by Jordan Weir
Most traders view options as only a short term tool. This is because the idea of a highly leveraged tool with the potential to make big bucks quickly appeals to the gambler inside all of us. Just like a card counting black-jack player, options strategies can be used to make significant short term profits, provided the trader is careful, and knows what they’re doing. But while options are usually employed solely by that clique of high-risk, high-reward traders, they actually have enormous benefits that tend to go unnoticed by many a long term investor.
The strategy I’m about to reveal is rarely used. In fact, I’ve only briefly heard mention of them on obscure websites, and even then, not in enough detail to give an example. So here it is, what I believe may be the biggest secret kept from long term investors on main street. The stock option strategy for the long term investor.
The strategy is a vertical option spread, using leap options. How this strategy works is you buy one option, while simultaneously selling another option for the same month, but at a different strike price. While XYZ is usually my generic ticker, I will use a real company in this case. Keep in mind, this is NOT a recommendation. Indeed, it would probably be a bad idea to invest in the example I’m about to give. Its just an example. Yet to get realistic prices for this strategy, it may be helpful to use a real company.
note:I wrote this part of the article about a short time ago, prices may not be 100% current. So GE is currently at 10.41 per share. In this case, let us talk the January 2011 options, giving GE ample of time to go the direction we think it will. So if you thought GE was an excellent long term buy, it would be reasonable to think it is going to at least $20 per share by that point. By January 2011, many people believe the recession to be over, and that single development alone should lead to a substantially higher stock price.
Buy one option to start the vertical spread, and sell a second option at a higher price to complete it. Giving our price target of at least $20, and given the current price, 10.41, I would buy the 12.50 strike call option, and sell the 17.50 strike call option. The 12.50 option can be bought for 2.71 at the moment, while the 17.50 can be sold for 1.40, giving us an total cost basis of 1.31 per share for the option spread.
Now lets look at this trade for a second. If General Electric is trading below 12.50 on the January 2011 expiration, both options expire worthless, and the 1.31 per option spread invested is gone. On the other hand, if General Electric is trading above 17.50, then the 12.50 option will be worth exactly $5.00 more then the 17.50 option, and so the position is worth $5.00 per share. If its between 12.50 and 17.50, the call we sold expires worthless, while the call we bought will have value equal to the difference between the stock price and the strike price; 12.50 in this case. Where is the break even? Well we paid 1.31 for the option spread, so if its exactly 1.31 higher then 12.50 (13.81), then well be at break even if the stock is at that point.
That gives us an amazing return of 281% if GE is above 17.50, for an annualized return of 107% (holding period is 22 months). Because of the high potential for risk – a complete loss of investment if GE is below 12.50 in Jan 2011, you shouldn’t put more then you’re willing to risk in the trade. Definitely a high risk, high reward play. Yet given how much time there is, its a much safer bet then short term options, and significantly more profitable then just buying the shares.
So now that the basic idea is out of the way, what are some examples of vertical spreads I would consider? I am a big believer in investing in emerging markets, so I’m long term bullish on EEM (IShares MSCI Emerging Markets Investment Index). The January 2011 25-30 vertical on EEM is only going for about $1.88 at the moment, with EEM trading at 25.30 so I think that would be a wise investment. Above 30 it would be worth $5 at expiration, while below 25 it would be worthless. Unless the economy further deteriorates, I can not imagine that occurring.
Similarly, I expect FXI (iShares FTSE/Xinhua China 25 Index) to go up. The “China miracle” isn’t over, merely in a subdued state due to temporarily reduced demand. The 30-35 vertical Jan 11 vertical would be worth $5 at expiration if FXI is above 35, which from its current price of 28.51, is not much of a stretch. That vertical spread currently has a $2 price, so that would be an even 150% return from now until January 2011.
A far more controversial play would be Bank of America. While the trader in me screams to short the stock, I foresee it being far more valuable then it currently is a couple years down the road. The simple reason is that yes; financial stocks have been hammered by the current collapse. Yes, some banking companies have gone bankrupt, or have been on the verge of bankruptcy. Is the financial system going to completely fail? No. Are out of control bank runs going to drive them out of business? No. Are people going to want to borrow money again after this recession ends? YES! Is pent up demand in housing going to cause a rush to buy houses at prices not seen in a decade? YES! Are banks going to profit from this? Most DEFINITELY. If BAC is above 10 at the January 2011 expiration, the 7.50-10 vertical for Jan 2011 would be worth 2.50, while only costing about $0.65. That would give a 286% return, or 108% annualized. The risk of course, is that BAC goes bankrupt, or BAC flounders under the $7.50 per share mark past January 2011. In either case, you would lose your investment. Yet with prices as low as they are now, that isn’t very likely.
For most people, the financial markets are not the place to make a quick buck. While some short term traders will have tremendous success with these option strategies, long term investors can use these same strategies while remaining focused on the longer term, to achieve gains vastly exceeding those of the regular stock market, while limiting risk.
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