It's Time to Take a Look at Options

Options are both a misunderstood and dangerous tool for retail investors. You can quickly make a lot of money using options -- and you can lose a lot of money just as quickly. But with volatility at a new low, it may be time to consider options as a way to make long-term bets on stocks.

Options are on sale by recent standards
There are four main factors that go into determining what an option is worth: the price of the stock, the strike price, the time to expiration, and volatility. Investors can choose stocks, strikes, and expirations that fit their goals and strategies at any time, but volatility is not something any single investor can determine.

Volatility changes with the market's whims. In late 2008 volatility spiked because investors became fearful of a recession, and the market would swing wildly every day -- that's volatility. We've had minor panics in the years since that have periodically sent volatility higher, as indicated by the CBOE Volatility Index (VOLATILITYINDICES: ^VIX  ) below.

^VIX Chart

^VIX data by YCharts.

But you'll notice that the index is at a new low, having fallen rapidly since the fiscal-cliff negotiations. This has the effect of making the cost of options lower. An option with the same underlying stock at the same price with the same duration costs less than it has in years, which makes options attractive. So how can we use options?

Put/call strategy
The strategy you employ will depend on what investments you're looking at, but I'd like to focus on two: a put/call strategy and LEAPS. I don't advocate short-term options, because the market can swing in unknown directions by the day. The longer the option, the more time you have for your strategy to play out.

A put/call strategy involves buying both the put and the call of a stock with a strike price as close to the current stock price as possible. It's profitable if a stock moves up or down a lot before the expiration date. Below, I'll go over some examples to demonstrate this.

This strategy also has the advantage of being long volatility, meaning that if volatility rises, the options will become more valuable if the stock doesn't move. If volatility goes up and the stock moves dramatically, all the better.

Options for the future
Another strategy is buying LEAPS, or long-term equity anticipation securities, which are simply long-dated options. There are currently January 2015 options available on the market, nearly two years in length. If you think a stock will go far during the next two years, then this can be a profitable strategy.

A long LEAPS strategy is when you bet that a stock will move higher before the options expire. They allow you to expose your portfolio to more upside than just buying the stock. I'll use my own personal position in SunPower (NASDAQ: SPWR  ) to illustrate how this works below.

On the downside, you can buy puts in companies you think are in trouble. If, for example, you think Best Buy won't last through the next two years because of deteriorating finances, you may buy out-of-the-money puts. A January 2015 $10 strike price put costs $1.19 per share right now. If the stock falls below $8.81, you have a profitable bet that was relatively inexpensive.

You can use a put/call strategy with LEAPS as well, which may be useful for boom-or-bust stocks.

A few ideas
I mentioned before that I've used LEAPS in SunPower, and here's why. My investment thesis is that SunPower is vastly undervalued, and as the market realizes the potential of solar, the stock will skyrocket. I recently wrote that it isn't unreasonable to put a valuation of $80 or more on the stock. If this thesis is correct, then options are a great tool.

Today, you could buy the stock or buy calls that would make your exposure much higher. Below is a table that lays out how much exposure you would have with a $10,000 investment and what the breakeven is versus the stock. If the option expires below the strike price, you would be out 100% of your initial investment. Between the strike and the breakeven (right column), it would have been better to buy the stock. But if the stock goes above breakeven, options are the best choice.

 

Price

Shares of Exposure ($10,000 investment)

Breakeven vs. Buying Stock

Stock

$13.39

746.8

$13.39

Jan 2015 $12 Call

$5.10

1,960.8

$19.38

Jan 2015 $17 Call

$3.30

3,030.3

$22.56

Just look at how many shares of exposure you get with options versus owning the stock. If the stock grows anywhere near the rate I think it will, then options are the best choice.

Of course, options come with risks, such as total capital loss. If this risk isn't for you, then neither are options.

Another idea is buying way-out-of-the-money LEAPS in Apple (NASDAQ: AAPL  ) . There are a lot of investors (myself included) who think Apple is vastly undervalued, and if the stock moves significantly higher, options can be a good play. January 2015 $700 call options are currently trading at $14.30 -- not bad for a two-year option. The stock has already reached that level once, and with two years to turn around, this is an investment I'm considering. And I'm not the only one: It was announced yesterday that David Einhorn owns $146 million in Apple call options -- exactly the trade I'm talking about.

On the flip side, companies you want to bet against can be used as option plays as well. BlackBerry (NASDAQ: BBRY  ) has been on a tear recently, but with the stock at $14.36 and the company's future in question, puts are intriguing. The 52-week low is $6.22, and a January 2015 $10 put can be had for $2.52. If the company goes belly-up in that time, you could quadruple your money.

A few things to think about
Options aren't for the faint of heart, and they can leave you out your entire initial outlay, so use them carefully. They're also best with stocks that are projected to move a lot, so they're not suitable for every investment.

Will Apple reach $700 again?
There's no doubt that Apple is at the center of technology's largest revolution ever and that longtime shareholders have been handsomely rewarded. However, there is a debate raging as to whether Apple remains a buy. The Motley Fool's senior technology analyst and managing bureau chief, Eric Bleeker, is prepared to fill you in on reasons both to buy and to sell Apple, as well as what opportunities are left for the company (and your portfolio) going forward. To get instant access to his latest thoughts on Apple, simply click here now.


Read/Post Comments (4) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 20, 2013, at 11:26 AM, sammycooool wrote:

    You are going to lose a ton of money!! Thanks for the laugh! Apple is dead, they have nothing to offer for all of 2013 and yet you think they can trade above their all time high, while they are $ 15.00/shr away from a 52 week low?? Just laughable stuff here! LOL

    Then there is BBG, they have the best phone in the world today and you want to short them below book value? Why do we not question why you don't have a job ..................

  • Report this Comment On February 20, 2013, at 11:49 AM, sct1947 wrote:

    How did you calculate the breakeven prices for the options in the table above? Thanks!

  • Report this Comment On February 20, 2013, at 4:31 PM, TMFFlushDraw wrote:

    @sct1947

    I used a $10k investment and determined the # of shares I could buy and the # of options I could buy at a given strike. This gives you your exposure.

    Than I calculated the point at which I breakeven on an option. Ex. A $15 strike that costs $1.50 would breakeven at $16.50. Then I used this formula.

    (-Initial investment + Option Breakeven Price * # of shares underlying option) / (option exposure / share exposure)

    I hope that helps,

    Travis

  • Report this Comment On February 24, 2013, at 12:56 PM, pryan37bb wrote:

    Another possibility: if you have an in-the-money call that has increased in value but still has significant time left before expiration, you could sell an upside call against it, just as you would with a stock position. It should probably be at least a 3-month call, otherwise the fees will eat into your return.

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