The option strategy that makes the most intuitive sense to most investors is buying put options to protect their holdings. There is a certain familiarity to this approach because it involves owning stocks or ETFs that most investors are very comfortable with. It is also very intuitive to buy insurance on a stock or ETF holding to cap your losses at a certain amount.
The buying of put options on long positions is in fact a good strategy since you are exposing yourself fully to upside risk and limiting your downside risk to an absolute amount. The major problem with this strategy is the cost of rolling over the put options. There is the cost of the option itself, which you would hope expires out of the money, but also there are the trading costs associated with rolling over the protection. In addition, it is often difficult psychologically for new investors to buy a position expecting a loss on it, but that is exactly what you would want to happen for the put option position in this strategy.
However, there is another very simple strategy that can achieve the exact same return as a long stock + put option position, but at a lower cost.
You can buy in-the-money (ITM) call options
This is a deceptively simple but very powerful strategy if used correctly. Since the selling of covered calls is an extremely popular strategy in the market these days it's making call option premiums razor thin on many popular stocks and ETFs. After all if everyone wants in on the trade they will bid up (or in this case bid down) the price of whatever they are buying (or in this case selling).
What may be surprising to some is that the payoff from this strategy is nearly identical to that of buying a stock and buying a put. Let's look at an example to compare:
Buy Stock + Buy Put Strategy
- Buy 1 share of SPY at 145
- Buy 1 put option on SPY with strike price at $140 for $1
Total cost of positions: $146
Payoff if SPY is at or above $140 on expiry = return on stock - option premium
Therefore, if the stock goes up to $150 you make:
- $150-$146 = $5 (stock return) - $1 (option cost) = $4
Then you have to subtract the trading costs of buying both of the above positions and selling the stock.
Total number of trades: three
Loss if SPY is below $140 is set an absolute amount:
- -$5-$1 = -$6
In this case, you also have to subtract the trading costs establishing the two positions as well as of exercising or selling the put + selling the stock.
Total number of trades: four
The good news is the loss is capped at $6 no matter how far SPY falls. The bad news is the number of trades needed to achieve this and the extra capital required to purchase the put ($146 instead of $145 for a regular position).
Buy In-the-Money Call Strategy
- Buy 1 call option on SPY with a strike price at $140.
The price of the call option will be $5 (intrinsic value) + $1 (time value) = $6 to make it comparable to the put example above.
Total cost of position: $6
Pay-off if SPY is at or above $140 on expiry = return on option
Therefore, is stock goes up to $150, the option value ends up at:
- $150 (SPY price) - $140 (strike price) = $10 (value of option)
And you make:
- $10-$6 = $4 <- same return as the buy + put strategy
There is only one trade you need to do on expiry date, in addition to the original purchase of the call, and that is to sell the call option.
Total number of trades: two (instead of three above)
Loss if SPY is below $140 is also set an absolute amount, and in this case its your entire investment:
- -$6 <- same loss as the buy + put strategy
Once again you have to subtract the trading costs establishing the call option position, but you can leave the option to expire which does not cost you anything.
Total number of trades: one (instead of four above)
The differences Between the Strategies and What to Keep in Mind
- The buying of stock + put option has higher trading costs as opposed to just buying the call option.
- The actual capital required to establish the positions is $6 for the call option play, while it is $146 for the stock + put option play. This is potentially 25 times leverage.
- You can use the money not invested in a call strategy to earn a low safe yield to offset some of your time value cost. Otherwise, you can use the money to buy other positions and increase your leverage accordingly.
- You will not be paid dividends on a call option play while you will be paid dividends if you hold the stock.
What if the Dividend Yield Is a Substantial Part of the Overall Return
It is point No. 4 in the previous section that is the only real advantage to holding stock + put vs. holding a call option (unless you are Warren Buffett and care about voting privileges). In general, the ITM call option strategy works best on low dividend yielding stocks and ETFs, but if necessary some planning can overcome this problem as well. When you own a call option you own the right to purchase the stock at a set price and as the dividend accrues in the stock price the value of the option grows as well. This gives you two options to capture the dividend on the day before ex-date:
- You can sell your option position and buy it back the day after. You do take the risk of price fluctuation overnight, but the strategy is cheap in terms of trading costs especially if you can time your regular roll-overs around dividend dates.
- You can exercise your right to purchase the stock, collect the dividend, and then sell the stock and purchase another call option the next day. This is expensive from the point of view of trading costs, but if the dividend is substantial and you are worried about price fluctuations it may be the best option.
How Is Buying Call Options Like Borrowing Money
If you followed the above explanation carefully you probably already know what I am about to write. If you had bought one share of SPY and one put option you would have spent $146. If you had bought a call option you would have spent $6. Since the payoff for both strategies is exactly the same, as illustrated above, you would have essentially borrowed $140 from the holder of a ITM covered call position.
The Key to Making This Work
The absolute key to making this strategy work is to understand how much you are actually paying to borrow the money and protect your holdings. The cost needs to be understood not in terms of dollars or in terms absolute percentage, but rather in terms of the annualized hit you take to the underlying return. You can think of it as interest on your loan, which reduces your expected return but gives you absolute protection and an opportunity to leverage. The Optionize Contract Search is one tool that can help you find the cheapest contracts to achieve these goals.
In summary, the ITM call option strategy allows you to borrow money cheaper than on margin, to borrow money in accounts where otherwise you would not be allowed to borrow, and to have some absolute protection against price drops.
Disclosure: I am long SPY. 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.