Sometimes options can be priced just right. At other times, they can seem cheap or they can be trading at a steep premium. When market volatility (which is a measure of the fluctuation in the market price of the underlying security) is touching its highs, beware the trap of paying too much for overpriced options.
When the volatility in a given equity or index surges, often what happens is the option premium climbs higher right alongside it. But when we see a pullback in volatility, well, it’s like watching an item you recently purchased go on a sale a week later. The value of options premium will usually make a decided move to the downside.
In fact, it takes only a little adjustment in volatility to whack the price down — even when the price of the underlying stock or index doesn’t move that much.
The lesson here is to not invest too much money in one trade. Yet, this is one of the great temptations of options trading.
The Siren Song of Options
Options, by their very nature, are short-term investments that allow you to control a lot of stock (100 shares per contract) at a relatively low price. This tool can provide immense leverage — but leverage can work both for and against you. The key to proper leverage management is to never risk more in an option trade than you’d be OK with losing.
Now it’s true that some investors get carried away with options. They are dazzled by how inexpensive options contracts are versus simply owning the underlying stock. Although options can cost anywhere from a few cents to more than your average stock, depending on how high the shares are trading, I like to keep things small.
I like to place my bets on options that are trading in the $1 (i.e., $100 per contract) range. That way, if they go up to $4, then I’ve just made a 300% return on my investment. But if the trade doesn’t go in my favor, the most I can lose on the trade is the $1 that I originally I risked.
Playing With Higher-Priced Options
However, not every stock gives you the opportunity to buy low-priced options. That’s when you have to shift your strategy. One way to play higher-priced options — yet still only pay a nominal amount to enter the trade — is via a bull-call spread.
This trade involves the purchasing of an at-the-money or in-the-money call option and the writing (i.e., selling to open) of an out-of-the-money call option at a higher strike price. And if you’re a little worried about holding options short, you’re covered by those long calls and you likely won’t have to touch a single share of stock because you’re in a spread trade and not truly “naked” (or, not “covered” with long stock).
A bull-call spread is also known as a debit spread, meaning you’re paying to enter the trade, but it’s significantly less than outright buying the call options because you’re also taking in some premium by selling calls in this simultaneous transaction.
For instance, if you buy a May 40 Call for $2.50 and sell a May 45 Call for $1, your net debit for the trade will be $1.50. In this scenario, you’ve “earned” $1 in premium upfront and have upped your odds of “profiting” with your trade, as the spread concept provides a bit of a safety net and gives you more leverage in the markets.
The bull-call spread is just one of many strategies you can use to play the options markets, but if you have a positive outlook on the stock and also want to limit your downside as well as the amount of your investment, spread trading is a powerful tool to have in your arsenal.
The caveat is that your profit potential gets capped, but while you might not “win big,” you won’t “lose big” either.
Keep in mind that with any options trade, the most you can lose is as much as you put into it. And while we’re all playing to win, the losers hurt a lot less when there’s not as far to fall.
Jim Woods is a Senior Editor for OptionsZone.com.To read more of his articles, go to http://www.optionszone.com/trading-ideas/gallery/forex-futures.html
Click here to sign up for a free, online presentation by Larry Connors, CEO and founder of TradingMarkets, as he introduces The Machine, the first and only financial software that allows traders and investors to design and build quantified portfolios.