Chapter 3
Calls as satellite.
The riskiest investment in stocks are options. I trade a fraction of our accounts in call options. The rest remains in the S&P 500. There are puts and calls. You make money on a put you buy when a stock or ETF drops. With a call you make money when the underlying asset rises. You make a deposit called premium to buy an option that is a small fraction of the cost per 100 shares of an underlying stock or ETF.
This leverages up the returns. You can make hundreds or thousands of percent returns with options but you can also lose the entire amount you pay for them. Hence these are very risky investments you have to pay attention to and learn well before you trade. You can also sell puts or calls. The small premium goes into your account. When the buyer of a call or put makes a huge gain though it becomes your loss. I had long wondered which is more profitable, the put or the call, long or short.
Then one day I ran across another article in the Journal of Finance entitled Stock Options as Lotteries published in 2013 by Utah University finance professors Brian Boyer and Keith Vorkink. What is revealed in their paper was nothing short of startling. They perform Monte Carlo simulations. They show that only long options make money, puts or calls. The biggest surprise was that long calls make many multiples more than long puts.
This result focused me on the path of constantly improving my skills as a call option trader. I pretty much exclusively buy long calls when a momentum stock soars on high volume. I sell when the upward trend weakens. I have learned from experience that Boyer and Vorkink are right!
Strike
But it was not enough to know that long calls make the most money. I also had to figure out the ideal strike and expiration. I tested long call positions in the money and out of the money as well as at the money. Here is how moneyness works. Imagine a stock is trading at exactly $100. A call with a strike at $100 means that you could exercise your option to buy the stock. This is called an at the money call. You would not gain or lose. If the strike is $105 the call is out of the money because if you bought the stock at that price you would have a $5 loss per share. If the strike is at $95 then the call is in the money because you could exercise it for a $5 excess and is thus termed in-the-money.
Expiration
The next problem I had to solve was what is the best expiration? I knew from the classic book Reminiscences of a Stock Operator by Edwin LeFevre that “the man who can get it right and sit tight is rare indeed” because the big money is holding on to the position over the big moves. So I started with LEAPs which are call options that don’t expire for a year. But when a friend of mine found out I was buying leaps, who was a market maker on the Philly option exchange, he told me I was throwing away money because of the high time value embedded in the high premium.
So I started trading 6 month expirations. And when the market moved really fast I shortened the expiration to between four to six months depending on chart conditions. I eventually decided by trial and error that the ideal expiration for my option positions is between 4 and 6 months with an at the money strike. Now I was off to the races on a good horse.
When to Roll
Time decay is the worst in the last thirty days. This means that you should be out of the option in the middle of the month before expiration. You should sell or roll a December call in the middle of November. May is the month to roll or sell for June calls, August for September calls and so on. If the option expires on December 16th then roll or sell your long call by November 16.
Gearing Up
You gear up by increasing your leverage. This means buying more calls. You have to have the courage to gear up when the market turns from bearish to bullish or you will be left holding the bag.
Gearing Down
You gear down by dropping your leverage. This means selling calls and buying the spider or leaving the proceeds in cash. Calls are your most leveraged assets. Cash is the least leveraged and an SPDR S&P 500 index ETF like the spider, symbol SPY, is in between. Just like the transmission of a car these are the gears you have to learn to shift your portfolio through. You have to shift your mentality from growth to preservation fast enough to survive when things fall into the dumpster.
Cash
There are a number of situations when it is best to be in cash. When I have made a lot of money in a call position and don’t see another clear opportunity I leave it in cash. When the market is really bearish, cash is better than trying to plunge the market with puts. Bear markets are harder to trade than bull markets and returns are more limited.
Share Replacement
The most powerful stock option strategy I have found is share replacement. In this strategy you spend the vast majority of your time finding stocks turning upward on high volume. The positive price response on high volume tells you many people are buying the stock including big players.
Not all stocks have good options. A stock trading at a dollar or two is probably better traded with shares. Well known, household name stocks with good businesses that are higher priced often have the best call markets. These stocks have really good liquidity. You can get a feel for liquidity by always paying attention to the open interest of the option chain between 4 to 6 months out in the future.
Apple is a good example.