- 2002: Volume 11, No. 2 Options as a Stock Substitute: Profit While Lowering Your Dollars at Risk

With stocks seeming to drop bombshells of bad news on investors these days, many wise investors are learning how to use options strategies to participate in a potential recovery while lowering their dollars at risk should serious bad news pummel a stock. I will offer both a short-term and longer-term options strategy that stock owners should consider, using options as a replacement for the stock.

You should consider using options to expand your growth strategy for the following reasons:

• Leveraged Profits—Percentage gains on option contracts often outpace those of underlying securities by five to 10 times or more. Potential for individual trading gains of 50 to 200 percent or more makes strategic option trading a powerful growth engine for your portfolio.
• Limited Initial Investment—Buying options contracts (each of which "controls" 100 shares of the corresponding stock) typically involves only fraction of the cost of buying the underlying stock or index.
• Bull and Bear Market Profits—Savvy option traders use strategies to generate profits on both uptrending and downtrending stocks alike. Call option contracts allow you to profit on expectations of a stock moving higher, while put options allow you to profit on a downtrending issue.

Strategy #1: Short-Term "In-the-Money" Options
Let's use an example where you like hypothetical stock XYZ's outlook over the next month. You think the stock should move up from the current price at 53 to 61 over the next month. If you bought the stock, 100 shares would cost you $5,300 (commissions are excluded in these examples for ease of comparison-you typically have to pay a commission whenever you enter or exit a stock or options trade). In contrast, you could buy one option contract that gives you the right to buy the same 100 shares at a price of 50, expiring in one month. This would cost you $550 (quoted as 5.50).

The 5.50 total value of the option is composed of two elements:

• The "intrinsic value," which is the amount the option is worth if it expired today (in this case, your right to buy at 50 is worth 3.00 = current stock price of 53 minus right-to-buy price of 50, also known as the "strike price")
• The "time premium," which is the remaining cost after subtracting the intrinsic value. In this case, 5.50 - 3.00 = 2.50 points of time premium. The longer the term of option you select before it will expire, the more costly the value of time will be.

The call option we have selected, with the right to buy at 50, is known as an "In-The-Money" option, because it has intrinsic value. I like to purchase in-the-money options as a stock substitute, as this allows you to participate more quickly point-for-point as the stock moves in your favor.

In-the-Money as a Stock Substitute Buy in-the-money options to get rid of time value and assume a greater focus on intrinsic value: Buy 100 XYZ shares @ 53 = $5,300 Buy one-month 50 call @ 5.50 = $550 XYZ goes to 61 in one month or less: Shares gain $800 or 15.1 percent ITMs gain $550 or 100 percent Source: www.BigTrends.com

Looking at the payoff versus risk in the option strategy compared to buying the stock, we see the following at the expiration of the option in one month:

• BENEFIT IF: Stock closes over 55.5 at expiration.
• BREAKEVEN IF: Stock closes at 55.5 at expiration.
• LOSE IF: Stock closes below 55.5 at expiration. This position would be a 100 percent loss if the stock closes under 50 at expiration.

Notice the leverage potential if the stock moves over 55.5 to your target at 61. You would make 15.1 percent on your stock, but your option would gain 100 percent. This would give you leverage of over 6.5 times buying the stock outright. The breakeven is calculated by adding what you pay for the option, in this case 5.50, to the strike price you purchased, in this case 50. The option would lose under 55.5 compared to buying the stock, though realize something else. The option would save you money if the stock plunged under 47.50. Why? Because if you bought 100 shares of the stock at 53, that would cost you $5,300. Under 47.50 you lose more than $550, which is the cost you spent to buy the option. Assuming you are sitting on the other $4,750 in a money market fund or cash equivalent, you cannot lose more than the $550 (plus commission) that you pay for the option. As a result, options can actually minimize your dollars at risk in a volatile stock that happens to plunge badly. Futures traders can also use this same method to cap their risk on a futures option as a replacement for the future, while maintaining the opportunity to leverage their investment many times over.

Strategy #2: Longer-Term "LEAPS" Options
Let's look at another stock ABC with a longer-term perspective. You think ABC stock should go from the current price at 50 to 75 or higher by the middle of January 2003. This gives you 16 months to be proven right in this example. If you bought the stock, 100 shares would cost you $5,000. In contrast, you could buy one longer-term option contract that gives you the right to buy the same 100 shares at a price of 40, expiring January 2003, at a price of 15.00 ($1,500 per contract). Options expiring more than 1 year from the current date are known as LEAPS options (which stands for "Long-Term Equity AnticiPation Securities"). These longer-term options can have expiration dates of up to three years before they expire, which allows you to not worry about short-term fluctuations if you have a longer-term view.

LEAPS as a Stock Substitute LEAPS are Long-term Options expiring up to three years from now. Buy 100 ABC Shares @ 50 = $5,000 Buy one January 2003 call @ 15 = $1,500 ABC goes to 75: Shares gain $2,500 or 50 percent LEAPS gain $2000 or 133 percent Source: www.BigTrends.com

In this case, the 15.00 options cost is divided into an intrinsic value of 10.00 (your right to buy at 40 could be converted (or "exercised") to then sell at the current price of 50 and pocket the 10 point difference) and the "time premium" is 5.00 (15.00 total - 10.00 intrinsic).

Looking at the payoff versus risk in the LEAPS option strategy compared to buying the stock, we see the following at the expiration of the option in January 2003:

• BENEFIT IF: Stock closes over 55.00 at expiration.
• BREAKEVEN IF: Stock closes at 55.00 at expiration.
• LOSE IF: Stock closes below 55.00 at expiration. This position would be a 100 percent loss if the stock closes under 40 at expiration.

The leverage potential if the stock makes your target at 75 by January 2003 is over 2.5 times that of owning the stock, as you would make 50 percent on your stock, but your option would gain 133 percent. The breakeven is calculated by adding what you pay for the option, in this case 15.00, to the strike price you purchased, in this case 40. The option would lose under 55.00 compared to buying the stock, and under 40 your option would expire worthless in January 2003. Under 35, the LEAPS option would cost you less dollars than buying the stock outright.

So you can see how options strategies that help you participate in a stock's upside for much lower total dollars at risk can help you enjoy leveraged gains if the stock rallies significantly, while also managing your risk. Some investors may want to put the rest in cash to be safe, while more aggressive investors may want to diversify some extra capital across other situations. In such cases, options can give you more flexibility to create additional opportunities for your capital to grow. And if your stock proves to be relatively volatile either up or down, options will often prove to be a much more effective way to profit from the upside in a stock, while reducing the amount you could lose if the stock happens to fall sharply.

Price Headley is founder of BigTrends.com, which provides specific real-time stock and options strategies and investment education to profit from significant market trends. Price has appeared on CNBC, is quoted frequently in Barron's, The Wall Street Journal, and other financial press, and is the author of the new best selling book, Big Trends in Trading.