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Trading Long Calls & Long Puts

Filed Under Beginner Options Trading 

Long Calls & Long Puts
 
In the last chapter, we found out that the covered call strategy relies on the purchase of stock and the sale of a call. We also found that the strategy has a potentially large downside risk since you must buy the stock and the sale of the call may only provide a relatively small downside hedge. Holding stock creates one of the biggest risks for investors, whether 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 can get the nearly the same benefits of long and short stock positions but with far less risk by understanding the strategies of the long call and long put.
 
As we learned earlier in the book, puts work in exactly the same way as calls but in the opposite direction. So for this chapter, we have combined the strategies of long calls and long puts rather than presenting them separately. If you understand the motivation and techniques for buying and rolling call options, you will also understand how to apply those techniques for puts. So to make better use of our time, we’re going to look at the long call strategy in detail and close with a quick example using puts.
 
One way that investors can greatly reduce the downside risk of stock ownership is to simply buy calls rather than stocks. But downside protection is not the only benefit that investors get by purchasing call options. They also gain tremendous leverage and the ability to better diversify their investments. So there are three main reasons why investors and traders buy calls rather than stock:
 
  • Protection
  • Leverage
  • Diversification
 
Which reason is most important depends on what type of investor you are and what you’re trying to accomplish. While any one of these benefits may appear to be the best to you now, it’s equally important to understand the other two, so let’s take a look at each in turn.
 
 
Protection
Let’s assume you are bullish on IBM, you believe it will rise sharply over the next six months and wish to buy 200 shares. Table 8-1 lists the current stock price along with some April IBM option quotes with 230 days until expiration:
Table 8-1: IBM Option Quotes

Table 8-1

If you buy 200 shares of stock it will cost about $16,000, which also represents the maximum amount you could lose on the investment. Although it would be hard to imagine that IBM becomes worthless, you’d certainly have to agree that a loss of, say, 30% or $4,800 is not out of the question. Let’s see if we can construct a more favorable risk-reward profile for less money by purchasing call options.
 
In this example, we’re assuming that you’re bullish on IBM, which is a directional outlook. In other words, you are buying the call option as a near substitute for a stock, and 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 directional or stock component to it. Chapter Six showed us that if you wish to buy a call as a stock substitute that you should look for one with a delta in the 0.80 to 0.85 range.
 
As stated in Chapter Two, your brokerage firm should certainly supply the delta values. However, if the firm does not, you can find them at a number of online resources, free of charge, such as at the Options Industry Council’s (OIC) site at www.888options.com, from PCQuote at www.pcquote.com, or from the Philadelphia Stock Exchange at www.phlx.com.
 
If not, that same chapter showed that we can find a sufficiently high delta by looking for a put option with about 30 to 40 cents above the cost of carry. The corresponding call (same strike) will have the delta we’re looking for. So which strike is this? At the time these quotes were taken, the risk-free interest rate was about 3% so the cost of carry for a $79.46 stock for 283 days is $79.46 * .03 * 283/360 = $1.87. If we tack on 40 cents to this price, we get $2.27 and the closest put to that value is the $75 strike.
 
We can also find a close approximation for the delta in a roundabout way by using a little theory we learned in Chapter Two. There we learned from Pricing Principle #6 that the difference between any two call (or put) prices cannot exceed the difference in their strikes. We can use this principle to give us a reasonable estimate of the delta. For example, look at the asking prices for the $50 and $55 calls, which are $30.50 and $25.70, respectively. The difference in these prices is $30.50 - $25.70 = $4.80. The maximum that difference could ever be is the difference in strikes, or $5. So the average delta between these two strikes is $4.80/$5.00 = 0.96. This tells us that the delta of the $50 call (lower strike) is somewhat higher than 0.96 while the delta for the higher $55 strike is somewhat less. Regardless, the delta of the $50 call is too high.
 
As we check the other combinations, we find that the $70 and $75 calls are $12.20 and $8.30, respectively. The difference in their prices is $12.20 - $8.30 = $3.90. If we divide that by the $5 difference in strikes, we find that the average delta is $3.90/$5 = 0.78. This means that the $70 strike has a somewhat higher delta and the $75 strike has a somewhat lower delta so the $75 strike looks like the one we’d want to trade. In fact, at the time these quotes were taken, the delta on the $75 strike was 0.73.
 
If you buy a strike lower than $75, you are paying for additional intrinsic value unnecessarily. If you buy a higher strike, there is too much time premium in the option and it may not respond to smaller changes in the stock’s price. (And that means you could lose on the option even if the stock price rises.)
 
It’s very important to understand why we choose a strike with a delta of roughly 0.80. The reason is that a call option with a delta of 1.0 is no longer considered an option; it is now a perfect stock substitute. 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. However, a call with a delta of 1.0 contains a lot of intrinsic value that we would rather not pay for. So you do not need to find a delta of 1.0 but should get close; and the 0.80 to 0.85 range will suit your needs as a means for stock replacement.
 
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. When we say “behaves like an option,” we really mean 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.

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