Each month, I receive a handful of questions from readers about their favorite stocks. Most of the time, they ask for a specific recommendation, like at what price point to enter Apple (AAPL).
So today, I'm going to focus on another thing they always ask about. How to get into their favorite name(s) cheaper. The answer of course is options. Now, before I get into the strategy, I must remind you that options trading does involve a serious amount of risk, and is not suitable for everyone. Before entering any options trade, including the ones I describe, you should always do your own research. That involves research on the stock, as well as the option strategy. You need to know how much money is at risk and over what time period. Also, the strategy I am proposing does not allow holders to receive any dividends the companies are paying, so you may want to take that into consideration, depending on the situation.
How do you get in cheaper? Well, the basic method is stock replacement, as I call it (others may have a different name). What is stock replacement? Well, you can replace an amount of stock for the same amount, through a deep in the money call amount, and usually, you don't have to pay any, or much of, a time premium, when it comes to the option. For this argument, I'll focus on Apple the most, as that is what most of my readers want to know about. But I'll throw in a few extra names, just for fun.
So let's look at Apple, a stock I am currently long. Apple closed Tuesday at $568.18. Let's say you want to buy 100 shares of the company. Forgetting commissions for now, that trade would cost you $56,818. For some investors, that is a large part of their portfolio. For other investors, they may not even be able to buy 100 shares.
But what if I told you that 100 shares of Apple is available for much less? Would you be interested? For most, the answer is yes. Well, I'll start out with a short-term trade, as options are primarily used for trading and shorter time periods. Let's say you want to hold 100 shares of Apple through the end of next week (next week is monthly options expiration week). You could buy a May monthly $500 call option on Apple, which would currently cost you $68.95. With this option, you are essentially long 100 shares of Apple for the next 10 days. This trade costs you $6,895, a fraction of the nearly $57,000 it would take to hold 100 actual shares. Because this option is deep in the money, it will basically move as Apple's stock does. With an option so deep in the money, you are barely paying a premium to hold it. The time premium in this option is just 77 cents, or $77 per option held. That is only slightly more than 1% of the total value, but really, it is not much. If you were to buy a $565 call currently, which is only slightly in the money, you would be paying more than $9 of a time premium, or several times what the option would be worth if it closed at today's prices at expiration.
Most people who want to be in Apple probably aren't looking for such a short holding period, so let's focus on some expiration dates further out. For this example, we'll use the October monthly options, which expire the third week in October. Because there is a lot more time to expiration, you will be paying more of a time premium, if you want to hold those $500 calls. In fact, $500 calls today would cost you $93, or $9,300 per contract, for 100 shares. That means you are paying a $25, or $2,500 time premium per contract. Apple would have to rise $25 by October just for you to break even. Yes, it could do that in a day, but that's not the point. So let's say you are willing to pay a little of a time premium, knowing that you're holding for a couple of months. The $400 October calls would cost you $174.80, or $17,480 per contract (100 shares equivalent). The time premium would be about $6.62, or $662 per contract. That isn't too expensive, and Apple would only need to rise about 1% to make you money. You probably like your chances there. This trade gets you 100 shares for the next five plus months, and it costs less than $18,000, less than a third the cost of 100 actual shares, and with not much of a time premium.
Okay, so let's say you want to be in Apple a while, like more than a year. How does January of 2014 sound for an expiration date? Again, since this is even further out, you would be paying a significant time premium for the $400 or $500 calls. The $500 calls would cost you nearly $139 at this time! The $400s would cost nearly $200. Both of those have a significant amount of time premium in them. So let's look at the $250 January 2014 calls. They would currently cost you $322.70, or $32,270 per contract. The time premium is just $4.52, or $452 per contract, which doesn't seem like much when you are putting down more than $32k, and especially for an option not expiring for more than 18 months. This trade still allows you to be long 100 shares of Apple, for just a little more than $32,000. That is still a lot less than the nearly $57,000 needed for 100 actual shares. You are still getting a close to 45 percent discount. Now, if you don't want to drop that much money into one options trade, you could buy the $300 calls (same expiration) for $277.65, or $27,765 per contract. You'll pay a few dollars more of a time premium, but the overall trade costs about $4,500 less. Since I recently wrote of why I think Apple is a good buy at these levels, compared with Amazon (AMZN), this might be a great trade to get in to. If I had a a lot more money lying around, I definitely would, but I don't have that much currently.
Another name I've looked at for this strategy is Cisco Systems (CSCO). Cisco does report earnings this week so you will need to decide when to execute this strategy. It's not life or death to get into this immediately, as I'm merely using Cisco as an example here. The reason I chose Cisco is because the name is trading at under $20, way less than the $568-plus Apple is at. You can use the same strategy with Cisco, you would just purchase more contracts if you want more money involved in the trade.
With Cisco, I'll focus on just two expirations. The first would be August 2012. You could buy a $14 call for $4.85, or $485 per contract. With Cisco currently trading at $18.71, you are paying just $0.14, or $14 per contract in the time premium. It isn't really that much. Using this strategy, you can get long 100 shares for about a quarter of the price, meaning if you used all options, you could get long 400 shares of Cisco for just $1,940, only about $70 more than it would cost you to own 100 actual shares. The second expiration is January 2014 again. The $10 calls would cost you just $8.95, or $895 per contract. Still a lot less than the $1,871 for 100 actual shares, and barely any of a time premium baked into that one.
For those people who read the Apple/Amazon article, and perhaps even some of the comments, there are a fair amount of people that believe Amazon is overvalued. Some investors might be willing to short Amazon, but to short 100 shares right now, you are talking about a trade involving more than $22,000. However, you can use the options strategy I've detailed, only this time, you would buy deep in the money put options.
For this example, let's look at January 2013 expiration. You could buy a $360 put for $138.20, or $13,820 per contract. This allows you to be effectively short 100 shares, but for about three-fifths of what 100 actual shares would be. Now, you could also buy the $300 puts (same expiration for $80.80, or $8,080 per contract.) You pay a slightly more time premium, but the cost is much less.
To conclude, buying deep in the money calls or puts can allow you to be long or short a stock for a fraction of the price. Some investors might like to be long 100 shares of Apple for $7,000 instead of $57,000. Now, remember that options trades are risky, and percentage gains and losses will be larger. However, your losses are limited to a point. If you hold a $500 call expiring in January of 2014, you know that you can only lose about $14,000 (per contract). Were you to hold 100 actual shares, you could lose 4 times that amount if Apple went to zero. Now, it doesn't seem like that would be likely in the next year and a half, but stocks can crash.
This is a very good options strategy to use, and can probably be used with most stocks. Now, if you are looking at a stock that is prone to more volatility, you will find yourself paying more time premiums. Don't forget about dividends as well. Apple hasn't started paying a dividend yet, and Cisco pays one, although it is small. This strategy may not be the best if you are looking to invest in a company like Verizon (VZ), for instance, that yields 5% or more. For Apple, it works fairly well.
Disclosure: I am long AAPL.