Option Investor
Educational Article

The Four Questions

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By Lee Lowell

There are basically four nagging questions that every option investor must face before putting on a position:

1. Which way do I think the underlying stock is going to move?
2. How much time do I want to give myself?
3. Which strike price do I choose?
4. Are the options overpriced or underpriced? (volatility)

Nobody said it was easy. To be truly successful in this arena, you must go through this checklist. The days of just buying any old call and watching it go up, are over. That internet bubble has burst. Shall we break it down?

The first thought of most option investors is which way they think the stock is going to move. Ultimately, wherever the stock ends up on expiration day will determine how much you will make or lose on your position (if held to expiration). Remember, you do not need to hold your position until expiration day. You can sell out your longs or buy back your shorts at anytime. Most likely, your target points will be hit sometime before expiration. Don't be afraid to trade it. The best ways to get a handle on possible future movement is to do some technical analysis on the stock, check the fundamentals, and keep tabs on the news. Hopefully this will help you form an opinion on future direction. If for some reason you don't have an opinion on direction but have a feeling of an impending move on a stock, then the strategies of choice are neutral option plays such as straddles and strangles.

Once you have formed an opinion on direction, you need to decide about the time frame in which you think your prediction will work out. This is one of the hardest decisions. Knowing how long it might take for a stock to make a desired move is almost impossible to predict. If you buy short-term options, your investment will be small and your overall risk will be low. But if the move doesn't happen right away, you can lose the whole premium. If you buy longer-term options (leaps), your investment is larger but you will have less daily decay and you can wait out the move. Once again, the move may never occur, but at least you're giving yourself the opportunity to be right. Some traders don't like to tie up that much capital for long-dated options such as leaps. So you can either buy a mid-term option (6-9 months out) or just buy near-term options every month. Buying front-month options each expiration for 12 months might end up costing you the same as buying 1 leap option at the very start. It'll actually cost more with commissions added in. This is a very difficult decision to make but I always like to give myself the extra cushion and usually choose options at least six months out. There's nothing more aggravating than seeing the stock make the expected move right after your options have expired!

Ok, you've got an idea (maybe) of where the stock might move to and you've picked the duration. The next step is to pick the appropriate strike price. Not many people give this one much thought. They go after the least expensive one. This usually results in picking a far out-of-the-money option with very little probability of becoming profitable. If you look at the deltas of these options, you'll see them with a value of anywhere from 1% - 10% depending on how far OTM they are. Delta tells us how much the option price should move along with a 1 point move of the stock. If your option has a delta of 5%, that means for every 1 point move in the stock, your option price will move less than 1/16 of a point! That's not the kind of movement you're looking for. By the time the stock has made it's expected move, your option will only have given you a few measly points. The delta also tells us the probability of your option finishing in-the-money. Do you want an option that has a 5% chance of finishing in-the-money? Plus, finishing ITM doesn't guarantee a profit.

Example: IBM is at $100. You buy the 110 calls for $4. IBM closes at $111 on expiration day. Your option is ITM, but only by 1 point. So you really ended up losing 3 points on this play. Buying OTM options are lottery plays that hardly ever pay off. Sure it's fun to play every once in awhile because there's always that chance, but it rarely happens. Playing ITM or ATM options will give you more bang for your invested dollars. You will have a delta anywhere from 50% - 90% which will give you good option movement. Sure the option costs more, but your probability of walking away with a profit is bigger. Take a look at a probability calculator on some websites. You'll see your chances of either making a profit or your chances of just getting to the break-even point. It all comes down to: do you want a cheaper option with a small chance of profitability or something that costs more but has a greater chance of yielding a profit. Again, it is a personal decision. I like to choose mostly ATM or slightly ITM options when I put on a position.

Lastly, and of course my favorite step: check the option's volatility. This will give you an idea of how fairly priced the options are. If you read my article from last week, you'll gain a greater understanding of this concept. In short, volatility lets us know how expensive or cheap the options are when compared to past volatility levels. If you are a buyer of options, try to make sure the implied volatility levels are low compared to its past readings and vice versa for option sales. Looking at charts of historical volatility levels will give you an idea of how your option stands today.

Succeeding in the world of options trading is difficult for anyone. Take these steps into account and you're sure to increase your bottom line.

Good luck.

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