

In-the-money call options give you the right – but not the obligation - to buy shares of stock for a lower price than the stock is trading for. Deep-in-the-money calls let you buy shares of stock for much less than their current market price. The price of deep-in-the-money call options is often far less than the equivalent shares of stock.

Let’s look at some of the advantages –

  • Invest much less money – reduce risk.

  • Diversify. What you save on one stock can be invested elsewhere. That also cuts risk.

  • Earn a much higher percentage return because you get almost identical profits to a stock purchase but invest less.

  • Those without the capital to buy iconic stocks with high prices will find deep-in-the-money calls more affordable.

But don’t just buy two or three option contracts with the same money you would have spent on stock. Do that and you put as much money at risk and fail to diversify.

What if a stock goes up? Deep-in-the-money calls go up almost dollar for dollar with the stock. They have what’s called a high “delta.” That’s why we buy them. You get almost identical profits for a smaller investment. Out-of-the-money calls (giving you the right to buy stock for more than its current price) don’t offer the same match between the stock and option prices. Deep-in-the-money calls keep their high “delta” over a broad range of stock prices.

What if a stock goes down? Your loss would be almost identical to a stock purchase, but it would be a bigger percent because of your smaller investment. Yet, the maximum possible loss on the option is smaller than on the stock, again because of your smaller investment.

Risk is not eliminated, but it sure is cut.

Here are three opportunities to put deep-in-the-money calls into action today:

FXF (Swiss Franc Trust) is an ETF tracking the Swiss Franc against the US Dollar. The Swiss Franc is consistently among the world’s strongest currencies. It’s a safe haven while the fate of the US Dollar and other major currencies remains uncertain. As I wrote this, FXF was trading for $116.65. Yet September $98 calls on FXF are asking $18.80. (These calls give you the right to buy 100 shares of FXF for $98 a share. The calls expire September 17, 2011.) 100 shares of FXF cost $11,665. One option contract costs $1,880. That’s only 16% of what the stock costs, with the same potential profit.

CORN (Teucrium Corn Fund) is an ETF tracking futures contracts on corn. Corn is the largest field crop in the US. It’s used for animal feed and in many food products and additives. No matter what happens to the US economy, people will still eat, and corn is among the safest commodities. As I wrote this, CORN was trading for $44.86. Yet November $30 calls on CORN are asking $25.80. 100 shares of CORN cost $4,486. One option contract costs $2,580. That’s only 58% of what the stock costs, with the same potential profit.

ABB (ABB Ltd.) is the world's leading producer of transformers, cables, power converters, circuit breakers, substations, and other electrical infrastructure. Its price is a proxy for electricity spending. The International Energy Agency says global electricity demand will grow 2.5% a year for the next 20 years. ABB is another long-term haven. As I wrote this, ABB was trading for $24.87. Yet September $15 calls on ABB are asking $10.20. 100 shares of ABB cost $2,487. One option contract costs $1,020. That’s only 41% of what the stock costs, with the same profit potential.

Here are some tips for using the Stock Replacement Strategy:

  • Always buy calls with at least three months until they expire. That gives them time to rise.

  • Options lose value fast in their last month, so close out your position before then.

  • Never let the stock price fall below the strike price. Close out your position before then, or the options will become too volatile.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.