In the past few years a giant company came under some intense pressure, trading down about $ 12.0 00 before it found what appeared to be a decent level of support, and began to consolidate. At this level, would anyone interested in going long for a discounted price and can afford it should have been advised to do it. Implied volatility was high coming off this precipitous drop, which caused the premiums on options to increase significantly. This scenario can be very attractive to sellers of covered calls or buy-writers. On Tuesday, December 2, the stock was trading at $ 58.9 90, December 60 Call was trading at $ 1.3, and it was only two weeks left until the expiration date
Let’s say you wanted to take advantage of this opportunity, but you would not be able in part due to capital requirements. The stock was trading at $ 58.9 90 and you do not have sufficient funds to support buying the stock at that price, knowing that to buy only 1000 shares would cost $ 58,900.0 00th
To take advantage of this opportunity you should consider using a strategy called the stock replacement. In many cases, an insufficient amount of funds in the investors account mean the loss of a golden opportunity when dealing with high dollar-priced shares.
Thus, an alternative to purchasing the stock outright is to find a way to get the actual stock to replace it with something else that is not so expensive. In this case, a deep in-the-money call just that.
If a call is deep in-the-money, which means that the strike price of the call is much lower than the price of the stock, the delta of the call approaches 100. This means that there are close to a 100% chance that this option will finish in-the-money.
This option will trade like stocks, penny for penny dollar for dollar (100 delta in a theoretical scenario.) ) If you remember, during the term delta mentioned when describing the option in question. Delta is the first derivative of the stock and has a three-pronged definition. The first is the percentage change.
Delta is given as a percentage change, which means how much percentage the option price will change with a movement in the stock. A 50-delta option will go 50% the amount that the stock does. If the stock moves $1.0, than the option will move 50% of one which is $0.5. A 30-delta option moves $0.30 on a $ 1.0 movement in stocks, and so on.
Delta can also be defined as the percentage chance. This is used to describe the percentage chance that the option ends in-the-money. A 90 delta option has a 90% chance of finishing in-the-money.
Finally, delta also be defined as a hedging relationship or hedge ratio that is the set of deltas needed to properly hedge a position.
It was important to explain the meaning of the delta to understand that the deep in-the-money call would perform and act just like stocks. A way to find out about the call you want to choose is in-the-money enough for your purposes is the delta. A delta in the mid to high 90′s is an ideal candidate.
The selection of the proper in-the-money call to use is a essential element of success with this strategy. To obtain an exact delta of all options under consideration for stock replacement use, you can go to any number of websites or contact your broker. If all else fails, there is a little trick of the trade that can be used to help in choosing a call that is deep enough in-the-money stock to fit the replacement criteria.
To do this, see the quote of the corresponding put (for example: In December 47.5 5 set if you look at 47.5 in December 5 call for replacing the stock). If there are no bids quoted putt, then the call is deep enough in the money to consider it as a stock substitute. There are several reasons for this is a good strategy, as we usually cover here, but in the context of this discussion it is enough to know that this method works.
As with the stock at $ 58.9 90, the December 47.5, calls met the criteria for stock replacement. This call had a mid to high 90′s and Delta while its corresponding put did not have a bid. In December, 47.5 5 call was trading at $11.4 45 or $0.05 over par. By purchasing this option, you would be in a psition equivalent to buying the stock at $ 58.9 95 (the strike price plus the option price).
Let’s say you bought the December 47.5 5 calls for $ 11.4 45 If a total of 10 calls were bought (an equivalent of 1000 shares), you would lay out a total of $ 11,450 to meet the purchase this buy-write. If you had bought the stock outright, you would have spent $ 58,900. The difference between the capital needed to buy shares directly ($ 58,900) and the capital necessary to buy into-the-money calls ($11,450) is the key to this trade.
Now that you have your shares (through the call you bought above), it is time to sell covered calls against this position, which would be the December 60 calls for $1.30. If the stock remains at current levels, would you capture the $ 1.3 premium you sold in December 60 calls because they would be out-of-the-money at expiration.
The $1,300 profit in this scenario represents an 11.35% return in just two weeks. If you compare the return on investment in case you invested $ 58,900 investment, the return would only be a 2.2 21% return in two weeks if you purchased the actual stock. The returns in this case out-performs the case when you buy the stock outright.
As we know, the maximum benefit of $2.35 will be achieved if the stock reaches $ 60.0 or more. This return comes from $ 1.3 30 that you received in the premium for the sale of the now worthless December 60 call plus a $ 1.05 gain from the December 47.5 call you bought. With the stock now at $ 60, the December 47.5 call is worth parity, which is $12.5.
You bought the calls for $ 11.45 so you got a $ 1.05 gains in the option. This gain of $2,350 represents a 20.5 per cent return in two weeks compared with a 3.98% return in two weeks, when the actual stock is purchased.
As you can see, you get the same overall dollar return on a lot less money – which creates a much higher percentage return. This is one of the positive leverage that the proper use of options can provide. When you start this trade, the buying and selling two different options simultaneously, which is known as a spread. A spread is a trade that buying an option against the sale of another option exists simultaneously and will be briefly discussed in the next section.
By buying the December 47.5 calls for $ 11.4 45 and then selling the December 60 calls at $ 1.3, you are buying the December 47.5 December 60 call spread for $10.1 15 This type of spread is known as a vertical spread.
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