Today’s Trading Lesson From TradingMarkets
Editor’s Note:
Each night we feature a different lesson from
TM University. I hope you enjoy and profit from these.
E-mail me if you have
any questions.
Brice
PS To learn professional options strategies, try the
TradingMarkets Options College.
Choosing The Best Option To Purchase
By Len Yates
An option is a beautiful thing. Buy
one. When you’re correct about the direction of the market, gains are
unlimited. When wrong, losses are limited.
Sure, time decay
works against your position while the underlying goes nowhere (or takes an
excursion in the wrong direction first), but this is an acceptable cost if the
option is reasonably priced. (That is, implied volatility is at normal or
below-normal levels.)Â As I have said many times, there is nothing wrong with
buying a reasonably priced option. An option purchase has an amazing risk/reward
curvature.
Prior to expiration,
an option’s profit/loss profile is a gentle curve, bending the most in the
middle, and flattening in either direction — kind of like a bent steel bar. On
one end, the curve flattens out into a 45-degree angle. This is when the option
is deep in the money. In the other direction, the curve approaches a zero-degree
angle. This is when the option is deep out of the money. See Figure 1 for the
familiar profile of a call option purchase.
Figure 1Â
An at-the-money option is at its maximum inflection
point. From there, as the underlying moves in the desired direction, your
position makes money faster and faster. For example, the first point the
underlying moves in your direction, the option gains perhaps ½ point. The next
point the underlying moves in your direction, the option gains perhaps 5/8
point. And so on, until, when the option is deep in the money, it moves point
for point with the underlying.
On the other hand, if the underlying moves against you,
your position loses money slower and slower, as the curve flattens out.
So, how does the trader decide which option to buy? Here is
some advice that may help:
Unless you enjoy living on the edge, buy an option with at
least twice as much life as you feel you’ll need. That way, a counter-trend day
won’t make you nervous. How many times have you been anxious when holding an
option with less than two weeks of remaining life and the market goes the wrong
way for one or two days? You’re probably wondering, “Has the market reversed?Â
Was yesterday’s price the best I was ever going to see? I wish I could have that
price back now! I think I’d sell just to be safe. Yes, but I can’t have that
price back. I’ll have to accept that the market is what it is now. Should I sell
now?â€
Stress is bad for trading. It leads to bad decisions. Use
an option with plenty of life and you can see the market through its little
wiggles without stress.
How far in or out of the money you buy is a safety/leverage
trade-off. For more safety, buy an in-the-money option. For more leverage (and
greater risk), buy an out-of-the-money option. I would never buy a far
out-of-the-money option, unless I knew something very special about the stock
(and I never do). In fact, I recommend always buying options at or around the
money, so that you’re near the option’s maximum inflection point. That way, if
the underlying heads the wrong way right out of the starting gate, it’s hurting
me less and less as it goes, but if the underlying heads the right way, it’s
helping me faster and faster as it goes.
Good discipline dictates that the trader set objectives and
stops. These should be decided, and written down, the moment the position is
opened. If the underlying moves in the desired direction, these should be
re-evaluated and adjusted upward at intervals. I have no advice on how to set
objectives and stops, nor when to adjust them; only that you should set
them, and obey them. Traders must settle on a system that works for them.