Option Investor
Educational Article

Paycheck or Lottery Ticket

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By Jim Brown

Which will you have a better chance of paying your mortgage payment with next week? The paycheck of course.

Many people come into options investing with a lottery ticket mentality. They want the big payoff. They open a brokerage account with their life saving of $2,000 and start dreaming. They lose it all on two or three deep out of the money plays and then complain the rest of their life that options are too risky. You know 85% of options expire worthless! That is a common misconception and even if it were true it is not necessarily bad. How many people write covered calls in their IRAs? Millions? These people want the options to expire worthless. Option trading is not risky if done right. Yes, you can lose money but ask Caterpillar or Xerox shareholders if stock ownership is risky.

Back to the topic. If you were budgeting your bills for the next six months you would count up the number of paychecks you were going to receive in that period. You would not count the number of lotteries you were going to win.

We need to focus on options trading as though it was a weekly paycheck. If you want long-term appreciation then buy stock. If you want short-term income then use options. There is a perfectly good method to turn options trading into cash flow.

You know what is coming....Sell Too Soon. But that is not the whole story. Option trading requires research, effort on your part and timing. All the best research in the world is worthless if you are too impatient to wait for the correct entry point. As I have shown before, in any ten day period in a stock cycle there are probably five days that option buyers will be profitable and five days that option buyers will lose money. This is not rocket science. It is simply applying proven principles at the right time.

In options trading "cheaper" is not always "better." Nobel prize winners developed the theory for pricing options. They were not dummies and some options are cheap for a reason. Just because a basket of tomatoes costs $10 does not mean a basket of rotten tomatoes is a better buy for only $1.

In the money (ITM) options are not cheap but have a high value. They have a very low time premium but higher stock value. At the money (ATM) options are the most expensive. Surprise! At the money options have the most time premium and no stock value. Out of the money (OTM) options are cheap and expensive at the same time. You have the time premium and you also have the distance out of the money. A $2 option that is $10 out of the money has a relative value of $12. A $7 option on the same stock that is $5 in the money has the same $2 premium where an at the money option may be $5 and be all premium.

When you buy calls you have to be right about all the factors. Timing, direction, speed and distance. A $2 call, $7 out of the money on a stock that is moving +$2 a week with three weeks to go is not cheap. It is a donation to the covered call writer that sold it. You can have the direction right but the speed and distance will bleed you broke. You can have the speed and distance right and the timing can kill you.


JC, I love you man but I am going to use you as an example again!

A very good friend of mine was in the office last week. After eight winning trades in a row he has hit a losing streak. I was talking to him about his trades and what he was buying. He said, I bought this XYZ call for $.44 and I thought if it would go to $.75 I could make a lot of money. Stop right there! Does anybody else see the problem? For an option to be $.44 it has to be so far out of the money you would have to take a cab to see it. But I can buy a lot of them. SO WHAT? A lot of nothing is still nothing. We had a heart to heart about in the money vs out of the money. Traders that have lost a large part of their bankroll tend to then concentrate on the cheap OTM options because they need a homerun to get back into the game. Sorry, it is a proven fact that homerun hitters strike out more than base hitters. If you only have a small amount of capital you should protect it with high quality plays instead of squandering it on lottery plays.

DISTANCE: When you buy an option how far does the stock have to move to get the return you want? Only you know. For an ITM buyer the stock only has to move $3-4 for a good return. For an OTM buyer the stock has to move much farther AND much faster to accomplish the same return.

SPEED: When you buy an ITM option the speed of movement in the stock price is not critical. If the stock goes flat or turns into a snail the ITM option will never lose its stock value and the time value decays at a much slower rate than an OTM option. If you have ever owned an OTM option when the fast rising stock corrected then you know the speed of premium decay increases expotentially with the decrease in stock price. You can't sell them fast enough.

DIRECTION: This is the simple part but I never cease to be amazed at how many people buy call options on stocks that are going down. Really. The line of thought goes something like this: Last week these option on XYZ were $10.00 and I got them for $1.00. SO? If the stock dropped -$15 in that week and is showing no signs of a rebound, why would you want to buy the calls?

TIMING: This is the hardest part. You can have the best stock in the world, moving in the right direction at the speed of light and buy calls at the open on a $10 spike and never see the price you paid for them again. (read the mailbag article tonight and you will see what I mean)

Timing stocks is easy compared to options. Stocks are one dimensional compared to options. Stocks go up or down or stay the same. Time has no real importance. Investment horizons are measured in years. Watch option premiums this Monday on any stock that is flat. The premiums will be evaporating before your eyes. Time passes, options decay.

The actual formulas for determining the value of options include several greek terms like Delta, Gamma, Theta, etc. The one I am most concerned with is Delta.

Delta is the rate of change in the option price for every dollar change in the stock price. Deeper ITM options have higher Deltas and OTM options have lower Deltas.

Assume for this example a stock trading at $50.
The Delta of an ITM strike price of $45 is .75
The Delta of an ATM strike price of $50 is .50
The Delta of an OTM strike price of $55 is .25

The Delta is the rate of change. For the ITM strike of $45 the option will rise in price +.75 for every dollar the stock price rises. Deeper in the money options have higher Deltas.

The OTM strike of $55 will only rise $.25 for every dollar of stock price rise.

Sounds simple but in practice many investors fail to estimate what will happen to the option price based on stock price and time passage.

Assume a $4 option, $6 out of the money with four weeks to go. (just am example)

The premium decay will cost you about $1 per week. ($4 divided by 4 weeks) Actually it is faster than that and accelerates the closer you get to expiration.

If the stock goes up +$2 in one week with a Delta of .25 then the option will increase in price +.50 because of the Delta and lose -$1 because of time decay. Your option is now $3.50 and the stock went up.

A week later with another $2 move your option will only be worth $3.00. You see where I am going here. The option can lose value while the stock is still moving up.

Paycheck Mentality

Option traders need to develop a paycheck mentality. An ITM option will go up 75% of the time as long as there is life in the stock. If it is moving +$2 a week the ITM option will increase. If the stock stops moving the ITM option will lose premium much slower than the OTM option.

A $5 ITM option which costs $6 will rise +1.50 for a $2 stock move in one week. $1.50 divided by $6.00 equals 25% return.

A $5 OTM option will lose $.50 with the same move because of the lower Delta and time decay.

Yes, two traders using options on the same stock in the same week can have totally different results. One can gain +25% and the other lose -25%. Trust me, I see it every day.

The trader with the paycheck mentality will buy the ITM options and hold them as long as the stock continues moving upward. The farther the stock moves the more Delta the trader gets. They will follow the option price up with stop losses and even liquidate some of their positions as the value increases. This minimizes the risk of a news disaster. Cash flow, cash flow, cash flow. Try this experiment. Calculate what your option capital would be if you compounded only 25% returns every two weeks for a year.

The Lottery mentality buys "cheap" OTM options and then holds them for weeks waiting for the premiums to just get back to what they paid for them even when the stock continues to move up slowly.

Which investor would you rather be?

Critical points:

Yes, your return percentage will be greater IF your deep OTM option is successful. However, your percentage of successes will be much lower.

Yes, because the Delta is much higher on deep ITM options the leverage works both ways. If the stock drops sharply the premium will also drop sharply. This is why we use stop losses.

No, I am not saying "never" buy deep OTM options. I do it all the time but only as speculation plays. Maybe only 1 in 20 and then only with very small amounts of money relative to my total capital. I like the thrill of the possible big payoff too. Most are news related plays like takeover rumors. In every lottery somebody has got to win eventually. Just don't bet with money you really can't afford to lose.

Next week: Exit Strategies, Escaping with a Profit

Jim Brown

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