Use This Long-Term Strategy to Beat the Market for Less Money

Although most investors think of options as short-term trading instruments, they can actually be used as part of a long-term, market-beating strategy.

If you think a stock will go up in price, you can buy the stock to benefit from the expected gains. Unfortunately, many investors have more buy ideas than money. One way to address this problem is with call options.

A call option gives you the right to buy 100 shares of a stock at a certain price (known as the exercise price) before a predetermined date (known as the expiration date). Some options on higher priced stocks offer contracts covering 10 shares of stock. The principles of options trading are the same whether the contract covers 10 shares or 100 shares. Options are available with numerous exercise prices at several expiration dates.

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Call options could be an alternative to buying stock for long-term investors with limited cash available to invest. This strategy uses options as a replacement for the stock. When buying an option for this reason, as opposed to buying an option as a short-term trading opportunity, the most important factor to consider is the size of the option premium.

Options trade at a premium to the underlying stock or ETF. This premium compensates the option seller for the risk of loss. As an example, if SPDR S&P 500 (NYSE: SPY) was trading at $165, a call option with an exercise price of $164 and an expiration date in two weeks might be available for $1.90, or $190 per contract, which covers 100 shares.

With SPY trading at $165, the intrinsic value of the option is $1. The intrinsic value is the difference between the option price and its immediate value. The difference between the intrinsic value of the option and the market price is the time premium. In this case, the time premium is $0.90.

Note: These numbers are meant to be used as an example. To implement this strategy, you would simply use options with a strike price very close to the current market price of SPY. Usually, there will be options with strike prices that are $1 or less below the current price.

If SPY remains unchanged over the next few weeks, the call buyer would lose the amount paid for the time premium. Someone who bought SPY would not have that loss, although they would have invested $16,500 for 100 shares instead of $190.

The further out the expiration date is, the higher the premium. As an example, consider the table below. It contains hypothetical prices for options with a strike price of $164 with SPY trading at $165.

This table shows that the cost of the call rises as the time until expiration increases. While the premium rises in dollar terms, the cost of premium decreases when the premium is considered in terms of time. The premium for the most distant call option costs about one-twentieth of the premium for the shortest option when the amount of time before expiration is considered.

Given the low cost of the premium in the long term, the most expensive option could be the most appealing to long-term investors. This should be the case no matter what the actual market prices are.

In this example, you could buy 100 shares of SPY for $16,500. If SPY gains 10% in 19 months, an investor gains $1,650, plus dividends. Assuming a dividend yield of 3% over that time, dividend income would add about $750 to the total return for a total return of $2,400 (14.55%).

Call options do not pay dividends. If SPY gains 10%, it will be trading at $181.50 a share when the option expires in 19 months. The option will be worth $16.50, which is its intrinsic value at that point. The call cost $1,240, so the profit would be $410 per contact. On a percentage basis the call buyer is up 33%, more than twice the gain of an investor who bought SPY.

Because the call costs so much less, an investor could buy more contracts. Five calls would cost $6,200 and would deliver a gain of $2,050, which is more than what the SPY owner made in dollar terms. The calls would cost $10,300 less than 100 shares of SPY, so the call buyer could earn interest on that amount and increase their gains slightly.

Since 1950, this trade would have been a winner 62% of the time. Over 19-month holding periods, the S&P 500 has shown a gain 76% of the time, so buying SPY does offer better odds of a gain.

The largest loss in the S&P 500 over that time period has been more than 50%. The loss to the call buyer is limited to the amount paid for the option, which would be equivalent to about 7.5% in this example.

This strategy could be followed for years, rolling profits into additional contracts. Doing so since 1950 would have delivered more than eight times the profits of a buy-and-hold strategy. The loss in the 2008 bear market would have been less than 10% of the account value for call buyers.