Coming Up A Little Short

I stumbled across this article about using options from Morningstar. The general point is to consider leaps as replacements for stocks because options are generally cheap these days and because they offer more potential reward while of course carrying more risk.

So the take away was maybe you should by leaps because they are cheap. Um what type of leap should we buy? How many?

The article came up very short about what strike to pick or how many to buy. The one example was McDonald's. The article gave details about buying a leap struck at $30, with the common at $28. The example was just nuts and bolt mechanics not strategic insight. Why does the author think the $30s are the best trade?

Options are a very complex investment vehicle. Articles that oversimplify or offer a vague idea for a strategy are not ideal.

My own ideas on the subject, leaps as a substitute for the common, are quite conservative. If you normally buy 300 shares you should only buy three options. Anymore and you would be over leveraged. Misusing leverage compounds this risk significantly. I tend to think that as an option buyer I want to pay as little time premium as possible. If you buy a deep in the money leap you would be paying little in time premium and possibly risking less capital.

Here is an example of what I mean with Qualcomm (QCOM). By the way this will be a repeat for long time readers. QCOM closed Friday at $34.75. A QCOM expiring in Jan 2007 struck at $22.50 was offered at $14.10. So $12.25 was intrinsic value and $1.85 was time value. Options that are deep in the money usually have a very high delta. A high delta means the stock will move close to point for point with the stock. So with this example you can get almost the same movement in the stock with only putting up a fraction of the cost. To me this is a logical use of leverage, in general terms. QCOM is just an example I have no position personally or for accounts I manage.

What about the less risk aspect? The QCOM option, above, is $12.25 in the money. Lets say an investor buys that contract now and then three weeks from now with not much movement in the stock bad news hits and the stock drops $10 per share to $24.75. So instead of being $12 in the money the option is now only $2 in the money. While we can't know exactly what the option in this example will do we may have a clue from the current option that is currently $2 in the money, the $32.50 option for the same month. That option was bid at $6.90 at the close Friday.

Using this as a rough template a $10 drop in the stock, or $1000 for a hundred shares, might only result in $7.20 drop in premium(I am factoring in the slippage from the bid/ask in my numbers), or $720 dollars for one option. This type of hit to the stock would cause the volatility to increase and the delta to decrease. The option at $12 in the money was cheaper in real term and the drop made it more expensive. If this is new to you, don't focus on the exact numbers because there are a lot of variables that could make this more or less favorable, instead focus on the concept. Once you have bought an option that has very little time premium, a sudden increase in time premium (volatility), caused by bad news, is not the worst possible outcome.

To be sure the are plausible arguments for buying only out of the money options in large quantities but that is not the right trade for me. I felt the Morningstar article lacked in spelling out a specific method. This post gives one idea, there are others.