Trading Idea
1

Replacing Stock with Longer
Dated Options

Tony Zhang
October 28, 2019
342 Views
0 Comments
8 minutes read
Replacing Stock with Longer
Dated Options

Long-term options (options expiring in more than 9 months) provide a cost-effective way of gaining long term exposure to stocks with a smaller capital outlay and limited risk. The average price of a stock in the TSX 60 has almost doubled in the last decade. This translates to significantly more capital being required to purchase 100 shares of an underlying stock. Many investors with smaller account sizes may consider using long-term options as an alternative to buying 100 shares of a stock. In this post we explore comparing buying stock to long-term options. To learn more on trading long-term options, view our latest webinar on this topic!

When to use Long-Term options

There are 2 types of long-term options – calls and puts:

Long-Term Calls

Long-term call options are frequently used as a replacement strategy for a long stock position as it offers long term upside exposure with limited risk. Calls should be used when there is a bullish outlook on the underlying stock or ETF for at least 2-3 months or greater. Long-term options are also a great way to mitigate downside risks. When the market is believed to be overbought or if a rally is extended with no significant pullbacks, the probability of a market correction becomes higher. Long-term options allow for upside exposure but limited downside risks if there is a market correction compared to owning a stock or ETF.

Long-Term Puts

Buying a long-term put offers downside protection against long positions in either individual stocks or a portfolio of stocks. Long-term puts should only be used for long-term bearish views greater than 2-3 months where there is a strong bearish outlook of declines greater than 10-20%.

Bullish Example

Assume that an investor has a bullish sentiment on BMO stock, currently trading at $97.61 (Oct 22, 2019) per share. Let’s compare buying the stock vs. buying a call.

Buying stock:

  • Buy 100 shares @ $97.61 per share = $9,761
  • Max reward = unlimited
  • Max risk = $97.61 per share (the amount paid for the stock)

Buying a 1 Year Call Option (In-the-money):

  • Buy 1 Oct 2020 $92 call for $800
  • Max reward = unlimited
  • Max risk = $8.00 per share

In this case, the long-term calls allow for maintaining upside exposure while reducing the risk and total cost of the trade when compared to buying the stock outright.

Bearish Example

Assume stock BMO is currently trading at $97.61 per share (Oct 22, 2019) and an investor has a bearish sentiment. Let’s compare shorting the stock vs. buying a put.

Short Selling stock:

  • Borrow to short 100 shares @ $97.61 per share = $9,761
  • Max reward = $97.61 per share
  • Max risk = Unlimited (as there is unlimited upside)

Buying Long-term Put Option (In-the-money):

  • Buy Oct 2020 $100 Put for $855
  • Max reward = $91.45 per share ($100 – $8.55)
  • Max risk = $8.55 per share

In this case, the put allowed for maintaining downside exposure while reducing the risk and total cost of the trade when compared to shorting the stock.

Benefits of Long-Term Options

Long-term options offer a lower capital outlay option when compared to buying or shorting a stock. The call and put options provide an asymmetrical risk-reward profile while maintaining a strong exposure to a stock’s movements with “in-the-money” long-term options. As long-term options have a slower level of time decay, they are typically suitable for investments with a time horizon greater than 2-3 months.

Limitations of Long-Term Options

Long-term options are less liquid than front-month options. Therefore, it is only viable to use them for longer term investing instead of short-term active trading. When deciding whether to use long-term options or to simply buy the stock, one should consider whether the stock is a dividend-paying stock. Options do not pay dividends and investors seeking to take advantage of dividend income may prefer buying the stock instead of using options. Furthermore, long-term options are available on only 64 stocks and ETFs, requiring open interest of 5,000 or more over a period of 6 months before they are listed. A list of all available stocks with long-term options can be found here.

Trading Long-Term Options

In-the-money (ITM) options offer a better profit potential and exposure than Out-of-the-money (OTM) options. Even though OTM options cost less to buy, it is important to remember that options are used as a replacement to buying and holding the stock for a long period of time. Therefore, an investor that uses options would want to maximize the capital appreciation of the stock by using ITM options.

Table 1: In the Money vs. Out of the Money


Source: OptionsPlay

Trading Tips

  • Expiration selection – Greater than 9 months as this minimizes time decay.
  • Strike selection – Buy In-the-money strikes (65-75 delta). This will usually cost between 20-30% of the underlying stock price.
  • Better for non-dividend paying stocks
  • Entry strategy – Enter with long-term bullish or bearish outlook of a stock or ETF
  • Exit strategy – Exit before expiration and set up stop loss and take profit prices based on stock price
  • Sell “Poor man’s Covered Calls” to further reduce your risk.

“Poor Man’s Covered Call”

This strategy refers to selling short dated OTM call options against the long position in a long-term call option. This replaces the stock leg of a covered call with a long-term option, otherwise known as a diagonal spread. By methodologically selling covered calls during the lifetime of the long-term option, an investor can collect around 5% of the underlying long-term option call premium in a single month. This can reduce the cost basis of the long-term options by upwards of 20-50% over the lifetime of the option if held to expiration. However, it is important to remember to roll the short call at expiration if it is above the strike price. Otherwise this may result in having to buy stock or exercising the long-term calls to deliver the shares.

Summary

Long-term options provide an alternative to gain long-term exposure to the capital appreciation of a stock while reducing the capital outlay and overall the risk. Due to the large amount of capital required to buy 100 shares of a stock outright, long-term options have become a popular tool for investors with less capital. When trading long-term options, use the trading tips in this post to maximize their effectiveness.

Take advantage of free access to OptionsPlay Canada: www.optionsplay.com/tmx

Disclaimer: The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

Tony Zhang
Tony Zhang http://tmx.optionsplay.com

Head of Product Strategy for OptionsPlay

OptionsPlay

Tony Zhang is a specialist in the financial services industry with over a decade of experience spanning product development, research and market strategist roles across equities, foreign exchange and derivatives. As the current Head of Product Strategy for OptionsPlay, Tony leads the research and development of their OptionsPlay Ideas & Portfolio platform. He has leveraged his interest in financial technology and product development to provide innovative, reimagined solutions to clients and the users they seek to serve. Previously he spent 7 years at FOREX.com with a capital markets and research background as a market strategist specializing in equity and FX derivatives markets.

46 posts
0 comments

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.