Question

Susan R. asks, “I struggle with which option to buy once I find a trade. The In The Money (ITM) options are expensive but they move well. They are risky because they have so much premium. The Out Of The Money (OTM) options don’t cost much but it takes forever to see them go up. How should I decide which ones to buy?”

Answer

Susan addresses a daily dilemma faced by option traders. This is a tough question to answer in one article – but I’ll try. First I need to set the table.

Every option I trade is determined by my opinion of the stock and my level of confidence in the trade. My opinion of the stock will result from technical analysis. I look at how the stock has traded recently. If it has a history of nice grinding moves, I will approach it differently than if it is volatile. If it is approaching a breakout on heavy volume, I will treat it differently than if it has been marching higher in small increments for months. My confidence is a function of how well I have traded recently, my ability to get a good “read” on the market and how good I feel about this piece of research.

I dissect my opinion into statements about direction, magnitude and duration. If I feel the stock will breakout and move 6 points higher in 6 weeks with a high degree of confidence, I may opt to buy out of the money calls with two months of “life”. This is my selection because these calls will provide the most leverage and the highest percentage rate of return. They also have the chance of going ITM. In that case, I will have a fairly large leveraged stock position to trade out of. My confidence has to be high and I can’t miss on any element or the trade will fail. These trades tend to have a higher failure rate but they produce incredible returns when they “hit”.

Let’s use another example where the stock has been in a strong sector and it is leading the market higher in a nice orderly fashion. It has moved sideways and rested for a week and now it looks ready to grind higher. Let’s say the market is shaky and this stock tends to drift lower in a weak market and lead any rally. Let’s also assume that I feel in a flat market the stock will grind 3 points higher over the course of 2 weeks. In this situation, I like the stock but my confidence is not very strong. I will trade fewer contracts and select an in the money front month option as long as it has 2 weeks of “life”. It must have a delta of .9 (or higher) and not carry more than a $.50 premium over parity. If I can buy the next month’s options for an extra $.30 I will probably make that choice. This selection allows me to participate in a move in the stock and I can take profits along the way. An out of the money option will not move enough for me to do so. Since the stock holds up relatively well in a weak market, I will probably have time to get out of the position without losing much if the market turns sour. In this situation I have more room to be “off” than I did in the OTM example. If the stock stays flat, I can scratch the trade and not lose any premium decay. If the stock only goes up $1 instead of three, I can still make money.

In this example I have assumed that the options are moderately priced. If the implied volatility is high, selling strategies would probably be more effective.

The take away is this, my opinion and confidence determine the selection. The more explosive the move and the higher my confidence, the more I lean towards out of the money options. The more grinding the move and the lower the level of confidence, the more inclined I am to trade In the Money options.

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