As most readers are likely aware, much of my trading is focused on a swing trading timeframe. Most of this focuses on large-cap stocks and highly liquid ETF’s. With these positions, instead of trading the stocks or etf’s, I will many times trade the options. There are two main reasons for this: 1) Risk control and 2) Leverage.
Several of the short-term reversal systems I trade don’t involve stops. An example of one of these systems can be found here. This means two things. 1) If I take a large position and the trade goes against me I may be tying up the capital for longer than I would like and 2) If disaster strikes (think Bear Stearns – and no I didn’t trade it) my position could get wiped out. Who knows where the next 90% drop is lurking?
By using options I an able to solve both of these issues. First, even when buying deep in the money calls, the outlay is significantly less that purchasing the stock. Second, they provide a “natural stop” for the trade (they’ll only drop to zero). I’ll use a recent Subscriber Letter trade as an example. Bank of America (BAC) was scaled into last week and the exit trigger occurred this morning. For my own accounts, I did not purchase any BAC. Instead I bought the June 25 calls. They cost me about 15% of what I would have spent to buy the stock. So if I wanted exposure to $100,000 worth of BAC, I instead would buy about $15,000 worth of BACFE. It's fairly deep and trades with little premium and a delta of nearly 1. If it goes up, I make nearly the same dollar for dollar. If it goes down, I can't lose more than $15,000 (unless I roll to another option). To put it another way, if you can get a deep call like this for 15% of the price of the stock, then you can effectively get a 10% position with an account risk of 1.5% (option goes to zero). Also, depending on how the drop occurs, premium may get built into the option, so I may not lose as much as I would have on the stock purchase.
With individual stocks, rarely will I take more exposure than I would if I were simply buying the stock. I don’t normally do it for leverage. I do it to control risk.
Index trades are a different story. Here I will many times look for leverage. The execution is generally the same, though. The S&P 500 is the index I trade the most and I normally do it with SPY options. As I look at my screen while I’m typing this the SPY is trading at $135.73 and the June 129 calls expiring in 3 days (SPYFY) are at $6.80. Only about $0.07 premium. The 129 calls with 12 days (RQQFY) left have about $0.15 premium in them. Either way the premium is quite small. If I want to get leveraged I can lay out about 15% of my capital and have 300% exposure to SPY. ($6.80 * 3 = $20.4 / $135.73 = 15%).
So that’s the general concept of how deep in the money options can be used to control risk and/or gain leverage. If you’re not familiar with trading options then it’s just enough to make you dangerous. I’ll try and follow-up in the next few days with some guidelines I use when considering these kind of deep options plays.
For those who would like to read more and gain another perspective on this type of option trade, check out Steven Gabriel’s write-up from a few years back.