You can buy call options as a vehicle to leverage your returns, instead of just owning the stock outright. Not all options can be used to this purpose. The opportunities are usually found after prices have risen some distance, when there are contracts outstanding at much lower strike prices – where the intrinsic value of the call is very large and the risk premium is very small. You calculate the total finance % implicit in the call option and compare it to the return you expect from the alternate investment. This model for using options assumes you are NOT buying the option as a ‘bet’: that you want the exact same risk exposure as owning the stock.
Instead of owning and paying for the stock outright …
- You pay only a portion of the stock price (the intrinsic value of the option).
- The price you pay compensates for the dividends you will not receive.
- You pay interest on the remaining portion (at your financing rate calculated below).
- Invest that remaining portion in an alternate investment at a higher return.
Your first step is to determine the interest rate you will be paying on that financed portion. The basic equation for options arbitrage is:
Call Value = Intrinsic Value – Dividend Lost + Put Value + Interest Cost
From your point of view: Call = Intrinsic – Dividend + Finance Cost
For you the finance cost is the sum of the Put and Interest values. To find options with low enough interest, you must find the calls with their opposite puts trading at very low values. These calls will be deep in the money. In order of these calls to exist, the stock price must have moved higher in recent history. Because these calls are deep in the money, the intrinsic value will be substantial – 15% (or more). Therefore you can only leverage the remaining 85% (or less). You can never leverage 100% of your investment using options.
EXAMPLE
In this example XIU is trading at $74.55.
$52 put = $0.325 average of bid and ask
$52 call = $23.45
The intrinsic value is $22.55 (=74.55-52.00).
The time to maturity is 1.25 years.
The dividend on XIU is 1.59% for a year, or $1.48 =($74.55 * 1.59% *1.25yrs)
Solve for the finance cost = $2.38 using the arbitrage equation.
- Call $23.45 = Intrinsic $22.55 – Dividend $1.48 + Finance cost
CONCLUSION: Your total finance % is 3.66% (= $2.38/1.25yr/$52.00)
