January 24th Trading Thoughts --- The Call Instead of Stock (CIS) Strategy

Hello Traders,

Thought I would continue a discussion on my current option trading positions and strategies.  This segment explores the CIS!! Hopefully it makes sense.  I'll try to answer any questions.  Glory to God, All Praise is Due Him!! Amen!!

Trades #7; 11; 12 Morgan Stanley (MS); United Airlines (UAL); Yahoo! (YHOO)  Purchase Calls Instead of Stock (CIS); Hedged with Buying a Near-Term Put Butterfly & Collar by Selling a Near-Term Call

Without question, the CIS option strategy is by far the most exotic that requires on-going maintenance and adjustments.  However, I believe the strategy logic and purpose is rather straight forward.  I will do my best to explain how I utilize this strategy and the criteria I use in selecting my CIS candidates.

The CIS strategy is essentially a “stock replacement” strategy.  As I mentioned at the beginning of my prior blog today, I believe options represent the most efficient means of utilizing one’s capital due to the leverage and time-frame one can benefit with a small amount of money.  I believe the CIS strategy takes full advantage of this benefit. 

First of all, to meet the CIS criteria I have to ask myself a few questions: 1) would I like to own the shares of this company?; 2) are the near-and-longer-term prospects for the company positive…do they have a great product or service?; 3) do I like the management team? 4) do they grow their earnings consistently or at least improving year-over-year?; 5) do they have good growth potential and are they taking market share?; 6) do they have a strong balance sheet/cash position?  Obviously, these are the same fundamental questions you would ask yourself if you were willing to commit buying stock in a company and becoming a shareholder. You want to take the same approach with the CIS strategy. 

Second, I want to look for companies that trade in a specific price range: Generally $30-$47 per share. I also prefer to have a stock that is trending higher, but has pulled back recently in price by 1 or 2 percent. I use $30-$47 price range because it provides easier hedging ability due to single strike options within the listed option chain.  Single strike options are generally available in this price range. However, once over $50 per share, most option chains increase by at least $2.50 per strike.  This makes it more difficult to hedge your long call position and would force you to “split-the-strikes” in order to provide an adequate hedge.  The CIS can be done at >$50 but it’s a bit more difficult to manage.

Third, the option bid/ask spreads should be no more than 10 cents wide.  The narrower the spread, the better the pricing you can obtain.

Fourth, there should be sufficient open interest volume in order to have decent liquidity for trading in and out of the options when it comes time to enter and exit a position.   

Fifth, I need the stock to have some volatility and price movement.  As discussed in my prior blog regarding double calendars, I explained how volatility in options provide more attractive premium values and volatility can help in hedging the CIS strategy.  I typically look at a 1 year monthly chart and want to see price movement average approximately $2-$4 per share per month.

Sixth, I now want to select a long deep-in-the-money (DITM) call option that has at least 90 days till expiration.  I want to purchase the calls having at least an 80% delta.  I do this because I want the calls to represent or mimic the actual price movement of the  underlying stock.  The lower the delta, the less impact it has to move in relationship to the stock price.  The higher the delta, the greater the impact it has to move in relationship to the stock price.  The higher the call delta, the higher the option premium price or cost will be.  At this point you will need to determine how much capital you are willing to commit.  Initially I typically buy only +3 long contracts with the idea of possibly buying more depending on how the position behaves. I'll describe that below under various scenarios. As previously stated, the capital requirements are much lower with options than stocks... even DITM options.  For example, if you were buying stock instead of the options and the stock is currently at $37 per share for 300 shares, the required outlay for the stock purchase would be 300 x $37 = $11,100.  Whereas the DITM may only cost $6.50 each x 3 contracts (or 300 shares) = $1,950 for essentially the same movement in stock price. That is powerful and efficient use of leverage and capital.

Seventh, after you have selected your long calls to buy, you now need to select your near-term hedge(s) to protect "some" downside risk to your long DITM calls. Notice, that I said "some", not all your risk. To hedge, I choose a near-term put butterfly with 25-45 days to expiration.  Specifically, assume that the stock is currently trading at $37 per share and I bought +3 April 32 DITM 90-day calls.  I would immediately hedge this long call position by buying +3/-6/+3 of the February 38/35/32 (27 days till expiration) put options.  Let’s also assume the net price of the put butterfly is a debit of $0.54 cents per contract.  Thus, the total cost of the put butterfly hedge is approximately $150.00.  The near-term put butterfly will help hedge your long call purchase to the 35 short strike of the near-term option.  At the same time you can further hedge your long call position and possibly pay for the entire cost of the put butterfly protection by selling a near-term call.  For example, you may be able to find a February 39 call that sells for $0.65 cents.  By selling -3 calls, or receiving a credit of $195.00 you more than pay for your put butterfly hedge at $0.54/$150.00!  However, by selling the 3 Feb 39 calls, you have now “collared” the trade and have limited your upside potential on your long calls.  Depending upon how bullish I am on the stock, I may forego selling calls initially with the hopes of either getting a higher credit or increasing the strike by a dollar or two to say maybe selling Feb 40 or greater call at a later date, or perhaps a Mar 41 call.  This decision is usually "one from the gut"!

Eighth, depending how things work out after placing the trade, you manage the trade accordingly.  For example, assume the price jumps from $37 to $45.  Your long-dated calls will also jump in relation… in fact the delta will probably be close to 100% under that scenario.  Your Feb put butterfly would be nearly worthless, so you would lose on that end of it… but so what?  You will have a very substantial profit on your long calls... remember it’s essentially the same as owning 300 shares of stock.  What if you sold a near term short call and collared the trade?   Obviously, you would lose on that as well.  You then would have to decide if you want to close out the position entirely or possibly roll the near-term call to a later month?  It’s your call!  It’s a good problem to have if you ask me.  What about the scenario where the stock price drops to $34 per share or lower then what?  Well, it depends on a number of things… is the stock down for a firm-specific reason or is it in sympathy to a downgrade made on a competitor?  Is it a macro reason?  Or worst case, did something fundamentally go wrong with the company that changes your outlook?  If that’s the case, you need to exit your entire position.  Otherwise, you may see this as an opportunity to buy more DITM calls, possibly 30-days further out in time depending on when this “news” hits or share price drop happens. If you decide to buy more, it may be necessary to close-out of your put butterfly or keep it depending again on how many days remain till expiration.  In either case, you still need to buy another +3/-6/+3 put fly… in this case at $34 per share you would likely select the 35/32/29 strikes.  Keep in mind depending on the volatility of the shares, the strike width may be only 2 strikes wide if it is a less volatile stock.  The more volatile the stock, the greater the width of the strikes you would choose as your put fly hedge.  If you had a scenario where the stock price fell to $35, your near-term put butterfly would be at maximum profit at expiration and you could then use the proceeds to help finance the purchase of more DITM calls and start the process all over again. 

In the final analysis, I guess I like the CIS strategy because how often have you purchased a stock and it immediately went against you?  Provided the stock does not crater, and even if it did you are only out the debit you paid for the calls, at least the put butterfly hedge and short call if collared , will under most conditions be profitable.  And if I still like the company, I can simply buy more DITM calls and try it again!

Below are the current CIS trade set-ups I have on. These are real trades and are for illustrative purposes only.

*MS @~ $31.03 / $31.54 / $30.55	MS CIS COLLAR WITH BUTTERFLY HEDGE					Open	Dollar Value	01/24/14	Current		Net P&L	MS Current Price:		$30.45
12/20/13	Buy	3	Apr 14	27	Call	$4.60	-$1,380.00		$3.925		-$202.50	Current Avg. IV:		29.81%
01/23/14	Buy	3	Apr 14	27	Call	$4.80	-$1,440.00		$3.925		-$262.50	1 σ move +/- to Feb expiry:        $32.95/ $27.93
01/24/14	Buy	3	Apr 14	27	Call	$3.95	-$1,185.00		$3.925		-$7.50
12/20/13	Sell	-3	Jan	32	Call	$0.47	$141.00	01/17/14	$1.36	closed	-$267.00
01/17/14	Sell	-3	Jan4	32	Call	$1.39	$417.00	01/22/14	$0.46	closed	$279.00
01/22/14	Sell	-3	Feb	33	Call	$0.46	$138.00		$0.18		$85.50
12/20/13	Buy	3	Jan	31	Put	$0.87	-$261.00	01/07/14	$0.48	closed	-$117.00
12/20/13	Sell	-3	Jan	29	Put	$0.27	$81.00	expired	$0.00		$81.00
12/20/13	Sell	-3	Jan	29	Put	$0.27	$81.00	01/07/14	$0.08	closed	$57.00
12/20/13	Buy	3	Jan	27	Put	$0.11	-$33.00	expired	$0.00		-$33.00
01/07/14	Buy	3	Feb	32	Put	$1.41	-$423.00	01/21/14	$0.55	closed	-$258.00
01/07/14	Sell	-3	Feb	30	Put	$0.56	$168.00	01/21/14	$0.14	closed	$126.00
01/07/14	Sell	-3	Feb	30	Put	$0.56	$168.00		$0.370		$57.00
01/07/14	Buy	3	Feb	28	Put	$0.21	-$63.00		$0.085		-$37.50
01/23/14	Buy	6	Feb	32	Put	$1.06	-$636.00		$1.96		$537.00
01/23/14	Sell	-12	Feb	30	Put	$0.27	$324.00		$0.77		-$600.00
01/23/14	Buy	6	Feb	28	Put	$0.07	-$42.00		$0.22		$87.00
01/24/14	Buy	3	Feb	32	Put	$1.84	-$552.00		$1.96		$34.50
01/24/14	Sell	-6	Feb	30	Put	$0.66	$396.00		$0.77		-$66.00
01/24/14	Buy	3	Feb	26	Put	$0.02	-$6.00		$0.06		$12.00
*Underlying Open Share Price
29.61% IV @ open				Initial Option Hedge =			-$102.00		O P&L=		-$495.00
	TOTAL MS P&L  =						-$495.00
							FOR ILLUSTRATION PURPOSES ONLY!!!

*UAL @~ $37.70	UAL CIS COLLAR WITH BUTTERFLY HEDGE					Open	Dollar Value	01/21/14	Current		Net P&L	UAL Current Price:		$46.13
12/12/13	Buy	2	Mar	31	Call	$7.63	-$1,526.00	01/17/14	$15.85	closed	$1,644.00	Current Avg. IV:		42.96%
12/12/13	Buy	2	Mar	31	Call	$7.70	-$1,540.00	01/17/14	$15.85	closed	$1,630.00	1 σ move +/- to FEB expiry:  $51.60/     $40.68
01/09/14	Buy	3	Jun	48	Call	$4.00	-$1,200.00		$4.050		$15.00
01/17/14	Buy	3	Jun	49	Call	$4.65	-$1,395.00		$3.675		-$292.50
12/12/13	Sell	-2	Jan	40	Call	$0.81	$162.00	01/17/14	$7.19	closed	-$1,276.00
12/12/13	Sell	-2	Jan	40	Call	$0.89	$178.00	01/17/14	$6.85	closed	-$1,192.00
12/12/13	Sell	-1	Jan	40	Call	$0.89	$89.00	01/03/14	$1.12	closed	-$23.00
01/03/14	Sell	-1	Feb	43	Call	$1.16	$116.00		$3.975		-$281.50
01/09/14	Sell	-2	Mar	50	Call	$1.75	$350.00		$1.425		$65.00
01/17/14	Sell	-2	Feb	40	Call	$7.59	$1,518.00	01/17/14	$7.25	closed	$68.00
01/17/14	Sell	-4	Feb	50	Call	$1.30	$520.00		$0.695		$242.00
12/12/13	Buy	2	Jan	38	Put	$2.01	-$402.00	01/07/14	$0.54	closed	-$294.00
12/12/13	Sell	-2	Jan	35	Put	$0.755	$151.00	01/07/14	$0.10	closed	$131.00
12/12/13	Sell	-2	Jan	35	Put	$0.70	$140.00	expired	$0.00		$140.00
12/12/13	Buy	2	Jan	32	Put	$0.27	-$54.00	expired	$0.00		-$54.00
12/12/13	Buy	2	Jan	38	Put	$1.89	-$378.00	01/07/14	$0.54	closed	-$270.00
12/12/13	Sell	-2	Jan	35	Put	$0.70	$140.00	01/07/14	$0.10	closed	$120.00
12/12/13	Sell	-2	Jan	35	Put	$0.70	$140.00	expired	$0.00		$140.00
12/12/13	Buy	2	Jan	32	Put	$0.26	-$52.00	expired	$0.00		-$52.00
01/07/14	Buy	4	Feb	40	Put	$2.69	-$1,076.00		$0.325		-$946.00
01/07/14	Sell	-8	Feb	37	Put	$1.275	$1,020.00		$0.120		$924.00
01/07/14	Buy	4	Feb	34	Put	$0.52	-$208.00		$0.050		-$188.00
01/07/14	Buy	4	Feb	48	Put	$2.69	-$1,076.00		$3.150		$184.00
01/07/14	Sell	-8	Feb	44	Put	$1.075	$860.00		$1.160		-$68.00
01/07/14	Buy	4	Feb	40	Put	$0.41	-$164.00		$0.325		-$34.00
*Underlying Open Share Price
41.02% IV @ open				Initial Option Hedge =			$1,974.00		O P&L=		$332.00
	TOTAL UAL P&L  =						$332.00
							FOR ILLUSTRATION PURPOSES ONLY!!!

*YHOO @~ $35.27 & $39.05 / $37.92	YHOO CIS COLLAR WITH BUTTERFLY HEDGE					Open	Dollar Value	01/21/14	Current		Net P&L	YHOO Current Price:		$37.91
11/20/13	Buy	2	Feb 14	30	Call	$6.05	-$1,210.00	12/18/13	$9.20	closed	$630.00	Current IV:		41.44%
12/05/13	Buy	2	Mar 14	34	Call	$6.15	-$1,230.00		$4.800		-   $270.00	1 σ move +/- to FEB expiry:  $42.25/ $33.59
01/24/14	Buy	2	Apr	33	Call	$5.95	-$1,190.00		$5.975		$5.00
11/20/13	Sell	-2	Dec	37	Call	$0.65	$130.00	12/18/13	$2.03	closed	-$276.00
12/05/13	Sell	-2	Jan	41	Call	$0.90	$180.00	01/07/14	$0.70	closed	$40.00
01/07/14	Sell	-2	Feb	44	Call	$0.97	$194.00		$0.390		$116.00
11/20/13	Buy	2	Dec	36	Put	$1.67	-$334.00	expired	$0.00		-$334.00
11/20/13	Sell	-4	Dec	34	Put	$0.68	$272.00	expired	$0.00		$272.00
11/20/13	Buy	2	Dec	32	Put	$0.21	-$42.00	expired	$0.00		-$42.00
12/05/13	Buy	2	Jan	40	Put	$2.24	-$448.00	01/06/14	$0.75	closed	-$298.00
12/05/13	Sell	-4	Jan	37	Put	$0.88	$352.00	01/07/14	$0.02	closed	$344.00
12/05/13	Buy	2	Jan	34	Put	$0.29	-$58.00	expired	$0.00		-$58.00
01/06/14	Buy	2	Feb	41	Put	$2.61	-$522.00		$3.750		$228.00
01/06/14	Sell	-2	Feb	38	Put	$1.14	$227.00		$1.735		-$120.00
01/06/14	Sell	-2	Feb	38	Put	$1.14	$227.00	01/24/14	$1.72	closed	-$117.00
01/06/14	Buy	2	Feb	35	Put	$0.39	-$78.00		$0.545		$31.00
01/24/14	Sell	-4	Feb	36	Put	$0.82	$328.00		$0.855		-$14.00
01/24/14	Buy	2	Feb	34	Put	$0.31	-$62.00		$0.325		$3.00
*Underlying Open Long Call Price
32.17% IV @ open 11/20/13				Initial Option Hedge =			$100.00		O P&L=		$151.00

Remember that option trading is risky business.  Become knowledgeable and paper trade before using real capital!!  All material in this blog is for illustration purposes only.

Happy Trading & God Bless!

H2Options