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Joe Springer
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  • Call Options Primer

    We had a blog question on "out of the money" options, so here is our quick primer on out of the money and in the money options.

    Call Options

    A call option gives you the right to buy 100 shares of a stock at a given price (strike price) before a certain date (expiration date).

    Think of a call option on Coca-Cola (KO), with a strike price of $30, and an expiration date in December of this year. This gives you the right to buy 100 shares of Coca-Cola between now and December, for the price of $30 per share.

    If Coca-Cola is trading above $30 per share come December, you would exercise your option and buy those shares (or sell the call to someone else that would effectively do the same). If Coca-Cola is less than $30, the call would expire worthless.

    In the Money

    Currently Coca-Cola trades for around $42 per share, so a call with a strike price of only $30 is "in the money". Every call with a strike below $42 per share is in the money, and the lower the strike price the "deeper" in the money the call is.

    For Coca-Cola, a call with a strike of $40 is in the money, and a call with a strike of $30 is deep in the money.

    Out of the Money

    Likewise, any call with a strike above the current share price is "out of the money."

    For Coca-Cola, a call with a strike of $45 is out of the money, and a call with a strike of $60 is (yes) deep out of the money.

    Intrinsic Value

    In the money call options have "intrinsic value."

    Our Coca-Cola call with the $30 strike has $12 of intrinsic value, as it allows you to buy shares $12 cheaper than the current price of $42.

    Out of the money call options have no intrinsic value.

    Time Premium

    A call's total cost is its intrinsic value plus the value of the time before the call expires, known as the "time premium." The longer you get to own the call before it expires, the greater the time premium.

    Think of two Coca-Cola calls, each with a strike of $30, but one that expires this year and one that expires next year. The intrinsic value is the same, but the one that expires next year will be more expensive because of the value of the extra time, the time premium.

    Trivia Time

    So there are two components to a call option's cost, intrinsic value and time premium.

    We saw how to calculate intrinsic value: the current share price minus the strike price.

    What about the time premium? That's a little different.

    We saw that the further out a call's expiration is, the greater the time premium will be. But what about calls of the same expiration? Is the time premium different between the calls?

    Yes it is. So here is your trivia question:

    For in the money calls of the same expiration, will you pay more in time premium for deep in the money or not so deep in the money calls?

    Answer

    You may have answered like this:

    The deeper in the money a call is, the less likely it is to expire worthless, so I would expect to pay more in time premium.

    Not actually. Call options allow you to tie up less money than buying common stock. This is effectively owning more shares than you could otherwise afford, or risking significantly less money for the same amount of upside participation as the common stock you could afford.

    This is what brings people to options in the first place. It also means that the less money you have to put up, the higher your time premium "fee" will be.

    A deep in the money call has a large intrinsic value so you will have to put up more money, and be able to buy less calls than if you bought not-so-deep calls. You will pay less in time premium in exchange for risking and tying up more money.

    You are also taking on less leverage. The deeper in the money a call is, the closer it is to resembling the common stock.

    Chain Chain Chain

    Let's have a look at an options chain. Here is Coca-Cola's chain for the January 15, 2016 expiry.

    Note that even though one call represents the right to buy 100 shares, the price for the call is listed as if you were only buying the right to buy one share. So while the $40 strike has a $3.60 bid, the real bid is $360.

    (click to enlarge)

    Let's look at the $35 and $40 strikes. Coca-Cola last closed at $41.94, so the $35 strike has an intrinsic value of $6.94, and the $40 strike has an intrinsic value of $1.94.

    There is an ask of $7.40 for the $35 strike, and an ask of $3.75 for the $40 strike.

    So if you buy at the $35 strike, you start making money when Coca-Cola reaches $42.40. If you buy at the $40 strike, you start making money when Coca-Cola reaches $43.75.

    So the deeper in the money call charges you less time premium, and gives you a lower breakeven point.

    Does that make it better?

    Only the future knows.

    If Coca-Cola's share price goes (and stays) below $35, they both expire worthless.

    Between $35 and $42.40 there is less pain in the $35 call.

    Between $42.40 and $45 the deeper call is still better.

    If Coca-Cola goes to $45, the $35 call makes $2.60 (per share), while the $40 call makes $1.25.

    This is basically a tie, and the higher Coca-Cola goes from here, the more the call with the higher strike will outperform the deeper in the money call.

    The reason it is a tie is that even though the $35 call has twice the return of the $40 call, it was also twice as expensive in the first place. For $740 you could buy one $35 call, or two $40 calls, so your return is the same.

    If you get a double and Coca-Cola goes to $84, the $35 call makes $41.60. That's a 562% gain off of your original $7.40. The $40 call makes $40.25. That's a 1,073% gain on the $3.75 you paid.

    Let's add a third call to the mix. The deep out of the money $55 call has an ask of $.23. That's less than a thirtieth of the $35 call's cost. With a breakeven of $55.23, it is a total loss unless Coca-Cola performs very well.

    But what can that cheapness return for you if Coca-Cola doubles? An old fashioned 12,509%.

    Takeaways

    So three call option takeaways:

    • The deeper in the money you buy, the less you pay in time premium
    • As the stock performs better, the deeper calls underperform the less deep, and the less deep underperform the out of the money
    • Cheap out of the money calls have really, really high upside
    Tags: KO, long-ideas
    Jul 09 6:06 AM | Link | Comment!
  • Get The Biggest Upside In The Stock Market

    (Author's note: working title was "Call Options, Then Email Derivatives and Text Leverage")

    Our last article on Tonix Pharmaceuticals (TNXP) led to some conversations about using call options, and we wanted to humbly offer our thoughts in the royal third person.

    Common Stock is Probably Best

    In order to get an informational edge in the market, you have to stick to the smaller stocks, the ones that can't interest big money. Our time is not well spent trying to know Coca-Cola better than the hundreds of analysts covering it.

    But the small stocks usually have no options trading at all, and if they do, they are probably illiquid. So usually the common stock is the way to go.

    How Liquid?

    One question we got is "how liquid do the call options need to be?" Our answer was "hold out for your price, if you get it that is liquid enough."

    Which begs the question "what is my price?"

    So here is our Holy Trinity Strategy for buying call options.

    Holy Trinity Strategy

    If you do not have a catalyst looming but you like a stock, the common stock is the much better choice. Options lose value with each passing day, everything else being equal, and you do not want to stay long in that situation.

    So the first part of the trinity is:

    1) Have a catalyst

    But not just any catalyst, one that is in the near term. You do not want to stay long in an asset class that loses value every day, so the rule of thumb here, and the second part of the trinity, is:

    2) Sell within a single digit number of days

    So this can put you there for the action, and time decay does not bite you too much. You still should probably buy the common stock instead of the call options. But you have permission to buy if you:

    3) Pay nothing or next to nothing for options

    Sound too good to be true? It usually is, and you should usually buy the common stock.

    But when options are approaching expiration, you can sometimes get them very cheaply. And if that coincides with your catalyst, and you are right about that catalyst, there is no bigger upside in the stock market.

    Bonanza

    We have been lucky, and we know we have been lucky, but we have employed this strategy several times, always with bonanza results.

    We noted in the comments section of the Tonix article that we did this with MannKind (MNKD). We were in the common stock, anxiously anticipating a catalyst, and someone started unloading out-of-the-money call options that were expiring in two weeks. They were looking to sell for 2 cents each, just looking to get anything for something that would likely be completely worthless in 10 days. We (foolishly/brilliantly) bought all of them we could, selling out all of our common stock. Within a week those calls were in the money by 35 cents, and we netted more than 1,000%.

    The key was that we were not looking to force our way into the options, we assumed they were a bad deal until a motivated seller gave them to us for next to nothing.

    But you can actually do better than next to nothing.

    On June 28, 2012 we published an article boldly titled: "Get Long Right Now, Market Is Low Risk And High Reward For 30 Hours." Two days later we published an article titled: "30 Hours Later Up 23.2%."

    What did we see? In addition to predicting one of Bank of America's biggest one day gains (thank you), we found FREE LEVERAGE in the form of costless call options, call options that had not expired but literally had a time premium of zero. See the articles for more info. And keep this one in mind too, that is the strategy.

    Stick with the Common

    What to do? Stick with the common stock, keep an eye on the options to see if the stars align, and pounce if they do.

    Disclosure: The author is long TNXP.

    Tags: TNXP
    Jul 07 6:59 PM | Link | 16 Comments
  • What Would You Do?

    I had an email:

    I was really looking forward to the VO article because I'm finding myself with some cash right now and not sure where to park it. However that's really for retirees and that's not me just yet. If you don't mind I'll give you a quick rundown of my situation.

    Income:80-90k, 29 years old
    Just sold house about a month ago and have about 150k liquid from equity (way too much I know, but it scary to really do something with it). Stock are very expensive right now etc etc...
    I have about 100k invested. (mixed: safer oil and some more speculative positions...tnxp)

    Happy to answer!

    150K liquid and you are 29, you are ahead of the game my friend. I'll give you some standard answers and my own fearless answers.

    "Stock are very expensive right now etc"

    The great value investors will generally tell you that when it looks like cash is the best bet, usually a mixture of cash and stocks does better. Bull markets historically go on longer and stronger than their value metrics would prescribe (this is mostly Bruce Greenwald and Ken Fisher I'm channeling here).

    I think you should be 100% invested in stocks at your age, it's hard to time the macro moves, and there is evidence that the greater risk is missing the upside. I also think that a PE of around 20 for the S&P is going to be a bit of the "new normal," with bonds yielding so little money has to go somewhere, you could even argue that stocks are pretty undervalued relative to fixed income.

    So understanding that you (1) have a long time horizon but (2) see the markets as expensive, I would:

    -Pick stocks - You have a position in TNXP, this is a stock with it's own trajectory, what the broad markets do will not be this stock's fate. I would pick your very favorites, six or less like a good Buffett disciple, and see what kind of diversified portfolio you can make of stocks that have their own trajectory.

    -Balance cash and extreme diversification for the rest. You know I like VO for a US index fund, but you could spread some around in Vanguard's VXUS and BNDX - the total international stock market and bond market. Very cheap extreme diversification.

    Some form of that should give you the upside a 29 year old needs, but enough safety to not take too much of a hit whatever happens.

    Hope this helps, all the best!

    Joe

    Update:

    I'm going to be so bold as to suggest two more equities that I've had my eye on.

    I've been slurping up David Merkel's Alephblog, he's a value manager and one of the most qualified voices in the insurance industry, and he likes National Western Life (NWLI) and Reinsurance Group (RGA).

    His thoughts:

    National Western Life

    Reinsurance Group

    Basically he likes NWLI as a conservative life insurer that has a long record of taking appropriate risks. They trade about two thirds of book value and PE of under 10. Life insurers have to sit on a ton of bonds, that's why so many trade below book, but this is a well managed and quite profitable company. It's also closely held by insiders and unfollowed. One additional point is that different lines of insurance don't mix well with certain other insurance lines, and this is a pure life insurerer with simple products.

    Then with RGA - reinsurance is actually the business that trades more like life insurance. Life insurance company values are generally heavily influenced by the future returns projected for their vast holdings (mostly bonds). These days with bonds paying so little that value is down. But a great fixed income game is providing life insurance - collecting more in premium value vs expected payouts to policy holders. Reinsurers are actually the companies that most resemble this model, and Merkel's favorite is RGA.

    Am I long these companies? No, I'm too active and they are too boring, but they look like excellent long term holdings.

    They both will trade with financials, you could combine the two for your financials position, and consider it advantaged bond exposure as well..

    Update:

    Might as well mention the other insurer on my list, also from Mr. Merkel, Endurance Specialty Holdings (ENH).

    His thoughts.

    He tells a story about when he first started in the insurance industry someone told him that Property & Casualty insurance is not "real" insurance - if the companies lose money they just raise prices. The implication being that rather than being able to accurately forecast outcomes, they charge a number and just raise it if they are losing money.

    He says that while that's not completely true, the best money is in P&C.

    ENH for example provides crop insurance. How do you insure that? Basically you have to err on the side of favoring yourself and charging too much.

    So there's a P&C insurer to go with a Life Insurer and Life Reinsurer, each with different risks - interest rate (Life), mortality (Life Reinsurer), and crops (P&C).

    Not a bad little self-constructed insurance company..

    Disclosure: The author is long TNXP.

    Tags: VO, TNXP, NWLI, RGA, ENH, Insurance
    Jun 28 1:22 AM | Link | 1 Comment
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