by Chris Rowe 09/17/08
Although options should be part of any balanced portfolio, when it comes to buying stocks that you don't plan to keep in your account for the long haul, nothing beats using call options as a short-term surrogate. Not only can you close the position at any time (or simply wait till expiration, when it gets closed for you), but you can bank similar returns for a fraction of the cash outlay.
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In fact, you can be making even more money on the capital you'd originally planned to allocate to stock-buying. So, when someone tells you that you have to spend money to make money, you can show them the fat returns you're making by saving money instead of spending it all in one place!
In fact, you can greatly reduce your risk if you take your 500 shares of ABC stock, sell it, and then buy five ABC call options that are in-the-money by a few strike prices.
(I'll explain which expiration date the call options should have in a minute -- and yes, it's important.)
If ABC is trading at $60 per share, and you pull up the option chain and look at the 2009 January calls, you might see the following call options available:
* ABC Jan 60 Calls trading at $9 (These are at-the-money.)
* ABC Jan 55 Calls trading at $12 (These are in-the-money by one strike price.)
* ABC Jan 50 Calls trading at $15 (These are in-the-money by two strike prices.)
* ABC Jan 45 Calls trading at $18.50 (These are in-the-money by three strike prices.)
MAKE MONEY BY SPENDING LESS
It makes more sense, instead of buying 500 shares of ABC stock at $60 (for $30,000), to buy five of the ABC Jan 45 Calls at $18.50 (for $9,250). Then, put the remaining $20,750 in a money market account and earn a 5% return on that "extra" cash.
In this case, the intrinsic value of the Jan 45 Call is $15 (because the stock price of $60 minus the strike price of $45 = $15) and the extrinsic value of the call option is the remaining $3.50 (because the call costs $18.50 minus $15 intrinsic value = $3.50).
This means that during the life of the call option (especially in the last few months leading up to the January expiration), that $3.50 extrinsic value (i.e., "time value") deteriorates. So, if your ABC stock trades flat at $60 for the next few months, the option would lose $3.50 and be worth $15.
Keep in mind that the $3.50 loss (assuming that you actually held on for the next few months) is a loss of $1,750. But, since you put the rest into a risk-free money market account, you would have earned $1,383.33 in interest.
So, the loss is reduced to $366.67. (And that would equate to 73 cents of the call option instead of $3.50 per share.)
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