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Which Option Should I Buy\?

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Which Option Should I Buy?

As option traders, we know that the path to success involves more than just picking a bullish stock and buying calls or buying puts on a weak one. Technical Analysis, with a dash of fundamentals and sector analysis thrown in for good measure, do a great job of helping us to pick the right direction on a stock, but if we purchase the wrong option, it can turn a potentially winning play into a loser. Proper option selection can not only keep our equity curve on the rise, but it can help us to milk more profit out of each of our trades.

In my Trader's Corner articles over the past several months, we have talked about numerous Technical Analysis tools that can be used to pinpoint strong trade candidates, and those bits of prose are archived on the site for any and all to peruse at their convenience. But that isn't our objective here today. We want to talk about how best to utilize the leverage offered by options to maximize our trading results.

We have talked about various aspects of option selection, approached from the perspective of analyzing option pricing (and potential changes to those prices) utilizing the Greeks. From Delta and Gamma to Vega and Theta, we pretty much covered all the fine points from a theoretical standpoint. For those of you that may have missed the discussion, you can head on over to the Options 101 archives and get caught up. The first article in the series was Paying Attention to Option Pricing on January 16th.

Based on some of the recent emails I have received, I thought it would be beneficial to revisit the topic this afternoon, with an eye towards the real world, rather than theory. But first, let's recap what we know intuitively to be true. Buying options gives us greater leverage than buying stocks, and if we are correct in the trade, our percentage returns will be substantially higher. But not only do we need to be correct about the direction of the trade, we also have to be correct on the timing of the movement of the underlying stock. And depending on what strike we select (ITM, ATM or OTM), we also need to be correct on estimating the magnitude of the move.

In simple terms, buying an option nearer to the money will have the option moving faster with respect to a given move in the underlying stock than an option that is further out of the money, due to the effects of Delta and Gamma. The price we pay for this outperformance is that the initial cost of the option is higher, so percentage returns will be lower. But that may be just what we need if we aren't sure how far the stock might move in our favor. Let's look at some examples of real option trading to better illustrate the point.

Let's assume that I have a penchant for trading IBM due to familiarity with the way the stock trades and I've been leaning to the short side since the big breakdown in early April. By my estimation, there have been two high-odds put entries since that time, each time the stock failed at resistance and rolled over in conjunction with daily Stochastics dropping back from overbought territory. Let's take a look.

Ok, so now that we have identified the entry points, let's see which option we would have tracked. First, let's look at the entry signal generated in late April. Aggressive traders could have entered the play on the failure at $90 resistance on April 19th, but waiting for the Stochastics to roll over would have had us entering the play on April 23rd. With the stock nominally trading at $87 when that more conservative entry point presented itself, let's call the $90 Put ITM, the $85 Put ATM and the $80 Put OTM. At the time, I would have used May strikes, but given the fact that May expiration has already occurred, let's do our examples with June contracts, since the data is more accessible.

Taking the high sale of the day for each of the respective contracts gives us entry prices as follows:

June $90 Put (IBM-RR) - $4.90
June $85 Put (IBM-RQ) - $2.90
June $80 Put (IBM-RP) - $1.50

Let's look at some historical charts of those three option symbols over the next 2 weeks and see how they would have treated us. And let's be really generous and say that our technical analysis prowess would have enabled us to ride the stock all the way down to the bottom on May 6th. We'll assume that our exit for each option contract was taken based on the closing price on that day.

Starting with the ITM option, we can see that our chosen contract (IBM-RR) would have gone from $4.90 to $13.20 in 2 short weeks, for a nice little profit of $8.30 or 169%. That's nothing to sneeze at, but the results get even better for the ATM Put (IBM-RQ).

Initiating the trade at $2.90 and closing for $8.70 gives us a profit from the trade of $5.80 or 200%. That gives our account a nice little boost over the profit of the ITM contract for a trade that covers the same move in the same stock. So let's carry it to the next level, using our OTM Put (IBM-RP).

Well now, would you look at that! Costing a mere $1.50 at inception, the trade using the OTM Put could be closed out on May 6th for $4.30. The profit in dollars is only $2.80, but we're going for that high percentage return, right? Gotcha! The percentage return on the OTM put is "only" 187%. That's right, we've reached the point of diminishing returns, at least for the magnitude move that IBM offered us in late April and early May. Not only does the ATM contract deliver greater return in terms of dollars, but in terms of percentage on initial capital invested, when compared to the OTM option.

If IBM had fallen all the way to the $60 level, then there is no doubt that the OTM option would have provided the highest percentage returns. But that isn't the sort of move that we should become accustomed to, especially in a rangebound market. Let's take a brief look at the second entry signal that IBM provided, this time around May 20th.

Using the same contracts, a quick visual scan of the charts above will show you the trap of using the OTM option. IBM hasn't fallen nearly as far (or as fast) this time around and the OTM option is trading near $1.70 vs. an optimistic entry of $1.20. That makes the percentage return on the latest move about 42%. While the percentage move on the ATM contract is only about 40% (entry at $3.00 and current price of $4.20), you'll find that with such a small move in the price of the OTM contract, getting out of the trade with that 40% profit is much trickier. Should we have to give up $0.20 to the market maker on each of the options, the profit on the OTM contract would fall to 25%, while the ATM contract return would only fall to 33%. And if we had to give up that $0.20 on each end of the trade (both at entry and exit), we would find our total profit cut to only $0.10 on the OTM put, which makes the trade hardly worth doing at all. Lop the $0.20 off of each end of the trade with the ATM contract, and we still have a profit of $0.80. It isn't stellar, but it still represents a profit of more than 25%. The OTM contract is far more sensitive to minute changes in the price, due to the low cost of entry.

So let's boil it all down to some useful knowledge that we can all use. Using OTM contracts is great when you want maximum bang for the buck, but this strategy only works consistently when we are rewarded with a large move in the underlying security. Here's how I gauge which option to buy when I am contemplating a new trade. After doing all of my technical analysis on the stock, I should have a target price for the stock in mind. If I'm trading puts, I may find stock XYZ that I reasonably expect will drop from $47 to $38 over the course of the next 2-3 weeks. If my expectations are met, then the best option to trade would likely be the $40 strike. The initial cost to enter the trade will be rather low, but I need the stock to stage that big move.

A far more prudent approach would be to utilize the $45 strike. Initial cost of entry will be higher, but it will be easier to harvest my gains when they have accrued, due to the fact that the option will be deep in the money if my price target is met. The real payoff though, is if the stock only drops to $43 before beginning to recover. The aggressive $40 option would not yet have really begun to appreciate, whereas the $45 strike will already have moved to in the money status.

And we haven't even talked about the possibility of the trade going against us. In the event that a trade goes sour, I have always found it easier to manage my risk in options that are ATM or even ITM. The options are more expensive, but they also happen to also have higher open interest and volume. Those two qualities normally translate into tighter bid/ask spreads and that means that we don't get chewed up giving back a fat spread on an illiquid option when the trade fails to perform as expected.

There are numerous methods that can be used for estimating price targets on prospective plays, but in a market that continues to bounce around in range-bound fashion, I prefer to err on the side of caution. While there will certainly be home runs in the weeks and months ahead, where individual stocks surge or collapse by 20% or more, the prudent approach is to hit singles and doubles until strongly trending markets return. How do we hit singles and doubles consistently? First off we have to pick the right direction on the right stock. But hopefully I've shown you that using ATM (or near-the-money) options can help you capture the lion's share of the profits available from more speculative OTM options on the large moves, while allowing us to harvest small gains from the smaller stock moves that seem to be becoming more common.

I hope this has been helpful!

Mark

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