Our friend and colleague at optionMONSTER, Chris McKhann, just recently asked the rhetorical question, “Is now the right time to buy calls” in an article on optionMONSTER.com in which he highlighted the merits of Apple (AAPL). Readers of my DRJ’s Blog know I have discussed the strength of the business model metrics at Apple in the past (Jan 24).
To hear all the talking heads bemoan the state of Apple, you’d think the stock was heading to zero. But let’s try a little experiment. Suppose we blacked out the ticker symbol and looked only at the company’s metrics:
• Forward P/E minus cash of 7.
• Gross margin of 38 percent or 39 percent this year.
• Revenue growth this year of 17 percent.
• Growing revenues in China at almost 70 percent.
Wouldn’t you be buying the stock with both hands? I said back in January that I think we all would. Consider this experiment against the question asked at the beginning, “Is this the right time to buy calls?”
Take a look at these more recent findings.
Call buying is probably the most recommended option strategy. That does not make it the best, and in some respects it is one of the most risky. But there are great times to buy calls, and this is one of them.
The appeal of call buying is that it is a limited-risk strategy with the potential to produce substantial gains. The leverage is huge, which is why “instant millionaire” hawkers often promote it.
For example, in Apple you could buy an April 440 call with the stock trading right around $430, ensuring the right to buy 100 shares at $440. The premium of that call is $6.30 at the time of this writing, for a total cost of $630. (Remember that one option represents 100 shares.)
An outright purchase of those 100 shares, meanwhile, would cost $43,000. So if Apple were to rally up to last week’s high around $470, you would make $4,000 on the stock for a 9 percent return.
But the calls – if held until expiration – would make $2,370 ($47,000-$44,000-$630) for a 376 percent return.
The problem is that there is only a 36 percent probability that AAPL will be above $440 at expiration and only a 7 percent probability that it will be above $470.
Most call buyers bet too much money on low-probability bets, and this over-leverage is what eats up capital. That is one of the biggest risks of this option strategy.
That said, there are times when buying calls make a lot of sense. The markets are near landmark highs, but volumes are light and some believe that we are poised for a correction. And volatility is low, which can be seen in a general way in the VIX.
The volatility matters because it is a key component of the option’s price. The higher the expected volatility, the higher the option price, and vice versa. Often in options, that expected volatility is higher than the actual volatility turns out to be, and that is the reason many professional traders use option-selling strategies. This presents the other big risk in option buying; that you are paying more than you should, in volatility terms.
If you are bullish on the overall market, but worried about a potential pullback, then selling stocks and replacing them with long calls makes a lot of sense. You could buy SPDR S&P 500 Fund (SPY) calls to get that upside exposure, for instance.
The SPY Weekly 157 calls, with 10 days left to trade, cost $0.52 and have an implied volatility of less than 9 percent. That compares to the current 10-day historical volatility of 9.3 percent and a 30-day historical volatility of 11.3 percent.
The key is to only replace your current exposure, not to leverage up because of the lower cost of the calls. To be clear, I would not add long calls to a long-equity portfolio here; I would replace the stock with the calls. If you had 1,000 shares of the SPY, then I would suggest buying only 10 or 20 SPY calls.
This would allow you to continue to have upside exposure while significantly lowering risk. And you want to buy options when volatility is low, as it is now.
For those of you who can’t or don’t want to sell your stocks, then buying at-the-money SPY puts actually gives you the same risk profile.
That hedges risk while maintaining the upside exposure. Consider it a kind of “inexpensive” insurance that is priceless if we do get a significant drop.
Jon “DRJ” Najarian
Jon ‘DRJ’ Najarian is co-founder of optionMONSTER® and co-lead analyst for the InsideOptions™ trade idea alert systems. He spent the first 29 years of his trading career trading in and around the pits of the Chicago exchanges.
“DRJ” is a frequent contributor to CNBC, the Wall Street Journal, as well as other prominent financial media organizations. Mr. Najarian also co-developed the patented trading algorithm the Heat Seeker®, used to detect unusual trading activity.
(Portions of this article appeared in optionMONSTER’s Options Academy newsletter of April 3.Chart courtesy of iVolatility.com.)