Fun With Options: Amplifying Returns by Buying Calls
The past two weeks, I introduced the basics of options (Part 1 and Part 2). Today we will look at how options knowledge can be applied.
The 100:1 Leverage inherent to options is extremely powerful, and can help significantly amplify returns. That said, leverage is a double edged sword, so it needs to be used carefully.
There are multiple ways to amplify returns. I will discuss three:
Amplification by Buying Call Options (our focus today)
Amplifying Returns by Buying Call Options
If we expect a stock to go up, we can buy the stock. One way to amplify investment returns alongside the stock purchase is to buy Call options. Ideally, I’d want to marry this call purchase with a future event that can act as a catalyst for stock price appreciation (eg: a new product launch). Alternatively, I can simply buy calls not due to expire for a while, thereby “buying time” for the stock to appreciate.
That said, we must however be careful not to pay too much for these calls. Recall that calls are depreciating assets - they lose value over time. This makes buying call options risky. If the stock doesn’t reach the breakeven price by expiration, then the Call options would lose money. The calls could also become completely worthless if the stock is below our strike price at expiration. Therefore, to manage risk, position sizing is paramount. On the other hand, if the stock does rise, the options could be worth multiples of their purchase price. That’s the tradeoff.
Amplifying Disney Returns: A Real World Example
In November 2019, I bought Disney stock at $130.75 and also bought the March 2020 $150 Strike Calls (at $1.36) to amplify my returns. This is because I believed that DIS stock could reach $150 because of the Disney Plus announcement. See here for details: https://playingfordoubles.substack.com/p/hacking-stock-speculation-part-1
When you buy Call options like this, what you’re saying is this:
“I’m ok making a little less on my stock position if my options lose money, but if I’m right, I could make significantly more than if I had simply bought the stock.”
This because buying call options have unlimited upside but a known downside.
The Disney trade has been very successful. Let’s review it together.
DIS Stock Purchase Price: $130.75/share
Option Purchase Price: $136/option (basically the cost of an extra DIS share)
Current DIS Stock Price: $144/share (up 10%)
Current Option Price: $395/option (up 290%!)
For the sake of discussion, let’s assume this trade involved buying 100 shares of DIS stock for $13,075. One could have used all the money to purchase the stock or some of the money to purchase options instead, thereby applying the amplification strategy.
The amount of amplification would depend on the number of options purchased. See table below.
Notice how just 4% leverage (i.e the percentage of the total purchase used for options) amplified returns by almost 75%! (see last column, third row).
Recall, this is only when the stock has appreciated 10% from our purchase price. If the stock goes up more, the amplification is even better!
That’s the Power of Options.
Of course, if the stock doesn’t move in our direction (or move in our direction fast enough), that creates downside leverage, which is bad. The worst case scenario is when the full option purchase becomes worthless. So taking that into account before placing the trade helps us manage our risk.
Risking just 2% to amplify my returns by 3.75% (a 37% improvement to just buying the stock) or risking 4% to amplify returns by 7.5% (a 74% improvement) is pretty great. I love that risk-reward trade off.
One important point to keep in mind is that the Disney trade had a clear catalyst (the launch of Disney Plus). I would always prefer to have such a catalyst present rather than simply pick an arbitrary number of months to expiration.
Question: Now that you understand this amplification strategy, how would you use it with KKR or WFC?
Next, we will discuss how we can Sell Call Options to Amplify Returns.
Keeping Learning how to Amplify Your Stock Returns
See you next week!