How to Pick the Right Option

In my 20-plus years trading options, and writing options trading articles, one of the most common questions I’ve received is, “Why didn’t my option make me money when the stock did exactly what I thought it would?”

Every one of us has “been there” when we bought a call or a put and the stock went up or down, respectively, and yet, we were left empty-handed because our option didn’t perform accordingly.

The answer to the above question is painfully simple: You didn’t buy the right option.

What’s painful about it is that you got the “hard part” right — picking the correct direction of the stock, exchange-traded fund (ETF), index, etc. But when you don’t use the right option, you can be left with a distaste for the options markets, thinking that you “just can’t win.”

And nothing could be further from the truth!

I like to use an analogy that if a carpenter only shows up at the job with a hammer, it’s impossible to get the job done because you need a whole toolkit at your disposal for different jobs.

In this situation, you not only need a screwdriver, but you’ve got to know which kind of screwdriver. Sometimes you need a Phillips-head, sometimes you need a flat-head, and sometimes you are going to need a drill to get the job done right.

Instead of asking yourself why the options markets are “out to get you,” take a step back and reframe the situation.

If you studied a security and you feel you know where it’s going to go, your next step is to ask yourself, “Should I use an at-the-money, in-the-money or out-of-the-money option?”

But, before you keep talking to yourself every time you look at your portfolio or examine an option chain, let’s talk a bit today about something called “moneyness” and how to use it to make and/or keep from losing money.

Show Me the Money

First, let’s talk about what “moneyness” really means when it comes to options, and then we’ll discuss when to use each.

1. An at-the-money (ATM) option has a strike (or exercise) price equal to or closest to where the underlying asset (i.e., stock, ETF, currency, future, index, etc.) is trading.

2. An in-the-money (ITM) option is at a strike price below the stock price (for a call) or above the strike price (for a put). This is what we call “intrinsic value.”

If you were to close the in-the-money position today, there would be an immediate benefit in doing so.

For example, if the stock is trading at $60 and you hold a $50 call, the intrinsic value of that call is $10. There may be value above and beyond that (called “extrinsic value”), but it would be worth at least $10 per share ($1,000 per contract) if you closed that position at that point.

3. Out-of-the-money (OTM) call options are those with strikes above the stock price, while OTM put options have a strike price below the stock.

Out-of-the-money options are comprised purely of extrinsic value, which is simply the amount over and above intrinsic value that decays as an option heads toward expiration. (Intrinsic value is not subject to time decay.)

Which One Should You Use?

Options that are at-the-money, in-the-money or out-of-the-money serve specific purposes. So, technically, you can and should use them all — but in very different situations.

At-the-Money (ATM) Options

At-the-money options benefit from quick, pronounced stock moves. You do not want to be in an ATM option for a long period of time because of its accelerated amount of extrinsic-value decay.

In-the-Money (ITM) Options

In-the-money options have a higher percentage chance of being profitable thanks to a glorious option Greek known as delta. (Learn why understanding delta is one of the most important lessons for options traders.)

Again, as we discussed above, ITM options have intrinsic value that is not corroded by decay. The deeper ITM an option becomes, the greater its value and the higher its delta — as its percentage chance of finishing ITM at expiration increases.

ITM (i.e., high-delta) options are great when you are planning to hold on to the options for the intermediate to longer term, particularly when you are using them in place of a long or short stock position.

Out-of-the-Money (OTM) Options

Finally, there are out-of-the-money options. These are typically the culprits when you buy an option and you get the stock move you expected but the option doesn’t perform the way you thought it would.

OTM options are by far the “cheapest” on the board, and many investors gravitate toward them in hopes that the stock is going to make a huge move toward those strike prices that are far out-of-reach.

Keep in mind that option prices are based on very strict mathematical formulas, and that stocks statistically are only going to move so far within an allotted time frame.

In other words, don’t equate “less money” with a “better position.” You might only pay 5 cents for an OTM option, but your chance of losing that $50 per contract is much higher if the stock doesn’t soar (or plummet) as much as you expect.

Use the Right Tools

So, let’s review:

  • ATM options are ideal for short-term positions.
  • ITM options are a lower-risk way of having a long or short stock position for a longer period of time.
  • OTM options are often best left to speculation (i.e., a lottery ticket).

Now, we’re only talking about buying options here. Many of you are curious about when to sell options. And there is a time and place for that — usually as part of a strategy that includes a hedge like owning a stock or a long option to help limit your losses if the position turns against you.

In other words, once you learn how to properly use the basic tools at your disposal, then can you take on more sophisticated projects (i.e., positions).

Remember, no carpenter ever built a mansion on his first day at the job!

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