Using Options To Build Low Risk Returns
Ever wonder how you could invest more but limit the risk and capital required to make an investment? Using options can achieve this strategy and offer you a low risk high return situation if the conditions are right.
Currently the market volatility is at historic lows (see VIX chart below).
When volatility is low, options premiums are cheap. This means you can buy options with a low premium which can be used to enter into positions without a large amount of capital. For example, lets look at SPY which tracks the S&P 500. Currently you can by a Dec 215 call for $.30. This means for a $30 (+commissions), you can make a hedge that SPY is going to go past $215 before December from it’s closing price of $200 today. Not a bad price for a market that seems to be breaking new highs often.
So how does this compare with a traditional approach to buying long into a position?
First you have to remember that Options represents the right to buy/sell 100 shares per call/put. In the example above if you buy 3 calls for $.30 each, your net cost before commissions is $90. As SPY approaches your target price of $215 your options will rise in value less time decay of the premium. Once SPY goes beyond $215 you option intrinsic value will increase inline with the increase in the underlying Stock.
I know it sounds complicated and it is. Since option premiums are so low, your maximum risk is the $.30 per contract ($30), but that may be a small risk if you believe SPY is going to go past $215 before December.
Case 1: SPY does not go beyond $215, you lose your $90.
Case 2: SPY equals $215 by December, you lose your $90.
Case 3: SPY goes over $215 before December, you make $300 for every dollar that it passes $215.
In a traditional approach to investing, you might purchase 300 share of SPY (300 X $200 = $60,000). The value of your $60k will match the percent SPY is up/down by December in our example. Your maximum risk is $60k.
The Difference Between Option Investing and Traditional Investing
Here is the difference, if SPY in December reaches $230, the option holder makes $4,500 or 5,000% the original investment, the stock holder makes $9,000 or 15% the original investment.
If the stock goes 30 points down, the option hold loses $90 (100% loss), the stock holder loses $9,000 (-15%).
Buying options can be profitable in a low premium environment, but one must remember that with buying options it is often a zero sum game with a clock that is ticking. If your prediction is not correct before the clock expires you lose your investment. With that said, however, you can make hedges for large market swings in either direction for a minor cost that can be used as insurance against your stock positions.