Warning: An important part of the options market that you may have relied on is no longer valid.
I’m talking about the fact that implied volatility changes with options, sending call option premiums into the stratosphere. Everyone strives to buy short-term exposure, paying huge premiums for the privilege.
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There are many cases, but I will use the most timely example. That’s Micron (MU).
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That price chart is what traders dream about. But if the stock stays like that, if you own it, you want to hedge it. And if you don’t belong, you want to. But you don’t want to be the “biggest idiot” you’ve ever bought.
The knee-jerk reaction has been to pass up the “missed” stock and instead buy out-of-the-money call options on it. After all, when controlling 100 shares of MU now requires more than $90,000 invested and thus at risk, why not buy an out-of-the-money call option for a fraction of that price?
Perhaps with financial commitment and a maximum loss of $5,000 or less, you may end up making more dollars using call options. That’s what I call a “good profit.”
READ MORE: I got a new one article from my partner Rick Orford in Barchart’s main library. It explains the basics of this method.
A rapid increase in the price of MU can often cause call option prices to remain very low. That’s because when a stock goes up, statistical options associate that with lower risk. The opposite case also applies. That’s why ETFs like the ProShares VIX Short-Term Futures ETF (VIXY) and the ProShares VIX Mid-Term Futures ETF (VIXM), which I’ve covered here, are important hedges against bear markets. High volatility is not usually associated with high prices.
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That is changing.
In the table above, I’ve highlighted where MU call options have rallied over the past month. And where they are now. Their perceived flexibility has gone down and not down. That means call options are more expensive than usual. Which means trying to “get away” from the old trader tactic of using call options as a surrogate to get our “fair share” of long moves in hot stocks has been blunted. This is because many investors have stuck with this method, and the increase in demand has offset the valuation of the call option.
I say this from my own experience. Recently I wanted to buy phones from MU. When I saw this happen, sitting at my trading desk, I said out loud “oh no!”
Chasing expensive calls is a sucking game when premiums are inflated. Instead, there’s a very smart, high-conviction structural strategy staring us in the face: we use ETFs with 3X the power of single stocks – the “celebrity” vehicles of the trading world.
Why 3X Leveraged ETFs Beat Buying Expensive Calls
If call options are overpriced, buying them means you’re fighting a heavy structural drag. The stock has to make a quick, big vertical move just so your option breaks even before the time decay eats away at your money.
3X single-stock leveraged ETFs completely eliminate this problem while keeping the boom alive. These high-octane vehicles are designed to deliver 300% of the daily performance of single mega-cap leaders – the “celebrities” of our fast-paced market such as Nvidia (NVDA), Apple (AAPL), or Tesla (TSLA).
When you buy a 3X leveraged ETF instead of an option, you get the asset acceleration you want without the clock ticking. There is no expiration date, and you don’t pay a huge volatility premium to the options broker. He successfully captures the pressure of the building, which is enhanced with a fluid balance tool.
The key, as always, is to not be a pig. Keep the size of your area VERY bright. My rule of thumb with 3x long ETFs is to buy one-third of what I would otherwise buy, so my “exposure” is the same as if I bought the stock.
But if it’s an inverse ETF I’m buying to exercise a bearish position or hedge against a stock or market segment, I’ll also do what smart hedge fund managers do: my short position will be on average smaller than my average long position. Bearish trading is good when it works, but the investment loss calculations can get you quickly if the initial movement in the stock is a strong movement. Remember, you lose 20% and it takes a 25% gain to break even.
You can be a bull or a bear with this strategy as many popular stocks are now available to trade with long and inverse ETFs. That means you can build your own short-short hedge fund, without the risk of default. And without having to consider the more expensive options. .
Rob Isbitts created the The ROAR Scorebased on his 40+ years of technical analysis experience. ROAR helps DIY investors manage risk and build their own portfolios. For Rob’s written research, see ETFYourself.com.
At the date of publication, Rob Isbitts had no (directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is for informational purposes only. This article was originally published on Barchart.com
