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Option Strategies:  Buying In-the-Money Calls as a Surrogate for Owning Stocks (5/27/05)

In the next couple of weeks, the second book in our series will be available:  entitled "Options, What are They and How Can the Average Investor/Trader Profit from Their Use?"  Find a Table of Contents and an excerpt here.  Options are important to the trader and investor alike because of their many uses:  providing income, limiting risk, discounting price in a stock purchase, and the repair of a broken stock ownership position are all possible.  They ought to be part of every trader/investor's bag of strategies, as should selling short.  Here, I want to concentrate on a strategy that proves useful when your capital is limited, either with a small account or with a larger one where most capital has already been committed.

Call options give one the right, but not the obligation, to either buy or sell stocks at a certain price (option's strike price).  The option seller (writer) gives the buyer the right to take his stock for a price (option premium) at any time up until that option's expiration date.   As the underlying stock's price goes up, the value of its call goes up proportionally.  And the reverse is true as well.  The degree of change depends on the relationship between the stock's price and the option's strike price.  The deeper in-the-money the option, the more likely it moves dollar-for-dollar with its underlying stock.  An option's delta defines the proportion of the option's movement against its underlying stock.  It also approximates that option's probability of finishing in-the -money at expiration.

Before going further, let's consider the downside of buying and selling options.  First, options aren't as liquid as stock transactions so bid/ask spreads typically run higher:  ~$0.10 to 0.50 for TSM stocks.  Commissions are slightly more too.  And finally, not every stock provides options (~2,500 stocks do).  That said, let's look at one of my favorite option strategies: buying deep in-the-money Calls instead of the stock shares themselves.  In today's environment, where volatility is low (30.8 percent implied volatility for CHTT), buying Calls is akin to controlling the underlying stock's shares at nearly the same price as the shares themselves but requiring far less cash.

Consider the CHTT trade below.  The recommendation is to buy the pullback reversal at $43.56, say 1,000 shares for purposes of this example.  Neglecting commissions, the cost would be $43,560 for the position.  If the position turns bad, the 7 percent loss criteria forces one to cut loses at $40.44 or $3,120.  On the other had, if it gains $3 the profit would be $3,000 or 6.89 percent on the money invested.

Another possibility would be to buy 10 Calls at the $40 strike (in-the-money by $3.56), each Call controlling 100 shares of CHTT.  Using the Black and Scholes model, one calculates the cost of each Call contract at $381 or $3,810 for the 10 that expire in 22 days.  In essence, one pays $3.81 a share to buy 1,000 shares at any time over the next 22 days  for $40 each, i.e., the effective price is $43.81 a share.  The profit/loss opportunities, however, are exactly the same as if one bought the position outright for $43.81 a share.  That is, one pays a $0.25 per share premium to limit the initial cash outlay to $3,810 (versus $43,560 for buying the shares outright).  A $3 gain in CHTT's price to $46.56 profits the Call position by the $2,750 or 72.18 percent on the money invested.  Note, one sells back the option before expiration so one never has to provide the $40 per share capital

Another benefit for the option position is the option's characteristic delta.  When one initially buys the calls with 22 days to expiration, delta is 0.88, i.e., as CHTT's price increases $1, the Call increases $0.88 and becomes further in-the-money.  With this $1 increase, delta increases as well, so the option trades even more like the stock over the next dollar increase.  Going the other way, however, the option position becomes less in-the-money, and delta falls.  If CHTT falls to $40.44 and triggers the 7 percent stop loss, $3.12 ($43.56 - $40.44) per share is lost owning the stock outright.  The option position, on the other hand, loses less.  If $40.44 is hit in four days, delta falls to 0.58, i.e., as CHTT drops $1, its Call drops $0.58.  When the stock triggers its 7 percent loss, the Call position's value has dropped to $1.35 for a loss of $2.46 ($3.81 - $1.35), significantly less than owning the shares themselves.  Because of bid/ask spreads, the results won't be quite this rosy.  I'll execute this trade tomorrow.

Though the above seems complicated, the details don't need to be understood exactly for each trade, just the general characteristics:  low implied volatility for the options of a stock means in-the-money Calls trade like the stock but with far less cash required; because of the characteristics of the Call's delta, stop loss points triggered by movement in stock price reduce losses for the option position relative to owning the stock outright. 

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CHTT - Chattem, Inc.

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Company Profile:  Chattem, Inc. (Chattem) is a marketer and manufacturer of branded over-the-counter (OTC) healthcare products, toiletries and dietary supplements. Its portfolio of products includes topical analgesics, such as Icy Hot and Aspercreme; medicated skincare products, such as Gold Bond medicated skincare powder, cream, lotion, first aid and footcare products, and pHisoderm medicated acne treatment products and skin cleansers; Selsun Blue medicated dandruff shampoos and conditioner; dietary supplements, including Dexatrim, Garlique and New Phase, and Other OTC and toiletry products, such as Pamprin, a menstrual analgesic; Herpecin-L, a lipcare product; Benzodent, a dental analgesic cream, and toiletries, such as Bullfrog, a line of sunblocks, Ultraswim, a chlorine-removing shampoo, and Sun-In, a hair lightener. These products are sold primarily through mass merchandisers, independent and chain drug stores, drug wholesalers and food stores in the United States and in more than 90 countries.

 

Company Fundamentals:  CHTT, a $875 million market cap company, is fundamentally strong from a earnings growth standpoint.  Zacks ranks CHTT a 1 a (ranked 1 four weeks ago), and PEG ratios of 1.03 and 1.40  for the next two years reflect the value left in the price (read about the effectiveness of PEG ratios in forecasting value here), though it has increased 25.9 percent in value over the past six months (S&P 500 increased +2.0 percent).  CHTT reports earnings on 6/08/05. Over the past two quarters, it has averaged a 12.1 percent positive surprise and produced a 37, 35, 57 & 50 percent year-over-year earnings growth and 10, 12, 16 & 17 percent year-over-year sales growth (producing 268 million in sales over the last 12 months). Further, this year's earnings estimates have increased 15.7 percent from $1.91 to $2.00 in the past 90 days, while top funds (top 15 percent performers in the past year) have increased their numbers by 9.3 percent over the past four quarters: from 86 to 94.   

 

Technicals:  As shown in the daily chart above, CHTT has just gone through a multi-month cup & handle.  We'll look to buy the reversal here.  On Tuesday, CHTT continued its pullback.  Let's try to catch the reversal here or in a few days at the support of its 20-day moving average.  Today's chart highlights the importance of breakaway gaps in providing future support for price, especially, if the gap is followed by a wide range bar as it was here.  On Wednesday, price continued to fall and not hit our buy point (chart not updated).  I think that it's setting up to bounce from its 50-day moving average tomorrow.  The best situation will be a narrow range candle tomorrow so we might buy the reversal bar on Friday.  On Thursday now, it looks like we're set up to reverse.  So wait for CHTT to exhibit strength (push higher than Thursday's high) before buying.  Notice where it has run before from this degree of being oversold (green bars).  See the option strategy (buying in-the-money Calls instead of stock shares) discussed for CHTT in the Trader's Corner section.