When I was a kid, my older sister would incessantly copy and imitate my every move and word. Not because she wanted to be like me; she wanted to irritate and make me angry.
It’s the age-old struggle between siblings. Of course, I would tell my parents, hoping to get my sister in trouble. But they always responded, “Imitation is the sincerest form of flattery…”
What seven-year old wanted to hear that, let alone understood what it meant?
Anyway, as time went on, we grew up, matured, and learned to be civil to each other.
In the financial markets, “imitation” can be so much more than an irritant or a form of flattery.
It can also be a way to slash your risk and compound your returns.
Options Are the Ultimate Imitators
If you’ve been reading any my contributions to The Rich Investor over the last few months, you know I’m a huge proponent of options trading.
Because anything you can do with stocks, you can do with options – typically with less risk and greater returns. Imitation at its best!
And, with increased market volatility of late and gut-wrenching selloffs happening seemingly every other day, it’s time to review my favorite option-buying strategy.
“Going Deep” Is the Plan
The biggest fear with investing is that you can lose everything you’ve put into the trade.
So, why not switch to a method that slashes that potential risk by up to 70%, while gaining an opportunity to triple the returns?
When you buy a deep-in-the-money (DITM) call option, you’re doing just that.
A DITM call option is as close to cloning – or “imitating” – a stock as you can get, with much greater benefits.
Now, let’s take a look at one of the biggest and best bulk retailers, Costco Wholesale (Nasdaq: COST).
As of this writing, COST is trading for $223.76 per share. Buying 100 shares would cost $22,376.
Buying a DITM April 2019 $160 call option would cost $66.25 per contract, which equates to a cash outlay of $6,625.
Since each option contract controls 100 shares of stock, it’s necessary to multiply the call option price of $66.25 by the 100 share multiplier.
How do we know which call option to buy, how much does it cost, and which expiration month should we use?
Take a look at the screenshot:
The key to choosing the correct call option is to make sure it has at least a 90% “delta.”
The 90% delta assures us that the call option will move 90% in lockstep with the stock’s move.
In other words, you’re getting the bang for your buck.
I’ve highlighted the $160 call option with a mid-point price of $66.25 per contract (splitting the “bid” price and the “ask” price) and a delta of 90.73%.
We’ve also keyed on the April 2019 expiration, which gives six months to see the trade play out.
Since we want these trades to be more of a long-term nature, it’s best to stick with expiration dates of at least six months.
Low Risk, High Reward
Right off the bat, by buying the call options, you’re saving $15,751 on the investment, which equates to a 70.4% discount.
Looking at those numbers in a different light, you’re also slashing your ultimate risk in the trade by 70.4% as well.
If COST goes belly-up, the call option’s loss is a heck of a lot smaller than the stock purchase.
On the profit side, let’s assume COST can return to its recent high of $245 per share by April 2019.
With the stock purchase, we’d see a return of 9.5% (that’s a gain of $21.24 per share, with an original cost basis of $223.76).
At expiration, the DITM call option would be worth a value of $85 per contract (a $245 stock price minus the $160 strike price equals $85).
Since the option was purchased for $66.25, it would yield a gain of $18.75 per contract and a return of 28.3% (that’s $18.75 divided by $66.25).
The DITM call option’s return is just shy of 300% better than buying the stock.
Why is the $160 call option described as “deep in the money”?
Well, the strike price ($160) is situated very far below the current price of the stock. Strike prices that are near the current stock price are said to be “at the money” (ATM). Strike prices situated above the stock price are “out of the money” (OTM).
In order for the strategy to work, it’s best, stick with DITM call options that have at least a 90% delta.
In the current market environment, where selloffs are wiping out millions (if not billions) of dollars in value, why not use a strategy that imitates the stock but yields 70% less risk?
Seems like a no-brainer to me.
The more you know…