Deep OTM Call on Value Strategy

Recall of an Option Strategy my dear friend Seraphim Czecker and I wrote on https://seekingalpha.com/instablog/47713424-prime-alpha-research/5163765-deep-otm-call-value-strategy about a year ago.

Summary

Now that volatility is projected to be higher due to late cycle, we can take advantage of cheap optionality through calls.

For this strategy, we found 11 underlying stocks with great upside potential that fit the option criteria we listed.

In this report we’d like to present the Deep Out of The Money Call (DOTM) strategy along with the 11 underlying stocks we’ve chosen for this options strategy.

Before we begin, we’d like to emphasise that the inspiration for applying DOTM came from Tyler Kling’s webinar on DOTM. Tyler has done amazing work for Macro Ops and it’s worth checking it out regardless of your trading style for improving your trading and getting ideas.

1. The Strategy

Essentially, what we are trying to achieve is to take advantage of cheaply priced stock calls as opposed to puts. This relationship can be clearly inferred from the volatility skew of SPX options:

As we can see, whilst deep out of the money puts (right side) tend to have a higher level of implied volatility, which translates into a higher price, calls are comparatively underpriced. The biggest reason for that is excessive hedging large institutional investors do – being long the stock market warrants buying protection in the form of puts, and since most investors are long the stock market, there is more demand for puts than calls.

Also notice how longer-dated options tend to have lower implied volatility due to the mean-reverting nature of volatility.

While most traders try to buy puts to predict the next crisis and mostly fail since puts are initially expensive, we will take advantage of cheap calls. Namely, we will buy low delta (10-20), low implied volatility (10-25%) and long-dated (6-18 months) calls on high quality stocks that have a strong upside potential.

To illustrate why, here are a couple of examples from Tyler:

As you can see, while the stock rose significantly, the option price rose sometimes more than 55x! The reason behind that is convexity.

To illustrate that, let’s find a deep OTM call on AAPL.

Here we can see the delta on all available options on AAPL.

Recall that delta is a Greek showing how much the price of an option changes given a 1$ dollar rise in the price of the underlying. Most importantly, it can also be used as a proxy for the probability of getting exercised. Hence, 15 delta option means the market believes the option has a 15% chance of getting exercised. Similarly, a deep in the money option with a delta of 99% essentially means it will almost most certainly end up in the money since it’s so far from being out of the money. Naturally, options that are less likely to get exercised (lower delta) cost less than those that are likely to do so.

We need, however, long-dated options. Let us stick to 18 January 2019 maturity:

The chart tells us that at a delta of 15$ the strike price is around 227$.

Now we can take a look at the implied volatility at this level:

As we can see, the IV at 227$ strike price is around 22%, which is in line with our criterion.

Now check this out:

The green line shows the call payoff on the day of expiration, but what we focus on is the purple line, which is the call payoff at this very moment. What we see here is that once the price increases even slightly, our option starts to pick up value exponentially even though it’s still far from the strike price.

Add to this the fact that you are making money on an increase in implied volatility through vega:

Notice how the vega value is higher for longer-dated options, since higher vol has a higher chance of moving our option in the money if there’s more time left as opposed to if the option expires tomorrow.

And also the fact that we don’t lose much time value on longer-dated options:

And we’ve got some high risk/reward trades there.

Another advantage is that you outsource your risk management, meaning you won’t get stopped out since you’ve paid the premium for staying in the market whatever happens.

2. Trade Management

For this strategy it is essential to hold this option until it reaches the strike price, since holding it till it gets ITM is where we are picking most of the convexity. Also, note that most probably only 20-30% of the options will actually reach ITM, but the winners will make up for all the premia we paid.

3. Underlying Assets

The essential point here is to go for stocks as opposed to fixed income, FX and other assets. The latter three tend to range, whereas stocks have that explosive long-term potential that options models underprice.

That’s why we’ve searched for 11 stocks with options fitting all of the criteria above, tradable via thinkorswim software and with a strong upside potential. Here’s the list:

· Kraft Heinz & General Mills

· Excessively penalised by the market due to growth issues, which is, however, absolutely normal for food companies. At the current market price, KH and GM look extremely undervalued and also attractive from a dividend perspective.

· Amgen

· The US healthcare giant shows constantly rising revenues and profits and is highly likely to grow in the future due to promising projects in the pipeline.

· BTI & Philip Morris

· The tobacco industry will likely continue to deliver stable growth. The stock price of both companies has been likely compressed due to concerns over people choosing to live a healthier lifestyle and to abstain from cigarettes. Even if that is partially true, we believe the market reaction has been excessive and that BTI and PM will rally. Additionally, they are well-positioned for the rise of E-cigarettes.

· Apple

· In general, the tech giant is positioned strongly in the market, outmatched its competition and exceeded expectations and most importantly has undertaken a shift from its dependency on iPhone sales in order to become a wide-range service provider. Additionally, Apple enjoys incredible liquidity due to its cash reserves making it a good bet.

· Disney

· The worldwide entertainment industry giant has shown phenomenal growth and success in the last years with many highest-grossing movies of all time being made by Disney. Even though ESPN has caused some troubles for Disney, there are other growth channels that will make up for it, for instance its own streaming platform in 2019. Overall, Disney will likely deliver outstanding growth in the future.

· Archer Daniels Midland

· As a farm products company, ADM is a processor of oil seeds, wheat, corn etc. and manufacturer of vegetable oil, corn, sweeteners, protein meal and other value-added food and feed ingredients. ADM has sustainable competitive advantages such as global transportation networks and is perfectly positioned for emerging markets.

· The industry is currently recovering from the cyclical lows and many companies had experienced falling revenues, whereas ADM enjoyed stable profits and will likely benefit even more due to rising commodity prices.

· CVS Health

· The US drugstore enjoys continuously growing revenue and profit. However, the recent rumours of Amazon entering the drug industry has made the stock price significantly even more attractive, since CVS is perfectly prepared for that. CVS is currently working on the acquisition of Aetna (60 Billion $ deal), an insurance company. This synergy will allow CVS to be a perfect provider of drugs, health insurance and medical checks.

· SAP

· This well-known German software provider has a classical moat: when firms switch to SAP, switching back tends to be rather expensive. The short-term fall in revenues due to the change in the payment model to annual subscription will have positive long-term effects, hence the stock price reaction is overdone.

· Hormel

· This US food company has had lower than expected revenues and profits due to lower Turkey prices, which is its main product. However, strategic management that is aware of market trends and strong revenue potential coupled with cheaper equity prices make this company very attractive from a value perspective.

We hope you found this report useful. We will keep you updated as to our options portfolio.

Many thanks to Manuel Fritz and his expertise, who helped us to identify the relevant equities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.