TMFTypeoh (75.91)

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Out of the money options: Whats your take?

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September 29, 2010 – Comments (11) | RELATED TICKERS: YONG , CMFO , CGA

Today, for the first time, i bought an option contract.

Well, 3 to be precise.

One of my favorite chinese stocks, Yongye (YONG), is trading at an absurdly low valuation (about 7x earnings). Why is it so cheap?

1) This market hates risk

2) This market hates china

3) This market REALLy hates small cap china

4) This companys growth is very fast, and it has a 6 month cash conversion cycle

5) All of this companies cash flow has been reinvested into raw materials, so it has no cash flow

6) Short sellers have been attacking other small cap china stocks (CMFO, CGA), investors fear this one is next

7) they recently bought a "customer list", which sounds bad on paper, but to me will be a boon for them for years to come

Add it all up, and despite growing earnings by 90% or so this year, and publicly stating a minimum of 50% growth for the next 2 years, along with margin expansion, and this stock is hated.

Well, i already have a full share of this stock in my portfolio (3%), but i wanted to get some more exposure at these prices. My solution? To buy the longest term options contract i could find.

YONG does allow options contracts, so i looked at the April 2011 contract. I found the $7 call options were going for around $1.35 each. I decided to buy 3 for a total cost of $415 after commisions.

Heres how it could play out:

YONG never goes higher than $8.35 from now to April 2001. I lose everything.

YONG expires at $8.35. I break even.

YONG trades higher than $8.35. For every dollar above $8.35, I make $300.

I would have LOVED a longer term option for YONG (a full year or more), but they don't exist.

Whats your take on options? Was this a stupid trade? Have you made money with LEAPS? Let me know below....

11 Comments – Post Your Own

#1) On September 29, 2010 at 9:09 PM, ikkyu2 (99.45) wrote:

My take on this is that it is gambling, not investing.

I like playing craps with a drink in one hand and a pretty girl standing next to me. Buying options and waiting to see how a stock price moves is not as pleasant to me, for two reasons:

1) It is less glamorous.

2) I prefer understanding how the game is being rigged against me when I am playing a game that is rigged against me.

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#2) On September 29, 2010 at 10:14 PM, TMFTypeoh (75.91) wrote:

ikkyu2,

I agree with you. This is WAYYY more speculative than 99% of my "real" investments. I was mostly interested in this trade for 2 reasons:

1) I've never done it before, but have studied options for a year or so now. However, the rubber has to meet the road somewhere, and you learn a lot faster when money is on the line. If i lose, then i will learn something, and i will consider the premium my tuition to a lesson.

2) This stocks growth has been for real, yet the price zips and zags between 7-8. I feel its worth more. As the short attacks subside, valuations will return. Whether of not that is by april, i don't know, but i thougt the risk was worth the reward.

Thanks for sharing.

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#3) On September 29, 2010 at 10:39 PM, BillyTG (98.31) wrote:

typeoh,

Don't fear options. Motley Fool for years shunned them as instruments of the devil. Everyone who says they are risky is right...and wrong.

Just like stocks and real estate and anything else, BUY LOW, SELL HIGH.

I have a huge portion of my portfolio in precious metals right now, and a lot of that is in calls expiring a year or more from now. Is it a gamble? Sure, but then so is buying a normal stock. Options have built-in time constraints, but with LEAPS, you have a lot more time.

If you want to compare it to gambling, fine. Playing roulette, you have 35:1 odds on an individual number. That means you can lose 35 times in a row, and hit your number once and break even. Same with options---you might lose it all on a few trades (unlikely, unless you are totally clueless), and then have another trade that doubles, triples, or quadruples. By making bets on good companies (the same way you do when buying stocks) and finding good risk/reward options, the odds tilt in your favor. I have friends that trade options exclusively. Their gains and losses are huge, but overall they are up. You have to have the stomach for it if you take that lifestyle. I don't, but I can handle a smaller percentage of my portfolio in options.

It sounds like your $450 trade is a nice, conservative way to test the waters.Keep reading all you can about options and don't trade on margin (can be very dangerous)!

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#4) On September 29, 2010 at 11:24 PM, ft215 (< 20) wrote:

This isn't gambling at all your paying less than 1/5 of what it would cost to purchase 300 shares of stock and you can sell your options anytime your actually risking less money and have the potential to make more

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#5) On September 29, 2010 at 11:49 PM, guiron (22.47) wrote:

Options can be worthwhile, but there is complexity involved that you need to be aware of. Out of the money options have no intrinsic value and will steadily lose value based on time and volatility. You can risk less if you buy, say, an out of the money call, but if the stock doesn't move, you lose money every day. If the stock moves lower, you lose money. If the stock moves a little higher, you lose money, because volatility drops and time marches on. However, if the stock keeps moving up, you might make money if you don't get eaten away by time first. Holding on to a naked long option is going to cost you money unless the stock moves far enough in the time before it expires.

But, if you educate yourself a bit, you learn that spreads help to limit your risk. Going long on OOTM call options is a little like a lottery ticket, more so as the strike is higher. If I think a stock is going higher I might sell a put spread, which is bullish and limits my risk, but still offers the leverage of options. It also limits my profit, but my personal strategy is always to limit my losses first, and it does this well. Spreads don't have the same delta as a naked put or call, so they don't move as much with the price when the strikes are close to the money, but they also don't bleed away from time nearly as quickly, and they require less margin. There are some good strategies involving LEAPs, but I pretty much stick to spreads for trading, which is what I do with options. I'm mostly a swing and momentum trader, so holding a OOTM call as it deteriorates and pay for the margin or opportunity cost is not an attractive strategy to me. I'd rather sell a put spread, hold on to the cash in the meantime and get paid for it, and buy it back when it gets cheaper. Much less margin involved, much less risk, and it's always nice to get paid to wait.

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#6) On September 29, 2010 at 11:58 PM, guiron (22.47) wrote:

I have friends that trade options exclusively. Their gains and losses are huge, but overall they are up.

There are many different approaches that work. I'd rather have decent but moderate gains and very limited losses. Turns out about the same in the end, at least for me, and I don't get the same stomach-wrenching ups and downs. Of course there are many who will say to limit your losses and let your winners run. I think this works better if you're trading stock, because you don't have time decay and volatility whipping prices around. I'd rather use a spread and have the choice to close one leg and let it ride if it's really doing well, but also the safety of otherwise limiting my losses.

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#7) On September 30, 2010 at 8:02 AM, Robuh (24.84) wrote:

Option contracts carry the same risk-reward profiles as any other investment vehicle at the time that you purchase them. You can purchase options that are low-risk/low-reward and you can purchase options that are high-risk/high-reward. The general efficiency of the market guarantees that this does not get out of whack too much.

The question you have to ask yourself is whether you see an inefficiency in the market that you can take advantage of (options have been mispriced or there is an arbitrage opportunity) or you see a statistical advantage by buying/selling the underlying stock and would like to instead use options to leverage your market bet. You have to make sure that your edge accounts for the commissions, the option premium, as well as the bid/ask spread.

If these conditions do not exist then buying the option contracts is gambling. There is always a counterparty to every trade. You have to ask yourself why the person on the other side is selling you the contracts.

My personal belief is that you're much better off writing options on stocks you care to own instead of purchasing options as stock replacement strategies. The advice is worth what you paid for it.

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#8) On September 30, 2010 at 11:14 AM, JaysRage (95.46) wrote:

If I play the "long" side of an option, I'm usually pretty deep in the money so that I end up paying a pretty tiny premium. YONG 2011 expiration options are probably one of the better option plays out there since they have warrant expirations for a little while longer yet. Once they are free of the downward pressure of warrants, I see no reason for the price to stay down in the cellar. Sure, the cash flow is a slight blip, but they have cyclical cash flow because of growing seasons, so that is totally a non-issue as long as things clear up. While it is a bit of a gamble taking the out-of-money position in this case, at least you picked a good stock to do it with.

I'm currently long YONG January $6 calls, but I got them for less than your $7 April calls at $1.30

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#9) On October 01, 2010 at 4:14 PM, TMFTypeoh (75.91) wrote:

Great advice everyone! I agree that i have a lot more to learn. Im sure that down the road ill pony up the $$$$ for a motely fool option subscription, im just not there yet.

JaysRage, glad to know were on the same trade, altough odds are better that you'll do better than me on this one. Still, we can both cross our fingers and hope for YONG at 10 by april, can't we???

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#10) On October 06, 2010 at 3:51 PM, JaysRage (95.46) wrote:

I think YONG to touch 10 by April would not be surprising at all. The fundamentals certainly support it, and there will be two earnings reports to support and buoy the stock before that time. Good luck!

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#11) On October 14, 2010 at 9:45 AM, JaysRage (95.46) wrote:

For the record, I closed out my Jan Calls. I still hold a solid long position in the stock itself, but my calls reached my target price, so I took profits.

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