Warning: A key part of the options market you can rely on is no longer working.
I’m referring to the fact that implied volatility is selectively rising, sending call option premiums into the stratosphere. Everyone is scrambling to buy short-term upside exposure, paying huge premiums for the privilege.
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There are many cases, but I will use perhaps the most appropriate example. That’s Micron (MU).
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That price chart is what traders dream of. But when a stock shoots up like this, if you own it, you’ll want to cover it. And if you don’t have it, you’ll want to have it. But you don’t want to be the “dumb one” buying at the potential peak.
The knee-jerk response has always been to transfer the stocks we “lost” and instead buy out-of-the-money call options on them. After all, when controlling 100 shares of MU now requires more than $90,000 invested and is therefore at risk, why not buy an out-of-the-money call option for a fraction of that price?
Perhaps for a capital commitment and a maximum loss of $5,000 or less, you could end up making more in dollars using call options. That’s what I call “good leverage.”
READ MORE: I found a new article by my colleague Rick Orford in the great Barchart library. Explain the basic concepts of this approach.
The rapid rise in MU price would normally cause call option prices to remain quite low. This is because when a stock goes up, options math correlates it to lower risk. The opposite case is also valid. That’s why ETFs like the ProShares VIX Short-Term Futures ETF (VIXY) and the ProShares VIX Medium-Term Futures ETF (VIXM), which I’ve covered here, are valuable hedges against bear markets. Higher volatility is not typically associated with higher prices.
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That is changing.
In the chart above, I highlighted where MU’s call options were as a whole about a month ago. And where are they now. Its implied volatility has increased, not decreased. That means buying options are much more expensive than usual. Which in turn means that trying to “get away” with the old traders’ trick of using call options as a proxy to get our “fair share” of long moves in hot stocks has been mitigated. This is because many investors have caught on to this approach and increased demand has blown the lid off call option valuations.
I say this from personal experience. Recently I wanted to buy calls on MU. When I saw this happen, sitting on my operating table, I said out loud “oh no!”
Making expensive calls is a fool’s game when premiums are so inflated. Instead, there is a much smarter, high-conviction structural strategy that stares us right in the face: using 3X single-stock leveraged ETFs, the “celebrity” vehicles of the trading world.
When call options are wildly overvalued, buying them means you’re fighting a serious structural hurdle. The stock has to make a massive, immediate vertical move just for your option to break even before time decays your equity.
3X Single Share Leveraged ETFs completely avoid this problem and keep the explosive upside alive. These high-octane vehicles are designed to deliver 300% of the daily performance of the individual mega-cap leaders – the “celebrities” of our current momentum market like Nvidia (NVDA), Apple (AAPL) or Tesla (TSLA).
When you buy a 3X leveraged ETF instead of an option, you get the dramatic asset acceleration you want without the clock ticking. There is no expiration date and you are not paying a massive volatility premium to an options seller. It is effectively capturing an amplified structural momentum through a liquid capital instrument.
The key, as always, is not to be a pig. Keep your position size VERY light. My rule of thumb with 3x long ETFs is to buy a third of what I would have bought, so my “exposure” is the same as if I had bought the stock.
But if what I’m buying is an inverse ETF to take a bearish position or hedge a stock or market segment, I’ll also do what smart hedge fund managers do: my short position will, on average, be less than my average long position. Bearish trades are great when they work, but the math of investment loss can quickly catch up with you if the stock’s first move is a strong bullish move. Remember, you lose 20% and it takes a 25% gain to get back even.
You can be a bull or a bear with this strategy, as many popular stocks are now available to trade through long and inverse leveraged ETFs. That means you can literally create your own long-short hedge fund, without the risks of going short. And without having to consider too expensive options. .
Rob Isbitts created the Roar Scorebased on his more than 40 years of experience in technical analysis. ROAR helps DIY investors manage risk and build their own portfolios. To view Rob’s written research, see ETFYourself.com.
On 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 are for informational purposes only. This article was originally published on Barchart.com
