The other day I discussed Options with a friend and I noticed that there are a lot of misconceptions out there. Call options got a bad reputation recently and I assume this is mostly because of the yolo stuff you see on reddit’s infamous wallstreetbets and twitter.
But can you also use Call options to express value investments? I wanted to share a few thoughts on this.
This is not financial advice and before you buy any options I would recommend that you read up on them. I put a good book in the description below.
So lets talk about Options. When people think of options they think about rampant speculation. Like someone buys a cheap option that expires by the end of this week. In my view this is speculation and I would strongly advice against it. Occasionally you see some people posting about how much money they made but the sad truth is that most people will lose their hard earned money this way.
NOBODY can predict where a stock price will be by the end of his week. There are simply too many variables and a few days isn’t a very long time horizon.
But here is the good news. You can also buy options that are 1-2 year out. So this puts the odds in your favor because it is much easier to predict if a stock will be up in 2 years from now compared to two days.
So here is an idea how you can use call options to express your value investment idea. I will not get into all details about options here but basically an option gives you the right to buy an asset for a pre determined price. You don’t have to buy the stock later and can also just sell your option if you want to.
Let’s say that based on your research you find a stock that is about 50% undervalued. So StockX is selling for $50 usd but based on your research you believe it could be trading at $100 in a few years.
So what you can do now is check the options chain.
The options chain basically shows you all the options contracts that are available for purchase for this Stock
Lets look at June 2023. Luckily for you you can buy the $40 strike price for $15 usd. Buying this contract would set you back $1500 and depending on your broker you also pay a small fee.
Ok what does this mean now. IF by June 23 the Price of the Stock is above 55 Usd ( $40 + premium of $15) then you are at breakeven. This doesn’t sound amazing at first that to if the stock would move up by 10% over 2 years you would barely breakeven.
But lets wait. You of course thought it could reach 100 so here is how your profits could look like if the price appreciates further than 55.
Lets say the stock reaches $70 within 2 years.
If you would have owned the stock outright you would have earned a decent 40% over 2 years. Thats a great return BUT your options are actually up a 100% ! Yes thats right. The options you paid $1500 for are now worth $3000
If the price moves to 85 a share over 2 years you tripled your money as your options would now be worth $4500. Lets also not get greedy but do you see the difference? If you’re right about the direction of the stock over 2 years then you can make a lot more money by using call options.
Side note: Keep in mind option holders do not collect dividends so you have to calculate this into your profits
When you think about using options for your value investment ideas make sure that you pick a realistic price and a contract that has enough time
Furthermore the premium you pay has to make sense. The numbers I used in my sample might not be available for you.
Don’t buy options that require unrealistic moves to move into the money. Let’s take my sample again
Lets say the option would cost $30 usd for the $40 strike price and today’s price is $50. You would need a 40% move just to break even. In this case the Investment might not make any sense and It would be better to buy the stock outright.
But what I am saying is this. When you found an undervalued stock then have a look at the 1-2 year options contracts and see if you can find a real bargain.
I hope you enjoyed the video. Please let me know your thoughts about call options and value investing in the comments below.