Hello investors,
So far, we have talked about the following trading plans for executing options trades. I'll quickly go over them below to ensure that everyone is on the same page. I want to be sure we are aware of the reasons why we are buying certain types of options and the mechanics of realizing profits from them.
Options Trading Part I (Which Options to Buy) - 11/16/2020
https://www.reddit.com/r/Midasinvestors/comments/jvivvt/options_trading_part_i_which_options_to_buy/
This post basically explains the concept of getting the maximum convexity on your return profile, which is a fancy way of saying getting the best returns for a unit of risk you are taking.
For instance, if you are betting a $100 on a company, you might as well do it using options because you could potentially get higher returns for a little more, if not the same, amount of risk you are taking.
You want to play a game where you will receive $300 for every $100 you bet, 3:1 payout ratio, not $100 for every $100 you bet, 1:1 payout ratio, which is the case for owning shares in a company.
Name of the game, purchase options with the best risk/reward scenarios.
(To determine the payout profile, almost all brokers offer the calculations to show what happens to the value of the option if stock price goes down by 30% or up by 30%.)
Options Trading Part II (When to Exit or Rollover Positions) - 11/28/2020
The next post explains when to close out your positions. Again, it goes off the idea of understanding your risk/reward for every position that you have and either existing your positions or rollover them based on how the situation has changed.
For example, if you purchased an OTM call option expiring in 12 months and 4 months later, you're already in-the-money with 4x your initial investment in unrealized capital gains.
At this point, your payout profile will look much worse than when you first entered the trade, meaning for every $1 upward movement in the stock price, you will gain $10 and a $1 downward movement in the stock price will decrease the value of your options by roughly $10, resulting in a 1:1 payout profile, which is almost the same as owning shares in a company as we discussed above.
Therefore, you need to answer the following question:
- Are you bullish or bearish on the stock in the next 8 months (the remaining life of the option)? Will there be external market forces that could hurt the stock's performance?
If the answer is bullish, then I would say either keep the options or rollover into more OTM option.
You would keep the options if you think the stock will still appreciate in the next 8 months but the upward movement won't be anywhere explosive, so you're essentially owning shares in the company at this point.
You would rollover into more OTM options at the same expiration date when you're still feeling very bullish on the company in the next 8 months and think that the stock could rise another 30% so you want the best payout profile. This also limits your risk by cutting down the weight of this option in your overall portfolio.
Options Trading Part III (Fighting the Theta Decay) - 12/13/2020
Lastly, this post was about how theta plays a role in calculating your returns.
It basically says that shorter period options are risky considering how much more theta decay plays a role compared to the intermediate and longer period options.
Please see the summary below:
1) Invest in the best risk/reward option terms.
2) Manage your risks by either keeping your options position or rolling them over and limiting your exposure, assuming you're still bullish on the stock.
3) Be aware of the risks of theta decay when buying short-term (3-6 months) options.
Which brings me to the topic for today's post: Leveraging Margins and Long-Term Options to Amplify Returns.
I believe that the optimal strategy to invest in a company that you believe in is to buy LEAPS on the company's stock.
(LEAPS are "long-term equity anticipation securities", another fancy word for long-term options.)
Why? Because it has the three key characteristics we are looking for:
1) Best risk/reward option terms.
2) Easier to manage risks.
3) Lower theta decay risks.
I'll go into the details of why LEAPS are suitable for our purposes.
1) Best risk/reward option terms.
The reason why LEAPS offer the best risk/reward scenarios, in my opinion, is that it gives you two things: 1) time to play out your thesis and 2) self-discipline.
- It gives you sufficient time to play out your thesis. Say you buy LEAPS on a company thinking that its next year's earnings will crush the estimates due to the amount of pricing power that the company has or the success of their international expansion plans.
On catalysts like these, you need more time for the stock to play true to the company's financial performance.
For instance, you bought Thor Industries, a recreational vehicle manufacturer, thinking that people will go for outdoor camping more due to COVID. What if Trump came out and said that the US will raise tariffs on aluminum, a key component of RVs? This will temporarily depress the stock price and if you had short-term options, you will likely realize losses.
If you had bought 2-year option, however, the stock would be given enough time to recover and actually rise above your entry point given that the tariffs news fades away and Thor Industries reports earnings that crushes the consensus estimates.
The key aspect to remember is the leverage involved in an option.
Leverage is when you put $100 to bet on a company but you actually get $1000 exposure, meaning you get 10x the exposure.
When you buy an option, you pay $1k in options premium to buy 1 call option contract on NIO to get $2800 of stock exposure ($56 stock price *100 shares * 50% delta) because each options contract is in units of 100 shares of the underlying stock.
(Delta is the sensitivity of the option price movement given $1 change in the underlying stock price. If Delta is 50% and the stock increases $1, your option price will increase by 50%.)
The point I wanted to make is that options in general provide you a leverage, which amplifies your return.
Therefore, for the amount of risk you are taking (the hefty premium paid for longer-dated options) against the reward you are receiving (the stock appreciation amplified by leverage), LEAPS offer good opportunities.
2) LEAPS also offer self-discipline.
By incentivizing you to hold on to your LEAPS when the market panics and the stock sells off, it allows you to be more disciplined, which is a key factor in a successful investing as I alluded to here.
And of course, people will be more incentivized to hold onto their options to benefit from long-term capital gains tax.
2) Easier to manage risks.
LEAPS are easier to manage risks because you know the amount of money you're risking to lose and you know what your returns will look like in different scenarios because it's a relatively same payout profile as owning shares but magnified due to leverage.
More importantly, it's easier to keep track of their performances as we have less complex trades, compared to say a box spread trade that requires more complex strategy.
3) Lower theta decay risks.
Longer options have lower impact from the theta decay. For instance, a 2-year option price will decline by only 10% if the stock price stays the same after 5 months, whereas an 8-month option price will decline by 30-40% if the stock price stays the same after 5 months.
I also sell naked put options on a short-term basis to benefit from the theta decay but since it limits the upside potential, I tend to express my view on a company through LEAPS.
The situations where I will sell naked put options is when I think the stock is overvalued and want a chance to buy the shares at a lower price but still want to collect some income if the stock price appreciates in the short-term.
For instance, a 4-week $350 OTM put option on Costco was trading at $4 premium and the underlying stock closed at $361 on 1/15/2021.
If I thought COST was overvalued, I would want to sell this put option and collect $4 premium. If the stock declines to $345, I am more than happy to cover my put options by buying shares at $350, a price lower than $361 on 1/15/2021.
Sell puts at the lowest price when you want to buy a stock. When price goes down, you can purchase the stock. This is a bullish view.
And since I firmly believe that Costco won't fall by 20-30% given the low volatility of the stock, I'm also not worried about losing lots of money when the stock goes down.
Alternatively, sell call option at exercise price where you think the stock will max out at. This is when you already own the stock and you want to cash out at a certain price point.
This is all to say that theta decay risks are lower for LEAPS and if you want a step ahead, you could potentially sell put options in the short-term to collect income. And btw, this is also a strategy that Warren Buffett uses all the time.
To summarize, LEAPS offer a way to both limit our risks and amplify our returns, while also gaining the tax advantage.
I wanted to also mention using margins in this post since we discussed the concept of leverage.
I am all in favor of using margins and if managed properly, it can be a great way to gain advantage as an individual investor.
Every single hedge fund and private equity uses some type of leverage, whether in the form of futures, margins, or options, to magnify their returns.
If you were receiving 10% return on a very diversified, safe portfolio in a year, I believe margins will offer a way to magnify that return while limiting risks.
Say $100k is invested across 50 very safe, low volatility stocks and you borrow $100k on margin to invest $200k total. What are the chances of your entire portfolio going down by 50%? Aka $100k and losing all your money?
Not to encourage you to take so much risk but adding margins while properly managing risks is a great way to enhance your performance.
Thanks for reading everyone and as always, please feel free to suggest any topic you want to discuss!
Cheers.
Submitted January 17, 2021 at 11:37PM by gohackthat https://ift.tt/39Jln2j
