A Strategy of Buying 'Long Shot' Call Options

A Strategy of Buying “Long Shot” Call Options

While a +10-20% rise in a broad market index is generally considered a “good year” or even “very good year”, the returns of individual stocks over a one-year period can be much more widely dispersed. Over the one year period ending 11 October 2024, of the more than 320 stocks with options listed on Cboe Europe Derivatives (CEDX), 19 stocks, or about 15% or one in seven, have risen by 40% or more over the past 1 year period, five have risen by 60% or more, and the extreme outlier of this period, Rolls Royce, is up almost 150%. Stocks rise by these enormous magnitudes when markets have significantly underestimated their upside potential over the following year, so of course, it is very difficult to know in advance which stocks are likely to do this over any given period. In this article, we explore how buying long-dated, out-of-the-money call options, can provide a low-cost, limited downside way to try and capture some of these “shooting star” stocks.

Step #1: Identify Stocks “More Likely” To Rise Significantly

When we look back at the 5 European stocks that rose by more than 60% over the past 12 months, that is, the top performers by price return, there seems to be no obvious common theme or driver. Below the stellar rise in the share price of aircraft engine maker Rolls Royce, the next strongest advancers over this past year were payment platform Adyen, enterprise software provider SAP, heath tech company Philips, and shopping mall owner Unibail-Rodamco-Westfield. These five companies are in very different businesses, have very different looking historical charts, and don’t seem to have been driven up by any common catalyst, which at first may sound complicating, but it actually means there are more chances to be “right” about big movers than just trying to find the next Nvidia. How you find these opportunities depends on where you believe you have any sort of “edge”, whether in technical, fundamental, or other forms of analysis. For the sake of example, let’s assume you’ve identified five stocks, let’s call them A, B, C, D, and E, that you believe have a “significantly better than average” chance of rising by 50% or more over the next year.

Step #2: Looking at Longer-Term Options

While a large share of the volumes on single-stock options tends to concentrate on options expiring within the next 1-3 months, when looking for stocks that may rise by 50% or more, it may be better to look at longer time frames in the 6-18 month range. As of this writing in October 2024, we can see good liquidity in many singe stock options on the Cboe Europe Derivatives Exchange out to December 2025. With this Dec 2025 expiry date, we next look at the relative costs of buying out-of-the money calls on our five stocks at different strike prices.

Step #3: Choosing the Strike Price (Important for Risk/Reward)

Suppose each of the stocks A, B, C, D, and E were trading at €100/share, and we expect that at least one of these five stocks will rise to at least €150/share by the Dec 2025 expiry date. Buying 150 strike calls on each of the five names would be cheaper than choosing any lower strikes, but that has the disadvantage of losing 100% of our premium even if the stock rises up to exactly 150 by the expiry date. To compare the cost/benefit of these different strike prices, we consider a few different combinations of what the options might cost at a strike of 130 vs 150, assuming two different levels of volatility for a given stock, and then show how these play out for different scenarios of where each stock moves.

First, we look at how much these long-dated, out-of-the-money call options are expected to cost with a 14-month expiry, 2.7% interest rates, zero assumed dividend yield, and two different implied volatility levels using the Black-Scholes model:

·        At an implied volatility of 20%, the 130 call would cost €1.76/share,

·        At an implied volatility of 20%, the 150 call would cost €0.44/share

·        At an implied volatility of 30%, the 130 call would cost €5.05/share

·        At an implied volatility of 30%, the 150 call would cost €2.40/share

The significance of the implied volatility priced into each option makes sense: a stock considered more likely to rise from 100 to 150 (or fall from 100 to 50) over a period of time should have more expensive options.

Next, we consider how these different option packages play out over a hypothetical scenario where we buy identical options for all five stocks, and then by expiration date, one of the stocks (it doesn’t matter which one, as we bought the same call options on all five) rises to 155, and the other four stocks all finish below 130 (and it doesn’t matter how much lower than 130). The results would then be as follows:

1.   If we bought the 130 strike calls at an implied vol of 20, we would have spent €880 on call option premium (5 x €1.76/share x 100 shares/option), and then received a payoff of €2,500 from the call on the one stock that ended at 155, a payoff of around 2.8x the premium paid.

2.   If we bought the 150 strike calls at an implied vol of 20, we would have spent €220 on call option premium (5 x €0.44/share x 100 shares/option), and then received a payoff of €500 from the call the one stock that ended at 155, a payoff of around 2.3x the premium paid.

3.   If we bought the 130 strike calls at an implied vol of 30, we would have spent €2,525 on call option premium (5 x €5.05/share x 100 shares/option), and then received a payoff of €2,500 from the call on the one stock that ended at 155, resulting on a slight loss vs the premium paid even though we were right about one stock doing very well.

4.   If we bought the 150 strike calls at an implied vol of 30, we would have spent €1,200 on call option premium (5 x €2.40/share x 100 shares/option), and then received a payoff of €500 from the call on the one stock that ended at 155, resulting on a loss of over half our premium paid.

Conclusions

Buying long-dated, out of the money call options on several stocks at the same time is one strategy for capturing a very large upside move in at least one of them over the term of the options, but still ultimately comes down to a question of costs vs probabilities. As with any option purchase, the price is low when the market expects the payout to be low, and if the upside move is significantly higher than the marketed expected to be likely, it is possible to earn many times the premium paid for the option in a best-case scenario. On the other hand, out of the money options mean 100% of the premium is lost if none of the stocks reach the strike price, and even if one or more of the stocks does exceed the strike price, it is still possible to get back less than the option premium paid. As with any trade, you need to weight downside risk vs upside potential.  

Learn more

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Cboe Europe offers trading in shares from across Europe and, through Cboe Europe Derivatives (CEDX), options are also available on shares in over 300 leading European companies. Learn more about CEDX here.

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· The above is the product of external market analysis commissioned on behalf of Cboe Europe B.V. The views expressed herein are those of the author and do not necessarily reflect the views of Cboe Europe B.V., Cboe Global Markets, Inc. or any of its affiliates (‘Cboe’). For more information on how this research was conducted and/or the author please contact [email protected]

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