One of the byproducts of an aging bull market is the gradual appreciation in stock prices across the board. What was once offered at a deep discount eventually becomes outright expensive. As prices ascend from the basement, it’s easy for some rookie traders to feel like they’re being priced out of the market — those boasting smaller account sizes might feel that the Googles (GOOG) and Pricelines (PCLN) of the world are untouchable.
We’ll explore a few avenues for the little guys to access these modern-day high-fliers, but first let’s consider just how high prices have risen and attempt to identify the underlying culprits for the lofty values.
Why So High?
The following chart produced by Strategas Research Partners shows the average stock price for companies in the S&P 500 Index since 1980. Prior to the recent breakout, the chart was essentially range-bound, albeit with a bullish tilt.
The most obvious explanation for the surge is the simple fact that the S&P 500 broke out to new all-time highs this year. With the benchmark blasting into uncharted territory, logic suggests that the average price of its components should be elevated as well.
Aside from market downturns, the other dynamic that can reduce share prices is a stock split. For example, suppose Apple (AAPL) — which has the largest weighting in the S&P 500 — issued a 2-for-1 stock split. Its share price would drop from $450 to $225, and the amount of shares held by stock owners would double. In other words, if you owned 10 shares pre-split, you would own 20 shares at half the price post-split.
If enough companies issued stock splits, the average share price of S&P 500 constituents wouldn’t theoretically have to be at an all-time high, even though the index is.
But stock splits aren’t exactly en vogue right now. Quite the contrary — the popularity of splits has been on the decline since the heydays of the late ’90s, when the number of annual stock splits among S&P 500 companies climbed above 100. According to Strategas Research Partners, we’ve seen only six stocks in the S&P 500 report stock splits this year. So unless Wall Street suddenly falls in love with splits again or we have a bear market looming on the horizon, high share prices likely will persist.
How to Play Anyway
Fortunately, those with smaller account sizes can use a variety of strategies in the options market to place bets on stocks like Google for a fraction of the price required to buy 100 shares. The key in using options as a substitute for buying stock is to position size properly so the leverage doesn’t overwhelm you.
One of the simplest approaches involves buying call options instead of buying stock. A call option locks in the right to buy a stock at a set price on or before a set date in the future.
A common mistake committed by newer traders when dabbling with options is using the same amount of money they would have used had they bought stock. Because of the high leverage inherent in derivatives, this approach can rapidly lead these naïve traders to the poorhouse.
For example, instead of using $85,000 to buy 100 shares of GOOG, they might use the entire 85 grand to buy 10 Aug 800 call options at $8,500 apiece. Even though both trades cost the same, their risk profiles are completely different. To lose 100% of the stock investment requires the shares to fall all the way to zero — an unlikely possibility. To lose 100% of the investment in the Aug 800 call options merely requires Google to fall beneath $800 — a price level it was below as recently as April!
A more sane approach consists of using delta to acquire a similar amount of exposure with call options.
When you purchase 100 shares of stock, you have a positive 100 delta position. Which is to say, you make or lose $100 for every $1 move in the stock. If you’re looking for a similar amount of exposure in the options market, you could buy a deep-in-the-money call with a high delta (above 80 or so), or perhaps two at-the-money calls with a delta of 50 apiece. Right now, the Aug 785 call, which boasts a delta of 81, can be purchased for $9,000 — only 10% of the cost of 100 shares of GOOG.
If $9,000 still sounds like a lot of dough, then you’ll be happy to know that option spreads offer the possibility to place a bullish bet on GOOG for only a couple hundred bucks. But that, my friends, is a lesson for another day.
The bottom line for now: If sky-high stock prices have you discouraged, give the options market a (responsible) shot.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.