Higher Upside: Reduced Premiums With This Options Strategy

Karim Rahemtulla By Karim Rahemtulla, Options Strategist, The Oxford Club

Alternative Income

One of the biggest obstacles to making money buying call options is the premium you pay to control the underlying shares. It’s like paying an extra tax, another hurdle to profits.

But there is a way to reduce that premium substantially.

It’s called a high delta trade. “Delta” is one of the Greek terms used in options parlance. Like in mathematics and engineering, delta refers to change. In options, it refers to how much an option price will increase with each increase in the underlying share price.

On the other hand, when you have a low delta trade, the option price will barely move when the share price moves. In other words, unless you get a big move in the stock, the option will likely register nothing more than a blip.

Here’s an example to show you how this works…

Let’s say you think stock XYZ is going to move higher. It’s trading at $20, and you think it’s going to $30 in 12 months. A $25 strike price option will cost you $2. In other words, $2 is your price to enter the game.

To break even, you will need the stock to hit $27 (the $2 you spent, plus the strike price of $25).

If the shares move to $30, this is a good trade. But if it stays below $27, you lose money.

The delta on this trade will probably be around 15. That means that the option will move up around $0.15 for each dollar move in the price of the shares. As the price of the shares gets closer or eclipses the strike price, the delta will increase.

However, you can choose a higher delta by purchasing an option with a lower strike price. And if you buy deep in the money – that is, if you buy an option with a strike price much lower than the price the shares are trading at – you can achieve a delta of 100.

A delta of 100 means that the price of the option moves in lockstep with the share price: For every dollar the value of the share goes up, the option does as well.

Buying deep in the money also reduces the premium you pay on the option significantly.

Let me explain. Say you buy a call option on XYZ with a $15 strike price, $5 under the current share price of $20. This means that you’ll pay at least $5 for the option (the intrinsic value) and probably another $1 for the time and risk premium. That’s 50% less premium ($1 versus $2) than if you bought the $25 call option.

But remember… because it has a delta of 100, your option will increase in value dollar for dollar with the underlying share price. This means your breakeven is lowered to $21 ($15 strike price, plus $5 for the option and $1 for the time and risk premium).

I use this strategy to control a stock that doesn’t pay dividends and to get a dollar-for-dollar move. Instead of shelling out $20 per share, I’m shelling out $6, reducing my downside substantially in the event the shares falter.

My upside is unlimited… and I’ll start enjoying profits almost immediately once the share price begins moving higher – in the case of our example, higher than $21.

Of course, the downside is that I’ll also lose money dollar for dollar if the shares move against me.

I use this on non-dividend-paying shares because options don’t pay dividends. And if I’m interested in receiving good dividends, I must own the shares directly.

Using a high delta strategy is one of the best ways I know to use call options without speculating. It allows me full participation in the upside of a trade and reduces how much premium I have to shell out to get in the game.

It’s one of the few times I advocate buying call options. While more than 75% of options contracts expire worthless, deep-in-the-money options have a much higher rate of success.

Stay Tuned…

Next week, I’ll begin my series on selling options. In my opinion, the options sellers are the big winners in options trading. But there is more to selling options than meets the eye…

Options have a very strong income component that the vast majority of investors are missing out on. I’ll explain two options strategies that will allow you to generate income from your current portfolio and also from any new purchases.

Good investing,