Saturday, November 30, 2013

how options give smalldog investors the bigdog advantage

one of the benefits of trading options is that they are levered products. in a stock replacement strategy the typical procedure is to buy a 70 delta call option in an expiration that is 90 or more days away. one typically pays less than 1/3 of the price of buying the shares with that method. the question is: how much leverage does that represent? the answer may surprise you but first i need to develop the concept of option leverage a little.

the key to understanding option leverage is thinking about delta in a different way. the definition of delta is that it describes the relationship between option price movement and the underlying equity's price movement. in a 70 delta option, a one dollar move in the equity leads to a 70 cent move in the option. however, an equally valid way to think about delta is that a 70 delta option gives you 100% of the performance of 70 shares of stock. so to figure the leverage of a 70 delta option one simply needs to compare the price of the option to the cost of purchasing 70 shares of stock or: 

delta * equity price / option price

thus, our 70 delta option purchased at 1/3 the price of the stock equals leverage of 2.1 (=.7*3)  - about the same leverage you get with a typical margin account where you put up 50% of the buying power (but without the sec looking over your shoulder!)

now, there is a special kind of margin account called a portfolio margin account that is only available to bigger dogs than me who can put together $100K in a non-retirement account. in a portfolio margin account one only puts-up buying power equal to 5% of the cost of the stock purchase, or leverage equal to about 20. so the question is can a smalldog stock-replacement trader achieve this same advantage?

yes! one can, but one needs to be a little less rigid about selection. here's the option chain on spy for the feb14 expiration (about 90days-to-expiration) with the mark (mid bid-ask) price and delta displayed:

the first strike (180) in-the-money, has a leverage of 21.6 (= .53 * 181 / 4.45 ) and the 2nd strike (179) itm  has a leverage of 20.4 (=.57*181/5.05). however, this 57 delta option is a little low for many stock replacement traders.

you see, another interpretation of delta is that it is approximately equal to the probability of expiring in-the-money and a 57% chance, though better than a coin flip, is playing a little too close to the edge. however, one can increase the delta by accepting fewer dte and still achieve 20x leverage. here's a look at the jan14 with 48 dte:

i calculate that the 175 strike call has a leverage of 20.2 (=.77*181/6.905) and is right smack in the middle of the 70 delta range coveted by stock replacement traders.

so who needs portfolio margin!?

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