Aug 06 2008
In The Money Is The Only Place To Be
Damn, if only I’d known that before! It seems so clear once it’s explained. Yet for many years, I’ve been making the same mistake over and over. No wonder my option winnings have been less than satisfactory.
It appears that I, along with the majority of stock option traders, believe that the way to make money is to buy out-of-the-money calls or puts. They’re cheaper and thus the potential ROI is potentially larger than buying in-the-money options, which are much more expensive. As I recently found out, this misconception is what shoots down about 90% of most would-be option traders. Bill Johnson of Options University really opened up my eyes on the on the first day of the Options 101 course offered online at Options University. (www.optionsuniversity.com).
Bill made it so clear. You see, stock options only really emulate close to a dollar for dollar move with the underlying stock when delta is above .80; and that usually only happens only with in-the-money options. If a trader has an out-of- the-money option, that option may have a delta of only .3 meaning if the underlying stock moves up one dollar, the option may only move up thirty cents. So, even though the trader may pick the right direction and the move happens before the expiration, that doesn’t mean the option trader will have a winner. First, the stock option must move into-the-money and pass breakeven (strike plus premium) before there is a profit. The probability of an option moving from an out-of-the-money to a profit position is much less than an in-the-money option moving into profit territory.
Lets look at an example that will open your eyes-at least it did for me:
Current Price: $35
Strike Price Option Price Delta Breakeven Extrinsic Value
$30 5.20 85 35.20 $ .20
$35 1.00 52 36.00 $1.00
$40 .30 20 40.30 $ .30
To reach breakeven with an ITM stock option, all the underlying stock has to do is move twenty cents. For an OTM strike of $40, the stock must move $5. The chances are much greater that an option trader will at least reach breakeven. Even though the ITM option costs much more, the probabilities are much greater that the option trader will breakeven or make money. Yes, if an option trader hits pay dirt with cheap OTM options the ROI can be much greater, but trading is more of a win-loss proposition than hitting home runs. Moreover, OTM options mostly expire worthless where as ITM option usually has intrinsic value as time decay takes huge bites out of option premium prices.
What we are really saying here is that trading options can be more successful when using the “stock replacement concept.” That is to say, option traders are buying a cheaper substitute for the underlying stock because ITM options move very similarly to the underlying stock. For Example, IBM is about $105 but an ITM call option with a strike of $100 costs about $6.80. So, if a move is predicted within the expiration period, the ITM option will move very similar to IBM. If it moves just $1.80 an option trader will have broken even on the trade. But some traders might say that there is more risk because more money is involved. That might be true but that represents a rather insecure attitude and- taken over the long run- will prove to be very much in error.
For a better explanation of this important concept, try taking Options University “Options 101 course” (www.optionsuniverstiy.com) and learn many other eye-openers that will make you a more successful and confident trader.
Get your free 7 Deadly Sins Report and click here, presented by Options University, and register now for the Forex World Currency Options Class with Greg MaDermott, starting August 18, 2008.
If you are interested in joining Options University’s affliiate program please sign up here.
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