Mid Term Call Strategy – Near The Money Call

We briefly discussed the short term strategy which utilizes DOTM (Deep Out Of The Money) Call to bet earning report. The stock can go either direction to certain level. Nevertheless, there is a option strategy to make a profit: We might long calls to profit from sudden jump, long puts to profit from plummeting stocks, long strangles or straddles, short iron condors to profit from drastic movement in either direction, or you might bet against no drastic, but no movement or mild movement by longing iron condors or shorting strangles/straddle. However, you should remember no matter what kind of setup you decide to take, your counterpart, very likely a market maker (MM), has already place the bid based on their sophisticated algorithm which is in favor of themselves. At the end of day. I mean at the end of market close of expiration day, MMs are likely the ones who profit eventually.

In the previous discuss of short term strategy,  theta (time decay) is the archenemy of DOTM (deep out of the money) near expiration call owner and the stock must appreciate rapidly. Theta can be found to describe the negative impact of time (i.e decreasing time value) pass to option price for both calls and puts. If delta is -0.80 (delta is always negative unless we can rollback the clock), which means the option will be devalued by $0.80 if other factors remain the same. The diminishing of time value accelerates when there is only 2 weeks left and race to the climax on the expiration day. If you need more leeway to allow your stock of interest to appreciate, you can choose Near the Money (NTM) Call which has approximately 2 months to expire. By that way, we will have sufficient time to ride the tide, but also have followup strategies when the tide is against us.

Each person has his own standard to pick stocks. I personally prefer the self-invented “3M” system to increase the probability of success:

1)Momentum: The underlying stock just breaks up and is in a confirmed uptrend, which is supported by favorable technical indicators and fundamentals.

2) Multiple non-correlated evidences, such as:

  •  The stock is recommended by Investors Business Daily and/or  Barron’s, such as it is on IBD Top 50 or one of the sector leaders.
  •  Phenomenon observed by myself, such as long line when dinning at Chipotle Mexican Grill, more electric cars on streets or in parking lots, more handbags of a brand, a full house of customers in Nordstrom, huge new job listing of your neighboring company (which usually means a M&A event might be imminent)
  •  Outperforming sectors:such as new energy, biotech and internet stocks of last year.

3)Market: We expect market will remain stable or maintain the uptrend. However, if there is a significant correction, most stock will go down with the broad market, no matter how pretty your chart appears to be.

We can purchase a high value, liquidated stock with delta around 0.5 and expect a ROI of 3-5 folds.

Here is a breakdown analysis of Greeks and I just assign an subjective probability value for simplicity:

delta: Let’s just assume we have a very nice pick and the uptrend will maintained. The probability of a winning delta is 80%.

gamma: The movement  (of either direction) can be accelerated or decelerated, P = 50%.

vega: If only consider the price of the expiration day, vega is not relevant.

theta: The time decay of the 1st one and half months are still manageable. Let’s just assume it will devalue 30%, or 70% favorable.

Overall, we have probability of 28%, not bad if we can gain 5x ROI.

Take home messages:

1. relatively low probability (not terribly low as DOTM),relative high ROI (not as high as DOTM),limited loss.

2. Followup possible: If the stock appreciates but time is running out, we can roll forward. If the stock is skyrocketing, we can roll up and let the profit run.

3. replicable, but ROI is not guaranteed. If we are successful one out of three trades (100% loss in 2 trades), we are only break even when we get 300% ROI on the winning trade. However, the probability of higher ROI will go much lower.

4. Not scalable: Except for those high volume liquidated stocks, Market Makers won’t allow you to purchase a great deal of NTM calls. They will lift the ask price when you are buying.

In essence, we can optimize our approaches to make right picks by refine our technical analysis and fundamental analysis, we can reveal more irrelevant events to predict the direction of the underlaying stock. However, we do not have the capacity to control the market and avoid adverse impact of an unexpected events. Thus, a prudent investor should have a sound exit strategy in mind before he press the buy button. Good luck!