Options get a bad rap for being extra risky, but a good use of options can be to get in on "expensive" stocks at a discount without the extra risk usually associated with them. This article is meant to illustrate why buying deep in-the-money options can provide a discount for purchasing shares of Amazon (NASDAQ:AMZN). AMZN is an incredibly hot stock these days, and many people would love to get in on it, but they just don't have the capital to make it worthwhile. This article isn't meant to portray a bullish or bearish sentiment on AMZN, but rather teach you a cheaper way to express that sentiment in your own trades. I'm a big fan of finding the best way to express trading ideas. Buying and selling long is great, but it isn't always the best way of expressing sentiment.
Suppose you are bullish on AMZN. Now, suppose you want to buy 100 shares of AMZN. At the current price of $766, you'd have to put forward $76,600 to express this trade. Most people aren't going to want to do this unless they are holding for a long enough time period where they want to also collect dividends on the position. The thing is, AMZN doesn't pay those out. So, what if there were a cheaper way to buy those shares while forfeiting the (non-existent) dividend? It would be identical to buying long, only cheaper. You can, with options.
What does an option get you in the market? Well, there are two types of options (puts are covered at the end of the article). A call option gives you the right to buy 100 shares at a certain price anytime before the expiration date. So, an Aug 765 Call option for AMZN gives you the right to buy 100 shares of AMZN at $765 per share anytime on or before the 3rd Friday of August (options always expire on the 3rd Friday of the month). A 734 Sep Call option gives you the right to buy AMZN for $734 any time before the 3rd Friday of September, and so on. AMZN also has weeklies where you could buy, for instance, a 777 Aug2 Call option that expires on the 2nd Friday of August (Aug1 would be the 1st Friday, and so forth).
Let's go back to the AMZN Aug 765 Call option. What's going on there? The price of AMZN is $766. This means you could exercise your option and buy 100 shares at $765 and immediately sell those shares for a profit of $766 (current price) - $765 (option exercise price) = $1 per share x 100 shares = $100 profit!
The idea is actually pretty simple. Why wouldn't everyone just do this and profit like crazy? Well you have to buy the option which costs you money. Currently the Aug 765 Call option costs you $12.75 which doesn't sound bad, but that is per share. So it actually costs you $1275 to buy that option. Your profit of $100 won't make up the cost of buying the option. See how people can easily lose money on these types of trades? You would need the AMZN share price to move up to roughly $778 before you see any profit using this method. Now when you exercise the option you get $778 (current price) - $765 (option exercise price) = $13 x 100 shares = $1300 - $1275 (option price) = $25 profit. This could be profitable depending on brokerage fees.
Okay, so bear with me here. This is not what I'm proposing you do. It's just to help you understand what options are if you haven't worked with them before. Often people will speculate on a price move and try to buy a cheap option in case there's a huge price swing. You could buy an Aug 800 Call option for $1.05. This is an "out-of-the-money" option because AMZN is not yet trading for $800. The option has no intrinsic value. If the 3rd Friday rolls around and AMZN is trading for $799, your option is worthless and will expire worthless. This is because if you were to actually exercise it, then you'd lose an extra $100 (on top of the $105 you paid for the option) from exercising it. Your brokerage won't make you do that. Options that have intrinsic value like our Aug 765 Call are called "in-the-money" because they could be immediately exercised for a profit. Again, not so complicated, but if you aren't thinking about these things, then you could end up spending a lot of money and getting nothing out of it.
So, was that Aug 800 worth it? Definitely not! To make that same $25, AMZN would have to move even more in the same time period. It would need to go to $801.30. Can you see why? I'm vetoing this even more than the first idea! Don't buy out-of-the-money options. It's almost always a bad idea. I know you'll probably do it anyway since we all have to learn from experience (and dang those cheaper options are more enticing!). I did it too. Even though I knew better. And they expired worthless.
Let's add on to our option knowledge. Options are bought and sold just like the underlying stock is bought and sold. This is where the magic happens. You don't need to hold the option until expiration, then exercise it to profit from it. You can sell it at any point and take your profit. The great thing about options is that the price moves with the underlying security. There is a value that tells you how much it will move too. The value is "delta." This is part of the so-called "greeks." Today, we only care about delta.
Let's return to the Aug 765 Call option. Suppose AMZN goes from $766 to $767. You really want your option price to move from $12.75 to $13.75 so that the $1 move in AMZN is a $1 move in your option. You could then sell your option for a profit of $1 x 100 = $100. Now that would be a discount! You'd get the same profit as controlling 100 shares of AMZN, and it only cost you $1275 instead of $76,600. Okay, well we can't do that. The delta tells you the percentage move of the option price compared to the underlying security. As of this writing, the delta is .5277, or roughly 53%. The move will only be half. So a $1 move in AMZN results in a $0.53 move in the option. Well, that's still great. I mean you'd make $53 by selling the option after that move. Really, not bad. Compare that to the previous scenarios where you only make $25 or less on a $13 move of AMZN itself. This is where the power of using straight buying of call options comes in (as opposed to fancy option strategies). The farther out of the money the option is, the smaller the delta. Also, the "deeper" in the money that you go, the greater the delta. That cheap-o 800 Aug Call option only has a delta of .0771. You'd never be able to sell that for a profit even with a huge AMZN price increase.
Here's the strategy. Look down your option chain until you find a .90 or better delta. For AMZN right now, you can get this at the Aug 730 for a delta of .9292 (basically 93%) priced at 37.1. This allows you to get (essentially) the same price action as buying 100 shares of AMZN for only $3710. That's a huge discount compared to buying those 100 shares at $76,600! A lot of people are scared of this because that are dishing out $3710 for an option. The thing is, if you were bullish on AMZN anyway, and wanted to buy it anyway, then this is the way to do it. You'll have to cash in before the 3rd Friday of August, but you can always set your own timeframe by buying an option with a much later expiration date. In fact, you could go out to January 2018 if you were that nervous about it (of course a 90% delta option that far out is more expensive, but it is still way less than $76,600). Remember you can sell anytime between now and 2018, so you don't have to worry about the option expiring.
What's the catch? Well, there isn't much of one. The price could always move against you, but that is the same as if you straight up owned those 100 shares. You'll pay the same 93% move when the price drops. You don't have to sell. It's really like owning those shares. Use the same entry and exit strategies as you would going straight long without the option. Hopefully I don't have to advise you about risk management too much. Have a plan!
The great thing about options is that they allow you to short the stock in exactly the same way. A put option gives you the right to sell at a certain price. So a 767 Aug Put option could be exercised just like the call option. You would be short the AMZN stock 100 shares at $767, then you'd buy back at the current price of $766 for a $100 profit. The thing is, the put option never needs to be exercised ... just like the call. As the price drops, the put option gains value and you could sell it for a profit just like the call. Look for the high delta put options if you are bearish. All of the above applies. This allows you to go long or short an expensive stock at an incredible discount. The power of discounts is that your risk/reward ratio is way higher even though at the end of the day you made the same amount of money.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.