What does that mean? Let’s say you have a long call option dated 3 months out on XYZ at $20. XYZ is currently at $23 and the option is priced at $4. Deltas are at .7. As XYZ moves up in price $3, the option will move up around $2.40. If XYZ drops by $3, the option price will drop about $2. That’s a 20% differential.
Larger moves increase the effect, as does lower volatility. For example, at 25% vol (above was 50%), the $20 Call is $3.18 at XYZ $23. If it jumps $3, the call goes up to $6, a $2.82 increase. If it drops to $20, the option is $1, a $2 decrease.
Long Options Hidden Benefit 1: Mid-term Option Price effects are positive
Now obviously most people understand the asymmetric payout of options, but too many people calculate options out to expiry. That’s a poor use of long options, but most options guides only explain options in those terms. That ignores the dynamic and very tradeable factors options have prior to expiry. Note the chart below on the right – the dotted line 1 month out is still break-even if the SPY doesn’t move, but it loses $2k at expiry – that’s a massive difference. It’s not shown in the left graph from an online options guide.
Buying ITM options as a stock proxy is an excellent strategy. It can be combined with selling short term OTM equivalent options (long and short are both CALLS or both PUTS) as a diagonal spread. That captures premium and offsets the premium loss on the long term options.
Generally, buying long-dated options and rolling them well in advance is a superior longing proxy strategy for a stock. It only works if the options are relatively liquid, but it is possible in less liquid markets to get options closer to the bid price, if you’re patient and set up your orders to stay close to the bid. The primary risk beyond the beta risk is theta or time premium decay.
Such a strategy is hugely resistant to downdrafts. The ETF SWAN, for example, puts 10% in long-dated long call options on SPY and the balance into Treasuries. Note in the graph the very moderate decline in SWAN during the March 2020 crash versus the SPY. Peak to trough was about 10% drawdown on SWAN and 30% for the SPY. SPY recovered stronger, of course, but it was still below SWAN relatively 75 days later.
The upside potential is also many times higher for the same amount of capital risked. Clearly, not all conditions are ideal for this. High volatility conditions make the strategy far less appealing. As the XYZ price rises, especially in a steady rise, volatility tends to collapse if it was high. Volatility collapse can be very punishing, so I avoid the strategy in that case. But when vol settles to more normal levels, if the market has been rising, it often makes sense to buy on a pullback through long-dated options. The strategy can be implemented 2 ways.
2 methods for substituting call options for stock
- Very short term calls at very high deltas: .85 or more. 2 weeks out or so. You will want to maintain some premium value because this will increase if the stock moves against you. In other words, if your delta is 1, then a move against you will have the same value as a move in your favour, until the gamma kicks in and makes the delta drop.
- 6-12 months out at .7 deltas approximately. These will carry much more premium and you will have to go fairly deep into the money. For a SPY option, you may pay $40+ for the option and be $28 ITM. Then roll the options frequently, perhaps every month, to maintain the expiry length at your choice. In the event of a crash, consider selling the options quickly. A crash causes volatility to spike, sometimes very high, but usually briefly. If you’re nimble, it’s usually a good idea to take a smaller loss and exit, then re-enter when the market settles.
Most people trading options early on get the asymmetric benefits of options, but they don’t really analyze them as in and out trades. Skilled option traders rarely hold to expiry. Instead they roll, take profits, defensively close, or cut losses. Though options are much more complicated to analyze pre-expiry, the effort to understand how they work and how they adjust to price in varying conditions is not only hugely beneficial no matter your style, it’s really essential to success in the markets.