FFO Options 12: Discovering Your Bonanza In Long Calls and Puts

1. FFO Options 12: Discovering Your Bonanza In Long Calls and Puts Dr. Scott Brown Stock Options

2. Chapter 8: Discovering Your Bonanza In Long Calls & Long Puts Dr. Scott Brown

3. Long Calls & Long puts • Covered calls have high downside risk since you must buy the stock. • The sale of the call provides little hedge. • Holding stock creates one of the biggest risks for equity investors … using covered calls or not. • Short stock positions create an equally big risk for short-sellers wishing to capitalize on a fall in the stock's price. • Investors and speculators get nearly the same benefits of long and short stock positions with far less risk by understanding the strategies of the long call and long put.

4. Option benefits • One way that investors can greatly reduce the downside risk of stock ownership is to simply buy calls rather than shares of stock. But downside protection isn’t the only benefit that investors get by purchasing calls. They also gain tremendous leverage and the ability to better diversify their investments. There are three main reasons why investors and traders buy calls rather than stock: • Protection • Leverage • Diversification

5. Directional Outlook • You are bullish on Panera Bread (NASDAQ: PNRA) • This is a directional outlook. • In other words, you are buying the call option as a near substitute for a stock, • You are not attempting to trade the volatility component of this option. • The only decision you've made is that you think the stock’s price will rise. • With this one-dimensional outlook in mind, make sure you buy an option that has a high directionalcomponent to it.

6. Delta • It's very important to understand why we choose a strike with a delta of roughly 0.80 and no lower than 0.70. • The call option with a delta of 1.0 is no longer an option; it is a perfect substitute for stock. • There is no time premium in a call option with a delta of 1.0 and it will rise and fall dollar-for-dollar with the underlying stock. • Keep in mind that this is only true as long as the delta remains at 1.0. It could decrease if the underlying stock price falls sufficiently.

7. Delta • On the other hand, an option with a much lower delta, say 0.50, has a lot of time premium and therefore behaves more like an option rather than stock. • “Behaves like an option," means that it doesn't respond too systematically with the stock. • Its price can also be greatly affected by time decay as well as volatility. • The important point is that you want to initially purchase an option that behaves much more like the stock.

8. More Option Benefits • Another reason options provide better protection than stop orders is that stop orders are "path dependent" while options are "time dependent." • This simply means that the performance of a stop order depends on the "path" the stock takes. While it is possible for a stop to protect you, it is equally likely that it may force you to sell too early. • In other words, options are constrained by time, which is why options offer protection that is time dependent, • Stop orders offer protection that is path dependent. • Unfortunately, most of the major losses in stocks come after the close when there is nothing you can do with a stop order but wait for the opening price. • Stop orders are not an equal substitute for options.

9. Protection • Choose a strike with a delta of 0.80. • This is because a call option with a delta of 1.0 is no longer an option. • An option with a delta of 1.0 will rise and fall dollar for dollar with the stock. • An option with a delta of 0.50 has a lot of time premium and therefore behaves like a an option. • Buy call option with a delta in the range of 0.80-0.85 and no less than about 0.70.

10. Panera Bread (PNRA)

11. Buy to open one January $95 2013 calls, PNRA Delta=0.706 • By placing a market order, you guarantee the order will get filled. • Alternatively you can place a limit order GTC at the theoretical price of $26.85. • Once filled, you control 100 shares. • Assuming that the order is filled for $26.85 theoretical price. The account will be debited $2,685 (100 x $26.85). • With the stock trading at $112.88 it would cost $11,288 to buy 100 shares, but you can control those same shares for $2,685. • With the protection of the call option the most you can loose is $2,685 the same you would lose on a 22.79% stop-loss.

12. Buy to open one January $95 2013 calls, PNRA Delta=0.706 • The call option provides protection. • If PNRA stock plummets from $112.8 to $50 the stock trader is down $6,288 (100 x $62.88). • The option trader is down only $1,660. If the stock price continues to fall, the stock trader continues to loose money while the option trader’s losses are capped at $2,685. • The option trader loses far less in a catastrophic drop.

13. Buy to open one January $95 2013 calls, PNRA Delta=0.706 • The reason that options provide better protection than stop orders is that stop orders are “path dependent” while options are “time dependent”. • Let’s assume you have 100 shares PNRA and place an order to sell your shares at a stop price of $78. • The stock might take the path of falling to $78, thus forcing you to sell, and then immediately turn around and climb much higher. In this instance, the stop order did prevent you from losing but you also missed future gains.

14. Buy to open one January $95 2013 calls, PNRA Delta=0.706 • By holding the call you are locked into the $95 buy price over a period of time. Only if the stock’s price rises after the call option expires will you miss out on future gains. In other words, you are constrained by time. • Stop orders are not an substitute for options.

15. Buy to open one January $95 2013 calls, PNRA Delta=0.706 • In many cases the call buyer has the ability to buy the stock at the lower market price. • Example: PNRA was trading at $112.88 and the Jan $95 call was trading for $26.85. If you have $112.88 available per share to buy the stock but decided to spend $26.85 to buy the call then you have $86.03 ($112.88 - $26.85) in cash. • Assume that at expiration the stock price falls to $80, which makes your call option worthless. It appears that the stock owner is better off because at least he has shares that might rise in the future while you have lost 100% of your investment with the $95 call. • However, you can buy the shares at the $80 market price out of the $86.03 that you have in cash.

16. Buy to open one January $95 2013 calls, PNRA Delta=0.706 • The $86.03 price is the crossover point between the two strategies of buying 100 shares of stock versus buying one January $95 call. • If the stock’s price is below $86.03 at expiration then you will have enough money sitting in cash to buy the shares of stock. • However, if the stock’s price above is above $86.03 then you will not have enough money to buy the shares.

17. Buy to open one January $95 2013 calls, PNRA Delta=0.706 • If the stock’s price is above $86.03 at expiration, the option trader will under perform the stock trader. The reason is that the call buyer must pay a time premium for the $95 call and the money is gone for good at expiration. • The time premium is the cost of losing less money for all the stock prices below $86.03.

18. Buy to open one January $95 2013 calls, PNRA Delta=0.706 • Assume the stock is $125 at expiration. The stock trader makes a profit of $12.12 ($125-$112.88). With the stock at $125, the call is worth exactly $35, which means that the option trader makes a profit of $3.15 ($30-$26.85). • Notice that the difference in their profits is $8.97 ($12.12-$3.15), which is exactly the amount of the time premium in the $95 call.

19. The Put-Call Parity Formula • The long call buyer will always underperform the long stock buyer by the amount of the time premium for all regions above the strike price. • The long call buyers will never get the time premium back. However, since we don’t know for sure whether a stock will rise, the call option provides a lot of protection by removing ALLof the downside risk. • The time premium is the cost of that protection.

20. The Put-Call Parity Formula • Option traders give up a little of upside profit potential in exchange for greatly reducing the downside risk. • If the stock falls below $75, the call owner will loose less than the long stock owner. With the stock below $75 expiration, the call owner loses all intrinsic value in the option but also loses the $3.84 time premium, which means the total loss would be $71.16 ($75 - $3.84), which is the crossover point that we calculated.

21. The Put-Call Parity Formula • Protection is one of the big benefits of buying options. • Call options provide protection from the downside risk of the stock. • Call options are really leveraged long stock plus a put option in disguise: C = S – Pv(E) + Put C = Call option S - Pv(E) = borrowing money to buy stock Put = put

22. The Put-Call Parity Formula • If you own a call option, you are effectively borrowing money to buy stock, and then buying a put option to protect your downside. Long stock owners do not have the put option, which is why they have a much bigger downside risk. • Put-Call Parity also shows that call options with high deltas and long terms to expiration can be viewed as less risky than long stock purchases. • Your maximum risk is much smaller and known up front and that is something we cannot say for stock owners.

23. Leverage • Leverage is our second motivating factor for buying call options. • Options provide tremendous financial leverage to the owner. For any given stock price movement, you can get a bigger return from a fixed amount of money.

24. Leverage • Example: The stock investor buys shares of PNRAat $112.88 while the option buyer pays $26.58. Now let’s assume that PNRA closes at $135 at expiration. To the stock trader, that represents a return of 1.195 ($135/$112.88), which is 19.5%. With the stock at $135 at expiration, the $95 call is worth the $40 intrinsic value. The return to the call trader is then 1.489 ($40/$26.85) – 1=48.9%. In other words, a 19.5% increase in the stock’s price led to a 48.9% return on the option.

25. Leverage • In order to understand the leverage of an option, we must compare “dollar equivalent” exposure. • The $95 call trading for $26.85 has a delta of 0.706. For the next one dollar move, this option’s price will rise by the delta, or 70¢, from $26.85 to $27.55. This 70¢ movement in option price is equivalent to $70 per contract. Now let’s see what a stock investor must spend to get this same $70 gain from a one dollar move in the stock. A stock buyer must buy the delta equivalent number of shares, which is 70 shares of stock that would cost $7,901.60 (70 x $112.88). So if an option trader buys the $95 call and a stock trader buys 70 shares of stock, then both will capture a $70 profit on the next one dollar move in the stock. Now we just need to compare the costs of these dollar equivalent exposures. The stock trader spends $7,901.60 while the option trader spends $2,685, which means there is 2.94 times ($ 7,901.60/$2,685) as much leverage in the option as compared to stock.

26. Other Views of Leverage • Example: a stock is trading for $100 and a $100 call is trading for $5. One way to view the leverage is to realize that the option trader, has leveraged the returns by a factor of 20. That is, for every 100 shares the stock investor buys ($10,000 worth), the option buyer can buy 20 contracts ($10,000/$500 per option = 20). • Let’s assume that the stock now rises from $100 to $115. If the stock trader buys 100 shares then the total value would be $11,500 (100 x $115), which leaves a profit of $1,500. With the stock at $115, the $100 call would be worth $15, or $30,000 for the 20 contracts ($15 x 2,000).

27. Gearing • Gearing = Stock price / Option price • Example: the stock was $100 and the option was $5, so $100/$5 = 20. This is just another way of saying the stock trader required 20 times the amount of capital to control the same amount of shares. • Gearing = Strike price / Option price • Example: this gives the same answer of 20. If the strike was $110 then the gearing is $110/$5 = 22. In this way, the option trader may pay $110 for the stock but is controlling it for $5, so it is leveraged by a factor of 22.

28. Omega • Measures the relative percentage changes between the stock and the option, a measure of elasticity. Omega = (Delta / Option price) / (1 / Stock price) • For instance, assume the call has a delta of 0.50. With the stock at $100 and the call at $5, if the stock were to move $1 (1% move) the call will move roughly one half of a point from $5 to $5.50 for a 10% increase. Because the option moved 10 times faster relative to the stock (10% compared to 1%), the elasticity (omega) is 10.

29. Omega • Can also be written as: Omega = (stock price / option price) x delta • Regardless of which measure you use, don’t forget the most important concept: • The higher the leverage the more speculative the position.

30. Omega • The option’s leverage comes from the fact that the strike price is simply a partition of the stock price. If you buy shares of PNRA at $112.88, you get all of the upside gains but are also exposed to all of the downside losses. • However, if your holding the $95 call at expiration, it will not have value for all stock prices above zero. Instead, it will only have value for all stock prices above $95. The $95 strike simply splits the stock into two parts: All prices below $95 and all prices above. When you buy the $95 call, you’re only participating in the gains if the stock rises above $95 but not if falls below, which is why long call options have an asymmetrical payoff to their profit and loss diagrams.

31. Omega • A one dollar gain to the stock trader produces a much smaller percentage gain than a one dollar gain to the option trader. However, the total dollar gain to the stock trader will be larger than the total dollar gain to the option trader since the option trader loses out on the time premium.

32. Definition of Leverage • There are two definitions of leverage to understand: • Control more shares with the same amount of money (risky). • Control the same amount of shares with less money (conservative).

33. Risky Uses Of Leverage • Let’s take look at the consequences for someone who tries to control more shares with the same amount of money. In our example, the option trader could have invested the full stock amount of $11,288 into the options, in which case he would definitely come out ahead of the stock trader in terms of total dollar profits. • However, if you are willing to put $11,288 into stocks then you should in no way be willing to place that same amount into an option. Leverage is an incredibly powerful tool but it is also a double edge sword … it magnifies the losses with equal force.

34. Risky Uses Of Leverage • Another reason for not investing the same dollar amount into options as you would for stocks is that you end up controlling a much larger number of shares than you’re comfortable holding. • If you had place your stock funds into the January $95 calls, you’d end up controlling 4 contracts ($11,288/$2,685). • A tiny drop in the stock’s price greatly magnifies the dollar swings in your account; there is simply too much leverage working against you.

35. Conservative Uses of Leverage • Control the same number of shares with fewer dollars at risk. • If you are willing to buy 100 shares of PNRA and wish to buy calls, then stick with two contracts since that controls 100 shares. The leverage you’re getting is based on the fact that you’re controlling the same amount of shares for less money. • You may not make as much in terms of total dollars as a stock trader but you won’t lose much either.

36. Conservative Uses of Leverage • There is another way you may wish to consider using leverage. This method allows us to buy more shares but without jeopardizing great losses. Let’s assume you are willing to buy 100 shares of IBM for $11,288. At the same time, let’s also pick a level that you’re willing to loose, say 20%. • You can guarantee a limited loss by using options. In this case, let’s take the 250% that you’re willing to lose, which is $2,822 (0.25 x $11,288) and use that money to buy the options. In this example, you would buy 1 contract ($2,822/$2,685 =1.05).

37. Conservative Uses of Leverage • You’d end up investing $2,685 (100 x $26.85) and that is definitely the most you could ever lose. • This is a nice method for those investors looking to increase their leverage a little while still managing the downside risk. • The idea is that you buy options with the amount of money you are willing to lose with the stock. • This is how you replace a stop-loss with an optoin!

38. Diversification • The idea is to spread your investment dollars through many different investments. • By spreading your investment dollars across many stocks you get the benefits of diversification. • Spreading the risk keeps you from having to guess which stocks will perform the best.

39. Buying a fixed number of shares • Many investors buy a fixed number of shares thinking that limits the risk. • Constant share amounts do not diversify your risk . If stocks are presume to move in a random fashion, Why you place a higher investment in a particular stock? • When you do this you are betting on that particular stock. • If you treat each investment as the “spin” of a roulette wheel, you should not bet more money on some spins versus the others.

40. Pick a dollar amount • Pick a dollar amount, rather a share amount, which you are comfortable investing on each trade. Then use that dollar amount for all investments and let the number of shares fall where they may. This method will yield far better results. • This constant dollar method can be use for options as well. • You will likely see a big difference in performance when you aren’t trying to guess which trade will be the bigger winner.

41. Options provides protection, leverage and diversification • At any time you can choose to get out of the long call option by selling the contract in the open market. • If the option is in-the-money at expiration it’s worth the intrinsic value. • If it’s prior to expiration, it’s worth the intrinsic value plus some time value. • If it’s not in-the-money it’s worth the time value and it’s up to the market to decide the value.

42. Rolling with Call Options • The real power of options come from our ability to alter risk-reward profiles as prices change. • That’s something you cannot do with stock alone. • Example: • You are a long-term investor who is bullish on Google (GOOG) and wish to buy 100 shares on August 8, 2005. the stock was trading for about $293 ($29,300 for 100 stocks).

43. You decided to buy the $290 call for $58, or $5,800 per contract to control 100 shares over the next 1.5 year. The order is: Buy to open, one contract, Google Jan. ’07 $290 call (OQDAR), at market (limit). Once the order is filled you have the right to purchase Google shares at any time for $290 per share, but the goal of an option trader is to simply trade the contract trade the contract and never actually buy the shares of stock. Google Example

44. Thirty five days later, the stock had moved up sharply to $308.25 and the $290 call was bidding $64.20. • At this time you can sell the contract to close with a profit of 10.7% per long call contract equivalent to a 5.2% appreciation per share of stock. • However, selling the option at the first sign of profit is usually a mistake. Trends generally last much longer than we expect. • The truth is that you can go broke taking profits if you tend to take them too early. • A lot of tiny profits can easily be overcome by one single loss . • Actually, you can do a little of both; you can take some profits and stay in the position by doing a simple hedging technique called roll-up. • If you are long a call option, you execute a roll-up by selling your current option and simultaneously buying a higher strike option.

45. The roll-up order • Following the Google example, the roll-up order should be the following: • Sell to close, one contract, Google Jan. ‘07 $290 call (OQDAR) and simultaneously • Buy to open, one contract, Google Jan. ‘07 $290 call (OQDAT) at market (limit) • By doing so, you will have reduced the amount invested and still control 100 shares. • You have reduced the risk. • With roll-up you slowly chip away the cost basis of the option thus removing some risk while staying in the position.

46. When you should Roll Up? • The stock price at which you roll up depends on what you’re trying to accomplish. • The choices are endless and that’s what makes options powerful. • The desire to use the roll-up is the reason we elected to use slightly in the money options to start with. • Buying far out-of-the-money options means that the stock must make a far bigger move before you can roll the position up. • The out-of-money options don’t provide the same benefits as in-the-money options. The first ones, are riskier.

47. Pragmatic Decisions • Check the net credit you’re going to receive from the roll-up relative to your current cost basis and the commissions and see if it seems like a good business decision. • If so, then it’s time to roll-up • You must balance the cost with the effects • The net credit received can be used immediately to withdraw, invest, or simply left in cash to be used at a later time.

48. Rolling-Up • As long as the stock moves in your favor, you should continue to roll it. • The roll-up allows the investor to maintain the position for longer periods of time because it reduces the risk of investing – it reduces the fear of holding the position. • You may decide to roll-up at-the-money option bringing in more cash (a bigger net credit) at the expense of needing bigger moves in the stock before rolling-up again.

49. Rolling-up Frequency • Some investors take a little more risk rolling-up less frequently in the search for higher profits due to fewer bid-ask spreads and commissions. • If there were no bid-ask spreads or commissions there will be no difference between rolling-up frequently or infrequently. • But if we wish to protect profits and reduce the risk of holding the stock, most option investors feel that the small losses from the bid-ask spreads and commissions are worth the reduction in risk that frequent roll-ups provide

50. Stocks v. Options • Regardless of which choice you make, you’re still controlling 100 shares. • It’s doubtful that the conservative stock owner would have held out for the profit because there’s too much to lose as the stock price climbs to seemingly inexplicable levels. • The options can also be use in conservative ways.