This week I want to talk about options. More specifically, how a good stock-screener is the best tool you can have for picking the right options. Regardless of whether you’re buying options or writing them, dealing with calls or puts, “nakeds” or “covereds,” you not only have to be right on the stock’s direction, but also the timing.
Even the most sophisticated of options strategies requires you to at least have an idea as to what you believe the stock will (or won’t) do within a certain period of time. People who buy options with more time, to be safe, are forced to buy options further out-of-the-money because of the cost, which ultimately reduces their chances of profitability. But by back-testing a stock-picking strategy to see if your stocks typically go up as soon as they’re identified (let's say within the first week or after four weeks), you can buy less time and closer-to-the-money (better) options. Simply put, you can make better decisions as to which options to get into.
For example, let’s assume we’re buying calls. If you know your stock-picking strategy has a high probability of selecting stocks that go up within the first few weeks they come across your screen, you won’t have to waste your money on purchasing options with excessive time. (As you know, “time” does indeed cost money when it comes to options, i.e. time value or extrinsic value.) And the less “needless” time you buy, the more money you’ll have to spend on buying an option that’s closer to the money, or even in-the-money (my favorite).
I won’t get into an options lesson in this article, but too many people treat option buying as a lottery ticket. They’ll buy the cheapest options (usually meaning several strikes out-of-the-money), and hope for an explosive move (which they’ll need if they’re too far out-of-the-money). Unfortunately, these moves often never come. And even if they do, often times by expiration, their time value has eroded with no intrinsic value at all.
Let’s say stock XYZ is trading at $50, and the options are expiring in five weeks. There’s a $45 in-the-money call at $5.60 (which means it costs $560), $50 at-the-money call going for $2.20 ($220), a $55 out-of-the money call going for $1.50 ($150), and a $60 call going for $.75 cents ($75). The 45 call has $500 of intrinsic value (the difference between the underlying stock’s price and the strike price), and $60 of time value or extrinsic value (amount of the option’s price that’s greater than the intrinsic value). The 50 call has $0 (zero) intrinsic value, and is fully comprised of extrinsic value ($220 worth). The 55 and 60 calls also have zero intrinsic value, and only time value too ($150 and $75 respectively). The interesting dynamic is that time value or extrinsic value declines as the expiration date draws near. In other words, as time goes by, your option is losing its time value.
To complete this example, let me go over a few scenarios:
Scenario 1:
Let’s say, at expiration, XYZ stock closes at $50. The 45 call is worth $500 for a loss of -$60 or -11 percent. Why? Because at expiration, there’s $500 of intrinsic value left, but the $60 worth of time value has ticked away for a loss of -$60. So out of your $560 investment, you get $500 of it back. The 50 call is worth $0, for a loss of $220, or -100 percent. That $220 was all-time value, and it has all been used up. The 55 and 60 calls will also expire worthless, with each one for a -100 percent loss.
It’s true that if you spent less on an option your absolute risk is less, since you can only lose what you put in. But the “worse” option you buy, the less likelihood there is that the stock will reach and surpass your strike price at expiration. (Less potential monetary loss per option, but less likelihood of making anything either.)
Scenario 2:
Let’s say XYZ makes only a mediocre move of $2 to close at $52. At expiration, the 45 call would be worth $700, which means it would have a gain of $140, or 25 percent. Therefore, you would get your $560 back, plus an extra $140.
The 50 call, in spite of XYZ’s $2 move, would have actually lost money. The 50 call would now be worth only $200—but remember, you paid $220 for it. The move gave you $200 of new intrinsic value, but all of the time value you purchased ($220 worth) would have ticked away. The net result would have been a loss of -$20, for a -9 percent decrease. So out of your $220 investment, you’ll get back $200 of it. The 55 and 60 calls both expire worthless, for a -100 percent loss on each.
Scenario 3:
This time let’s say XYZ goes to $55; the 45 call is now worth $1,000 at expiration. That’s a $440 gain, or a 79 percent increase ($1,000 - $560 investment = $440 gain). So you get your $560 back, plus an extra $440. Good trade. The 50 call will be worth $500; that’s a $280 gain or a 127 percent increase. Excellent. You get your $220 back, plus an extra $280. But on a $5 stock move, your option captured only about half of that. The 55 and 60 calls, in spite of XYZ’s $5 run-up, both expire worthless. Yes, even the 55 call: It has no intrinsic value and no time value left—so it’s worth nothing.
Scenario 4:
This time, let’s say XYZ shoots up $10 to close at $60 by expiration. The 45 call will be worth $1,500 ($1,500 - $560 investment = $940 gain or a 168 percent increase); you get your $560 back, plus an additional $940. Awesome.
The 50 call also fared well: It’s now worth $1,000 ($1,000 - $220 investment = $780 gain or a 355 percent increase). You get your $220 back, plus an additional $780. The 55 call is finally profitable as it’s now worth $500; your gain is $350 ($500 - $150 investment = $350). That’s a 233 percent increase, but a bit disappointing considering you got only about $3.50 worth of a $10 move. The real disappointment, though, is for the 60 call. Once again, it’ll expire worthless, as all of its time value has ticked away, leaving its value at $0.
Of course, the out-of-the money call strategy will score big if there’s a huge move and you have lots of options. But short of that, the “cheap”, out-of-the-money calls will often expire with a -100 percent loss. Ouch. And how much money are you really willing to commit to an out-of-the money play knowing the odds are so stacked against you?
Unfortunately, that’s how too many people do it. And because they rationalize that they can get cheaper options for the price of one really good one, they’ll often spend just as much—and lose it all.
And if you buy more time (until expiration), the options will cost even more—for a potentially even bigger loss. In fact, every one of the above scenarios would have done commensurately worse.
So getting back to my point: Once you have an idea as to how good your screening strategy is at picking winners, and how quickly they move once they’ve been identified, you can then go about picking the best option that will give you the highest probability of success.
For instance, what if you knew your screening strategy picked stocks that had a high probability of going up within the next few weeks? You wouldn't need to buy two, three, or even six months of time. Then you could spend your money on getting a closer out-of-the-money, or better yet, an at-the-money or in-the-money option.
I personally like to look at options simply as a cheaper way to invest in stocks. Because if I bought 100 shares of a $90 stock, that would cost $9,000. But if I bought an $85 call option with four to six weeks left, while the stock was at $90, I’d have the right to buy 100 shares of that stock at $90. And I’d probably only have to pay about $5.50 to $7.00 ($550 to $700) to do so. (There of course are other considerations to the pricing of options that are beyond the scope of this article, but you get the idea.) The benefits of my in-the-money preferences are: If the stock went sideways, I’d retain the majority of my investment since my option is comprised of mostly intrinsic value. If it went up a little, my option would still have a great chance of gain. If it moved up nicely (as I’d expected), I’d get the lion’s share of the move. And if it collapsed, my maximum exposure would be limited to my purchase price. (And even less if I sold prior to expiration.)
So what does all this mean?
Make sure you screen for good stocks!!!
And make sure you know what the probability is for those stocks to move, say within the next week or month, etc. And the only way to really know is to back-test your screening strategies.
This way, even a crummy option strategy will then have a better chance of profit. But with better knowledge of your stocks’ movement potential you can employ a better option strategy for even bigger gains.
Here’s an easy way to get started. In the Research Wizard, some of our best and “winningest” strategies come loaded with the program. Simply add the filter called “optionable” (meaning these stocks have options), add the optionable filter to these strategies and then go find the best options.
Here’s three optionable stocks from some of my favorite stock-screening strategies (1/29/08);
BKE Buckle Inc. (from the sow_10_20_50_200_ma screen [moving average screen])
FFH Fairfax Financial (from the “Winning Ways” screen)
NWA Northwest Airlines (from the “Big Money” screen)
Get the rest of the stocks from each one of these screens, and start making better stock and option decisions today. Remember, the key to successful stock-picking is in discovering those screens that have produced profitable results in the past. The key to better option selections is in knowing what to expect from your stocks (and when). And how will you know? By back-testing! Click here to find out more about our free trial to the Research Wizard stock picking and back-testing program: http://researchwiz.zacks.com
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.