Option Investor
Educational Article

What's My Plan\?

HAVING TROUBLE PRINTING?
Printer friendly version

What's My Plan?
By Lee Lowell

I often hear people say, "I think stock ABC is going to go up, I'm going to buy some call options." This is the end of the thought process and the investor ends up buying any old call option on stock ABC. No consideration was given to which month to buy, which strike to buy, whether implied volatility was high or low, whether earnings are due, if a spread play might be in order, how do the support numbers look, or maybe selling an option would be the most beneficial play. Unfortunately, TV infomercials can make options trading look glamorous and easy. That's not the case. Successful options trading is hard work. You may get lucky now and again, but if you want to be a successful, long-term options trader, you must put in some effort.

I'd like to go into a little more detail about some of these steps that one should take before deciding to take an options position. For me, it always comes down to whether I would want to hold the underlying stock in my portfolio for a long time. For others, it may be pure speculation and a one-day hold. The bottom line is whether the stock will actually move in the direction you anticipated, but doing a little more preparation can possibly lead to an even bigger profit or less of a loss.

Once I've decided on my stock of choice, I always check its historical and implied volatility. For those of you who follow my articles, you know that I'm a volatility addict. Check the "Options 101" history section during February and March 2000 for my previous in-depth discussions of volatility. In short, implied volatility tells us whether the option premiums on any particular stock are cheap or expensive when compared to its past. Each stock and its options will go through cycles of high and low volatility. You've heard this before, but your objective is to concentrate on option-buy strategies when volatility is low and concentrate on option-sell strategies when volatility is high. This increases your chances of success. Volatility is one of the components of any option pricing model. A low volatility input will yield a lower option premium and vice versa.

If the implied volatility on the stock I like is at very high levels, then I look at selling puts or put spreads. This lets me sell some very juicy premiums while having the chance to buy the stock at lower levels. This doesn't assure me of ever getting ownership of the stock, but at least I've received a credit into my account for the effort. If I truly wanted to own the stock and the volatility levels were very high, then I would just outright buy the stock at that point. I could also institute a bull call spread which would let me buy and sell the high premiums at the same time and thus not expose myself to a volatility crush. On the flipside, if the stock's implied volatility is extremely low, then I would not hesitate to buy LEAP calls or whatever month I feel the stock will move by. But since my timing has never been good, I stick with the LEAPs. LEAPs also gives you the extra padding when your timing is off. You will lose some value but not as much as if you owned the stock outright. And when the stock starts to move up and volatility starts to increase, that is when I start selling covered calls against the LEAPs. (see previous article).

This ties in with which month to choose when buying options. As you know, any long option is a wasting asset. The longer it takes for the stock to hit its profit point, the faster your long call will erode. With each passing day, your option gets a little cheaper. This makes it harder for you to sell for a profit. As I said before, my timing stinks so I will always choose an option with at least 6 months before expiration if I'm not going for the LEAPs. Most people like to play close-to-expiration options because they are cheap and the payoffs can be big. But if your entry level is off and your timing is off, and/or if you bought an overvalued option...then say goodbye to that option because decay will take over. You're just not giving yourself enough time for the option to mature. Then, your emotions begin to make the trading decisions for you. But if you are a short-term speculator who has lots of faith in your timing models, then by all means, stick with what works for you. I've had no luck. Buying the extra time gives you that margin for error if you happen to get in at a bad entry point or if some rumors may be floating about.

Now what about which strike to buy? Again, most people like to buy out-of-the-money options because they are cheap and the returns can be astronomical. But the success rate is very low. The stock has to move a great deal in a short amount of time in order to make a profit. (See my articles on probability of profit). To get the real bang for your buck, stick with at-the- money or in-the-money options. They may cost more but you'll get more movement out of them and they won't be comprised of just all time value (extrinsic value).

Another idea is to employ a spread trade. You can buy a call spread which will not only lower your break-even point but it will also lower your initial capital outlay. This is a great strategy to use that can deal with high volatility issues, and you can tailor the strikes to the level you think the stock might reach by expiration. Say for instance you like Copper Mountain Networks (CMTN) for a long-term play. The stock's been beaten down recently and looks very oversold. At the moment, the implied volatility on CMTN is on the high side, so buying outright calls can be a little risky if volatility starts to drop. You could purchase the longest dated ATM call which happens to be the March 2001 $40 call for 13 points. This makes your break- even point $53/share. If CMTN continues to go lower and volatility starts to fall, you will lose quickly. Instead, you can buy the longest-term ATM call and sell an OTM call against it as a spread. You could purchase the March 2001 $40 call and sell the March 2001 $70 call for about 8 points. If volatility starts to drop, then both options will lose value. The $40 call's loss will be somewhat protected by the $70 call's gain. The spread will cost $500 cheaper and the break-even point has been lowered to $48/sh. It's true that your profits are capped at 22 points, but you won't be kicking yourself until CMTN moves past $70/share. That's a healthy move from its current price and plus, who wouldn't be happy with a 22 point profit?

The last items are fundamental and technical in nature. Being able to spot good support and resistance levels, having good timing and momentum indicators will certainly help you in picking a decent entry and exit point. Plus, with the free information overload that exists on the web today, you should always know when the stock has analyst meetings, earnings announcements, stock splits, etc. These actions are notorious for inducing big volatility moves. Use it to your advantage.

So the next time you want to buy a call option, take a little extra time to check the details and remember your Options 101!

Options 101 Archives