The Retail Investor
Since the advent of commission free trading, we have seen a surge of stimulus-check fueled, leverage crazed, retail investors storming the markets in search of gold. Investing has never been easier with popular platforms like Robinhood turning the tide with commission free investing and automated tax forms all with a shiny easy-to-use app on your smartphone. Retail investor trading volume has grown by the millions since 2019 with large increases in option contract trading.
Why Options?
I hypothesize that at some point stimulus check fueled retail investors realized investing in their favorite companies--or bluechips--didn't provide enough of a return for their risky appetites. Shares in companies like Apple (NYSE:AAPL), Tesla (NYSE:TSLA), and SNAP (NYSE:SNAP) by themselves didn't provide the get-rich-quick gold rush their stimulus check trading gurus had promised. Options, however, are highly leveraged financial instruments that could provide that return. Specifically, out-of-the-money (OTM) options came with cheap price tags and promises of 5X -20X returns within days.
So.. how bullish can I go?
Options trading on a bullish hunch provides a variety of strategies when it comes to placing trades fitting your timeline, risk appetite, and budget. The most common bullish options trade is buying a call option (long call).
The basics of a call options is as follows. A call option gives you the right but not obligation to buy a share at strike price k before the option expires. The value of the call option rises with the stock price as the right to buy shares at strike price k becomes more valuable. Now, the investor can either exercise their right to buy or sell the option altogether. A call option is in-the-money (ITM) if the strike price k is below the current share price. If that option were to be exercised today, it would contain some intrinsic value.
A call option is out-the-money (OTM) if the strike price k is above the current share price. This means any value in the option is from its time value since exercising would yield nothing. Hence, OTM options with primarily time value are cheaper than ITM options. This lends investors cheaper access to leverage.
As of 4/20/22, an APPL call with strike 175 and TTE of 2.5 weeks goes for about $62. At the time, AAPL trades at ~ $167.50 a share. With this cheaper option price comes a riskier position. For the position to be profitable at expiration, the share price must be greater than $175 + price paid for the option. This requires a 5.5% upwards movement in 2.5 weeks.
Figure 1: P/L chart for a AAPL call option: k = 175, TTE = 2.5 weeks
We can see that with a quick enough bullish move, the contract can bring in upwards of a 400% ROI. Not bad for a $62 initial investment. However, OTM requires an extreme upwards movement of the underlying stock to occur very quick. As time-to-expiration dwindles, much of its original extrinsic value diminishes by the day. Bottom line is OTM call options will provide large leverage opportunities, but this is paid for by harshly raising the expected move for the underlying stock.
ATM Same Strike Split-Strike
This strategy utilizes margin (borrowed capital) to achieve its leverage. Most brokerages won't allow you to buy contracts using margin precisely because it can be very risky. However, we can circumvent this by creating an options spread. By buying an call option with strike k and selling a put option at strike k, we are financing the long call with the short put.
Figure 2: Split Strike with call/put @ = 167.50 and TTE = 2.5 weeks
The P/L chart shows the profit throughout the life of the options spread. At expiration, a price movement to $177 a share provides a return of about $1000 on a trade that gave an initial credit of $37.50 to begin with. The leverage is through the roof. For comparison if we bought 1 share for $167.50, we would profit $9.50 if the share price reaches $177 at the end of the 2.5 weeks. The downside, however, is extremely substantial. If the stock plummets, the put option will be exercised by its owner and you as its seller will be obligated to buy 100 shares at the strike price k. Hence, you will need the capital to fulfill this assignment and be at a loss of (k - stock price). If the trade sentiment is wrong, the losses are equally leveraged. This may lead to your broker issuing a margin call requiring you to post additional capital.
Summary: The advent of retail options volume and a strong post COVID-19 economic recovery period has led to no shortage of bullish options trades on the markets. In this article we propose a same strike Split-Strike options strategy providing monumental leverage along with extended risk. In more complex trades, the large risk can be somewhat mitigated by adding a long OTM put to the position to cover assignment risk. This would negatively affect the leverage. The biggest difference between an OTM call option and this strategy is how leverage is received. OTM call options get their leverage by sacrificing moneyness for a cheaper buy in price. Split Strikes provide leverage by indulging in a trade with large margin requirements. Regardless of the chosen strategy, every options investor should acknowledge the risks any options trade comes with proceed with caution and informed decisions.
[1] https://www.cnbc.com/2021/01/22/trading-volume-is-up-so-far-from-2020s-breakneck-pace-as-retail-investors-get-even-more-active.html