Adjusting for Market Events

Playing Momentum Names in a Frothy Market

When the news media ramps up the volume as the markets approach or hit periodic highs, advisors can find themselves in one of two camps - either they are trying to convince their clients to stay properly valued in the market, or they are dealing with excited clients who want exposure to the high-flying, high-growth, momentum stocks.

Because these high-flying, high-growth stocks are typically at frothy valuations, buying a full position may eat up an outsized portion of a client's portfolio - exposing them to high volatility and risk. However, advisors can capture the same upside potential as outright stock ownership, while limiting the downside risk, by buying calls on these equities.

Many times, traders buy cheap, out-of-the-money call options that expire in a few months or less to participate in the anticipated advance of expensive stocks. Though these trades are attractive to many investors because they do not cost a lot of money, they often prove to be very frustrating because the stock must react as expected in a short time period.

So instead of following the well-trod path of buying cheap, out-of-the-money call options that expire in a few months, advisors should focus on longer dated, at- or in-the-money options that can take advantage of longer-term themes and trends. As many seasoned traders understand, timing is everything in the market, which is why many cheap bets tend not to work as planned.

A lot of clients balk at buying naked options at first. Since the option can expire worthless, it may be seen as a gamble or unnecessary expense - two things which may be true of cheap, out-of-the-money options. However, using the following example, one can see that it is not; rather, it is a calculated investment that affords upside, while simultaneously defining downside to the cost of the option.

OK, it's late March, 2013 and we?re looking at XYZ, our theoretical blue-chip that falls into the momentum category based its recent uptrend. Say that you or a client likes the fundamentals of XYZ, which is trading at $186.67, and that you have identified a price target of $210. You want to implement a bullish, longer-term strategy, but you just do not want to tie up the capital it would take to buy stock.

You could look at in-the-money January 2015 $160 strike calls for $31.10 expiring in 2015. This strike selection could be considered conservative for two main reasons: (1) it is deep in-the-money (by 14 percent), and 2) the amount of capital necessary for the right to own 100 shares per option contract is $3,110, while the price to own non-margined stock is $18,667 for 100 shares. [1]

XYZ does pay a dividend, currently $3.80 annually; however, dividends are not paid on options, meaning the buyer of XYZ January 2015 calls misses out on three of the remaining dividend payments.

On the plus side - and it is always helpful to think of your trades as having positive and negative traits - the XYZ trade is in-the-money with an 87 delta, which means that for a $1 increase or decrease  in the price of the stock, the option will increase or decrease by $0.87. This delta will change based on the direction of the stock, and can serve as an indicator to get smaller if stock goes down or bigger if stock goes up. So while we still have directional risk in the call, another risk factor, time decay, is less at this stage (one year out until expiration) versus an option that has less time until expiration (i.e. the shorter-term option has less time to be right).

On the negative side, option holders will not pocket the three remaining dividends, nor do they have voting rights, which few investors use or value. Secondly, the price of XYZ could decline below $160, which would make the options expire worthless. That 14 percent decline in the stock price would cost 100 percent of the investment. However, one wouldn?t trade a $3,000 stock position for the equivalent in an options position, but one can trade the nearly $19,000 stock position for one requiring $3,000 of capital ? thereby reducing capital risk while keeping a client positioned in the market. 

Most importantly this allows traders the opportunity to continue participating on the upside. Put another way: trading long-dated options is not a lottery ticket or a gamble; it can be a way to effectively and efficiently manage a portfolio without over-committing capital.

Joe Cusick is the vice president of wealth and asset management at MoneyBlock, an independent broker-dealer. Options involve risk and are not suitable for all investors. Prior to investing in options, please read ?Characteristics and Risks of Standardized Options? available from The Options Clearing Corporation or MoneyBlock (call: 1-800-591-8243) upon request.

[1] Purchase of one call option at price of $31.10 (1 x $31.10 x 100 (the multiplier) =$3,110