By Chris Ebert
Do you have a question for the Option Scientist? Send it to firstname.lastname@example.org. Your last name and e-mail address will be kept confidential.
Q: Mr. Option Scientist: are there any creative ways to use options to go long on a stock such as Ford (NYSE:F)? – Darren C.
A: Darren C: Actually there are quite a few possible trades, some more creative than others. However, creativity is not necessarily better than simplicity. The effects of creativity can be seen in some examples:
1. Deep In-The-Money Long Call
A deep in-the-money long call is often a suitable substitute for buying stock. With Ford options having a good amount of liquidity, and the low level of option trading privileges required for a long call by most brokers, this option trade may be the best choice for many, despite its lack of creativity.
For every 100 shares of stock that would have been purchased, simply buy 1 call option at a strike price well below the current price of Ford stock. The expiration date is not highly important, as it tends to have a very minor effect on profits. Options that expire in one month or as quickly as one week are often a good choice due to their low cost (higher intrinsic value at a lower premium) and high amount of liquidity. Just choose the lowest strike price that has sufficient trading volume and a narrow spread between the bid price and the ask price.
The expiration date is not a huge concern because if the option nears expiration and you need to keep it open longer, you can just just roll it out – sell the call and buy another one at a further expiration. Or, if you need to take profits or cut losses, just sell the call early; there’s no need to wait until expiration day.
Profit is unlimited and will be nearly the same as going long Ford shares. Losses are limited to the relatively small premium paid to open the call, unlike potentially large losses on long shares of stock which cost much more to purchase and also carry a risk of going to zero.
2. Synthetic Long Stock
Synthetic long stock is a little more creative, but not all traders are permitted to use it. For those who do have the privilege, it can be a neat way to trade.
For every 100 shares of stock you would have gone long, buy 1 call option and then sell 1 put option at the same strike price and the same expiration date. The strike price does not matter, nor does the expiration date. So choose an expiration date and a strike price with good liquidity. Options that expire in two or three months are perfect candidates on a widely-traded stock such as Ford. Further expirations reduce the cost of commissions associated with rolling shorter-term options. You don’t need to wait until expiration to take profits or cut losses, just sell the call and buy back the put whenever you are ready to exit.
The neat thing about this trade is that it is usually free; it requires no trading capital when opened using at-the-money options. The premium collected by selling the put pays the premium required to buy the call; that makes it free. It does come with margin requirements though. Those requirements exist because even though it costs virtually nothing to open synthetic long stock, profit and loss is essentially identical to being long 100 shares of stock.
Profits are unlimited, and losses are only limited by the fact that the stock price can never fall below zero.
3. Deep In-The-Money Naked Put
As with synthetic stock, naked puts are not available to all traders. But they are a great way to capture gains when a stock price increases.
For every 100 shares you would have bought, sell 1 put option at a strike price well above the current price of Ford stock. The expiration date should be kept as near as practical to avoid the option accumulating time value in an uptrend. Options that expire in a month or a week are often good choices, but further expirations are acceptable if the commission costs involved with rolling nearer-term options are a concern. The strike price should be just shy of the highest price you believe the stock will reach before the option expires. In a perfect trade, the stock will just barely exceed the strike price on expiration day, causing the put to expire worthless. The premium is then yours to keep, or spend, as you wish.
What makes this trade unique is that you will actually get paid in advance for the potential profit. The premium you collect from selling the put represents the maximum amount of profit, and that goes into your account the moment you open the trade. Now, you can’t actually spend all that capital because of margin requirements. But it will be in your account.
The fact that you get paid in advance does not in any way limit potential losses. Losses are nearly limitless and are generally the same as stock ownership. Profit is limited to the premium collected. The nice thing about a naked put is that no closing trade is required if the stock price increases and the put expires worthless. That can save commission expenses. As with other option trades, there is no need to wait until expiration to take profits or cut losses, just buy back the put if you need to exit the trade early.
4. Bull Put Spread
Because a naked put is not a trade that everyone can open, a creatively assembled bull put spread becomes a possible alternative. Done correctly, a bull put spread can be made to perform almost the same as a naked put.
For every 100 shares of stock you wanted to go long, sell the same put option you would have sold in the naked put example above. Then buy the least expensive put you can get your hands on. Sometimes there are puts available for a nickel or less.
The difference between this trade and a naked put is that your broker is protected if the stock suddenly has a meltdown. The maximum loss is limited because the put you purchased will gain value if the stock price falls below that strike price. Because you are providing the broker with some protection, the broker is more likely to allow this trade than to allow a naked put.
While losses are limited, they can be significant. The maximum loss is essentially equivalent to the loss on 100 shares of long stock if the share price were to fall to the strike price of the put you purchased. Profits are limited to the net premium received when the trade was opened, and maximum profit occurs when the stock price exceeds the strike price of the put you sold and that put option expires worthless. Again, that saves on commissions as no closing transaction is required.
5. Butterfly Call Spread
Another creative way to go long is to open a butterfly call spread. If done carefully, the spread will return a profit in a moderate uptrend, but experience little if any loss if the stock moves unexpectedly down instead.
For every 100 shares of stock you want to go long, buy 1 call option at a strike price equal to or very near the current share price of the stock (at-the-money). Next sell 2 call options at a higher strike so that the total premium collected is sufficient to cover the premium paid to buy the first call option. Lastly, buy one more call option at a higher strike than the first 3 options, so that the strike price of the calls that were sold is halfway between the strike prices of the call options that were purchased.
For example, if Ford was trading at $11 the trade might look like this:
- Buy 1 $11 strike call
- Sell 2 $12 strike calls
- Buy 1 $13 strike call
The net premium will be highly dependent on the expiration date. The choice of expiration date should match the time frame in which you expect the stock to move up. Profit on butterfly trades tends to occur only when they are nearing expiration. So, if you expect the stock to move up in the next month, use options that expire in one month.
Profit on a butterfly is limited, and only occurs when the stock price moves to a point near the middle strike price. Even when the stock price does move to such a point, profit tends to only occur in the final days leading up to expiration of the options.
Risk is limited as well, and the maximum loss that can occur is equal to the net premium paid to open all 4 options. Loss generally occurs when the stock price moves outside of the range of the lowest and highest strike price.
These are not the only possible option trades for someone looking to go long on a stock. But they do represent some of the versatility that options provide, especially when a little bit of creativity is introduced. Each of the above trades has one thing in common: there exists a range of stock prices in which these option trade behave identically, or very near identically, to taking a long position on the stock.
The preceding is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences. He recently co-published the book “Show Me Your Options!”
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