Buying Options as a Way to Buy Time

I have written several times about selling options to enhance returns on a portfolio of value stocks. The other day, someone asked me if I ever buy options to gain excess returns or to speculate on market direction.

From time to time, I do buy options. Almost always, these are call options, betting the stock will go up, as I prefer to hedge the downside by selling premium rather than buying puts.

I use a somewhat different approach to buying options than I do when selling them. When I sell puts, I stay very short term. When you sell options, you are selling time. Selling too much time creates too many opportunities for something bad to happen, so I stay short term, going out only a month or two at most.

When I sell in combination, I am trying to create a specific set of trades over time that I can exploit, regardless of direction, so I will go out a bit longer. When I buy calls, I also think of it as buying time for something to go right, so I buy as much time as I possibly can. I use LEAPs (long-term equity anticipation securities) for this purpose. I like to buy options at least a year out, if not longer.

I buy long-term calls only on stocks that have been beaten up and are down substantially. As always, the valuations have to be attractive to me, and there needs to be a reason to believe they will appreciate substantially over the next 12 to 18 months.

I would like to say I thought of all this all by myself, but as with all great ideas, the truth is that I stole it. The idea of using LEAPS to gain substantial leverage on undervalued stocks was introduced by Joel Greenblatt in his first book, the unfortunately titled but extraordinarily good You Too Can Be a Stock Market Genius. Properly used, LEAPS can give you hedge-fund-like leverage of three times or more without borrowing a dime.

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At the time of publication, Melvin had no positions in stocks mentioned, although positions may change at any time.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.