How To Purchase An Inexpensive Option Contract Using options as an alternative to the outright purchase of a stock can produce much better returns when the trader is correct on the directional forecast of the security.
The leverage that an option provides is the tantalizing bait that lures many speculators into the world of option trading.
New traders with small accounts are particularly vulnerable to this market because of the low cost by which they may participate.
But what constitutes low cost? How do we measure the pricing of an option contract without becoming an expert in the Black-Scholes formula? Experienced option traders will often use implied volatility (IV), to determine how much premium has been priced into an option.
With the correct software, this data can be plotted so that the current implied volatility can be compared to past IV values.
Because the implied volatility is what constitutes a portion of the premium paid, we can use the historical IV as a benchmark when determining how much we should pay for an option and if it is undervalued.
It's All About Expectations Implied volatility is nothing more than the expected movement of an options price over a specific period of time.
As an example, if stock XYZ, priced at $50.
00, has shown historically that it can move 10 points in one month, its expected future price action could be reasonably ascertained to be 10 points.
Compare this to stock ABC, also priced at $50.
00, whose past price action has never exceeded 2 points in one month, and you can begin to see why the expectations would be much higher for XYZ.
However, historical price actions are not the only considerations for determining implied volatility.
News, earnings, uncertainty, and future events also play a big role in the pricing that goes into an options premium.
Obviously, if FDA approval is pending for a new drug being developed by a pharmaceutical stock...
the expected price movement could be huge one way or another after the announcement.
In this example, if historical volatility had been low that would have less bearing on the fact that big expectations in price swings are forthcoming.
Of course, time value also plays a big role in the cost of an option contract as well, and is worthy of additional discussions that are beyond the scope of this article.
In this article we are looking at buying either front month or next month expirations where time value will be of little concern because the intended time frame for these trades are a few days to a few weeks.
Substituting An Option For A Stock With this type of trade, we will be using the option strictly as a proxy for the underlying stock.
We have a directional bias, an expected price move, and we are betting that this move will occur within a few weeks.
By selecting an under-priced, in the money option we remove much of the risk from a decrease in implied volatilities while we are in the trade.
We simply want as close to a point for point move in the option price as in the underlying stock.
This parity in price movement is what we are looking for with this type of trade.
Again, by removing as much premium and time value from an in the money option as we can, we give our trade a much better chance to make money if our forecast is correct.
Here are the steps I take when trading options on short-term trades.
Choose Near Term Expiration: By selecting an option that is expiring within 6 weeks you remove most of the time value priced into the contract.
Go Deep In The Money: Generally I like to go at least 1 or 2 strikes in the money, sometimes even more.
How deep I go is determined by the percentage of premium after I have subtracted the intrinsic value from the price.
Premium Must Be Below 30%: With short-term trades, any time you pay more than 30 % in option premium it can be very difficult to make money.
The formula for determining the premium with an in the money option is quite simple and takes away the need for IV charting and mathematical gymnastics.
Here it is: Subtract the intrinsic value from the cost of the option.
The resulting value will be the premium being charged.
If the premium is below 30% of the total cost, then you have an option that in most cases is reasonably priced.
Sometimes, you have to go 5 or 6 strikes deep to get there...
but by using this technique you can logically remove the mystery surrounding all the factors that go into the premium charged for an option.
The leverage that an option provides is the tantalizing bait that lures many speculators into the world of option trading.
New traders with small accounts are particularly vulnerable to this market because of the low cost by which they may participate.
But what constitutes low cost? How do we measure the pricing of an option contract without becoming an expert in the Black-Scholes formula? Experienced option traders will often use implied volatility (IV), to determine how much premium has been priced into an option.
With the correct software, this data can be plotted so that the current implied volatility can be compared to past IV values.
Because the implied volatility is what constitutes a portion of the premium paid, we can use the historical IV as a benchmark when determining how much we should pay for an option and if it is undervalued.
It's All About Expectations Implied volatility is nothing more than the expected movement of an options price over a specific period of time.
As an example, if stock XYZ, priced at $50.
00, has shown historically that it can move 10 points in one month, its expected future price action could be reasonably ascertained to be 10 points.
Compare this to stock ABC, also priced at $50.
00, whose past price action has never exceeded 2 points in one month, and you can begin to see why the expectations would be much higher for XYZ.
However, historical price actions are not the only considerations for determining implied volatility.
News, earnings, uncertainty, and future events also play a big role in the pricing that goes into an options premium.
Obviously, if FDA approval is pending for a new drug being developed by a pharmaceutical stock...
the expected price movement could be huge one way or another after the announcement.
In this example, if historical volatility had been low that would have less bearing on the fact that big expectations in price swings are forthcoming.
Of course, time value also plays a big role in the cost of an option contract as well, and is worthy of additional discussions that are beyond the scope of this article.
In this article we are looking at buying either front month or next month expirations where time value will be of little concern because the intended time frame for these trades are a few days to a few weeks.
Substituting An Option For A Stock With this type of trade, we will be using the option strictly as a proxy for the underlying stock.
We have a directional bias, an expected price move, and we are betting that this move will occur within a few weeks.
By selecting an under-priced, in the money option we remove much of the risk from a decrease in implied volatilities while we are in the trade.
We simply want as close to a point for point move in the option price as in the underlying stock.
This parity in price movement is what we are looking for with this type of trade.
Again, by removing as much premium and time value from an in the money option as we can, we give our trade a much better chance to make money if our forecast is correct.
Here are the steps I take when trading options on short-term trades.
Choose Near Term Expiration: By selecting an option that is expiring within 6 weeks you remove most of the time value priced into the contract.
Go Deep In The Money: Generally I like to go at least 1 or 2 strikes in the money, sometimes even more.
How deep I go is determined by the percentage of premium after I have subtracted the intrinsic value from the price.
Premium Must Be Below 30%: With short-term trades, any time you pay more than 30 % in option premium it can be very difficult to make money.
The formula for determining the premium with an in the money option is quite simple and takes away the need for IV charting and mathematical gymnastics.
Here it is: Subtract the intrinsic value from the cost of the option.
The resulting value will be the premium being charged.
If the premium is below 30% of the total cost, then you have an option that in most cases is reasonably priced.
Sometimes, you have to go 5 or 6 strikes deep to get there...
but by using this technique you can logically remove the mystery surrounding all the factors that go into the premium charged for an option.