I scan the options market as well as questions sent in by readers on a daily basis looking for tidbits that could help us all make better use of options. From time to time, I do a Friday Seeking Alpha column that highlights some of the most notable thoughts and information since the last update.
First, I preview something I will cover in-depth in Issue No. 9 of the option investing newsletter, which goes out to subscribers Tuesday morning. A subscriber asked: Why do you go OTM on your Ralph Lauren (RL) and Amazon (AMZN) calls? Isn't more conservative (safe) to go ITM? He was referring to the following portion of an article published early this week:
I hope that Ralph Lauren (RL), up on Tuesday and Amazon.com (AMZN), really up on Tuesday, get crushed with the rest of the market on a crash or correction. If they do, it's time for me to jump in. Look to last year. See the sharp drops and see that both RL and AMZN were two of the stocks that not only led us out of the darkness, time after time, but outperformed.
Tuesday serves as but one indication for me that the very same will happen again this year. On a major correction, I will seriously consider the following trades:
BUY RL January 2013 $180 calls (priced at $18.72, as of late Tues)
BUY AMZN January 2014 OTM (by $20-$40) calls
Stocks like RL and AMZN, historically, have performed relatively well over the last year during times of broad market weakness and/or participated predominantly in ensuing rallies to, ultimately, move higher. Because I believe in the long-term stories of both companies, particularly AMZN, I am willing to go OTM on long-dated calls only.
Also, it's important to note that the RL calls, at the time I wrote that article, were, for all intents and purposes, ATM or slightly OTM. As RL pulls back into the low 170s, they go a bit deeper OTM, but not much. AMZN, meantime, was and still is relatively deep OTM, but, honestly, given the way this stock performs, I don't think it's unrealistically deep OTM. Look at how AMZN came out of the gate Friday morning with the market down. Other than silver and oil ETFs, some leveraged, AMZN outperformed everything else on my watch list. And that takes place with some consistency.
In a nutshell, on stocks like AMZN, Apple (AAPL), Chipotle Mexican Grill (CMG) and Priceline.com (PCLN) - a mixture of momentum and sound underlying and sustainable long-term, growth-oriented business models - I like to use the leverage OTM options can provide. That veers from my normal thought process on using calls to play upside. Here's why.
I am fairly confident that stocks like AMZN, over the next 6-9 months will attain new highs, regardless of the broad market environment. As such, I want to take advantage of the lower-priced premiums OTM calls offer. If I am correct and the stock continues to power ahead, my calls end up ITM and I begin to reap the benefits and relative comfort of being ITM.
I stress - I do not haphazardly use this strategy. That does not mean I will never be wrong. That said, I am only willing to go this route on a handful of stocks that, over time, have proven to be market leaders during times of strength, weakness and when the dust settles.
Generally, on 99% of the stocks in the universe, I will only go ITM and only use long-dated calls. Time Warner (TWX) provides an excellent example. It also gets at the fallacy of using valuation metrics, such as the P/E ratio to make trading and investment decisions.
I am long TWX stock. I love practically everything about the company. It's likely a stock I will take into retirement with me, scaling into what should be a relatively large position 5-10 years from now. Traditionally speaking, it's woefully undervalued at a forward P/E of under 10. That said, I have little, if any, confidence that this slower (though still nicely)-growing, dividend-paying stock will rocket ahead like APPL, AMZN, CMG, PCLN and RL has.
With that said and illustrated, I expect appreciation. I just cannot, with any confidence, bank on a TWX OTM call morphing into an ITM call in relatively short order. As such, if I end up buying TWX calls, I will take the conservative path with something like the TWX January 2014 $30 calls. At a delta of .67, I get closer to replicating direct stock ownership as the price of the underlying stock slowly but surely climbs higher.
Again, this strategy - going ITM and long-dated - takes center stage a vast majority of the time. AAPL, AMZN, CMG, PCLN, RL and others like them represent exceptions to the rule. And, given the reality that the momentum and sound fundamentals cannot last forever (or can they?), they also represent relatively risky exceptions you should not enter into, using any type of option, lightly.
Additional disclosure: I am long RL, TWX.