Sometimes Buying An Option Makes More Sense Than Buying The Underlying Stock

Sep.21.12 | About: ARMOUR Residential (ARR)

When considering an investment in high-yield stocks with options, you may want to take a look and see how the call options are trading before buying the stock outright.

Take ARMOUR Residential REIT, Inc. (NYSE:ARR) as a good example. ARMOUR trades an average of 8.8 million shares per day with a market cap of $2.2 billion.

Yield: 14.44%

Dividend Amount: 9 cents

Ex-Dividend Date: October 11, 2012

You can buy shares at a price of about $7.60 at the time of writing, or you can buy an October $7.50 strike call for about 12.5 cents (bid is 10 and the ask is 15 cents). Learn more about stock options by clicking here.

If you buy the stock, your total risk exposure is $7.60 a share, but if you buy the at the money call, your risk is reduced to 12.5 cents. Often, the main concern with buying calls is worry the time decay will take away most or all of any gains that might otherwise be earned compared to buying the stock.

Stock options in theory price in upcoming dividend payments, and as a result, options can often trade inside periods of virtually zero time decay.

Because the time premium with ARMOUR is relatively low, if the stock moves higher, the Delta (Delta is the amount an option price moves in relation to the underlying stock) will be relatively very high. Plus, as the share price moves higher and higher, the option will quickly trade at full par with the stock (of course there is no guarantee the shares will move higher).

Why should the shares move higher? Stocks tend to increase in front of big dividend ex-dividend dates. At a yield of over 14%, ARMOUR's dividend clearly qualifies.

As long as you are willing to buy shares, buying the call options instead allow you to have much lower risk, and to participate in any upside appreciation in the stock, with zero or near zero time decay between now and when the options turn back into a pumpkin.

The options are expected to fall in price on the ex-dividend date in reaction to the dividend in theory. In the real world, they often don't, just like the stock is influenced by other forces. Still, if you view an option trade instead of an outright buy as a short-term position between now and a few days before ARMOUR trades ex-dividend, you can take a free ride for almost two weeks.

That is almost two weeks of unlimited upside, and only 12.5 cents of downside.

When learning a new trading strategy, it is better to use a simulated trading account first. It is easy to make mistakes when starting out on a new strategy and mistakes cost a lot less with a simulated account.

Strategy: Buy the October $7.50 call for no more than six cents over intrinsic value with at least 10 trading days before ARMOUR trades ex-dividend if you would otherwise buy the stock anyway.

As the ex-dividend date approaches, decide if you want to own the stock through the ex-dividend date and, if so, if it makes sense to exercise the calls do so. Otherwise sell one or two days before the ex-dividend date.

I use a proprietary blend of technical analysis, financial crowd behavior and fundamentals in my short-term trades, and while not totally the same in longer swing trades to investments, the concepts used are similar. You may want to use this article as a starting point of your own research with your financial planner.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.