Interested in buying options?
You might have heard about the leverage and the enormous profit potential that you could achieve when buying options. But you also might have heard about traders who lost a lot of money with this trading strategy.
Should YOU be buying options?
In this article you will learn what you need to know before buying options, and important tips & tricks that will help you select the best options to buy.
Like most financial decisions in life, there are both advantages and disadvantages when it comes to buying options.
Buying Options: Advantages
- Risk is Fixed = As an option buyer, the risk that you have on the trade is limited to the amount that you pay for the option. It doesn't matter if you pay $50 for an option or $1000 for an option, the most that you can potentially lose is the price that you pay. Because risk is fixed, there are no surprises and the risk & potential reward of a trade can be determined BEFORE a trade is actually placed.
- Unlimited Reward = Option buyers pay for the right to BUY or SELL a stock at a specific price. Since there's no limit to how much a stock can move higher, the potential reward on a purchased call option is theoretically unlimited.
- Leverage = Options are derivatives based on the price of an underlying stock. Options give traders the ability to control relatively large positions with a small amount of money. It's not uncommon for option buyers to control 100 shares of stock worth $5,000 or more for as little as $100.
Buying Options: Disadvantages
- Expirations = One of the biggest drawbacks to buying options is an option's expiration. As an option buyer, expirations work against you. This is because options will lose some value as they approach expiration, and many options expire worthless.
- Leverage = Leverage is both an advantage AND disadvantage. Profits are magnified when you can control large positions with a small amount of capital, but loses are magnified as well.
After considering the advantages and disadvantages of buying options, there are a few things you should know before buying your first option.
Real Value vs. Time Value
An option's price is going to be based on real value (known as intrinsic value) and time value (known as extrinsic value). Real value is the value of an option if the option were to be exercised now. As an example, if you buy a call option with a strike price of $50, the option will have real value any time the stock price is greater than $50. This is because a call owner has the RIGHT to buy stock at the strike price. If the stock is greater than this price, there is real value priced into the option.
Time value is the difference between an option's price and the real value of an option. If an option is priced at $1.50 with only .50 cents of real value, there is $1.00 of time value priced into the option. Time value is the premium paid above an option's real value. Time value can increase or decrease depending on the time left to expiration and a stock's volatility.
Options are classified as “in the money”, “at the money” or “out of the money” depending on the intrinsic value of an option.
- In The Money (ITM) = Any option with intrinsic value (real value)
- At The Money (ATM) = An option with a strike price that is closest to the current stock price
- Out The Money (OTM) = An option that only has extrinsic value (time value)
ITM options are always going to be more conservative, but also more expensive since they will always have some real value priced into the option. OTM options will always be cheaper but more aggressive since the entire price of the option is based on time value.
The concept of time decay is important for option buyers. It's said that time decay is an option seller's friend, and an option buyer's enemy. This is because time value erodes as an option approaches expiration. The time value priced into options will decay greatest in the last 30 before expiration.
Many new option traders get frustrated when an option starts to lose time value because of time decay. This is because they don't understand the idea of time decay and how an option behaves in the final days before expiration.
Tips & Tricks - How To Avoid Newbie Traps
New traders are often drawn to cheap options because of the profit potential. Although there will be big moves and “home run trades” from time to time, cheap options are cheap for a reason. This is because lower priced options are OTM options with a lower probability of success, and/or options with fast approaching expirations that will likely suffer from time decay.
To avoid the common pitfalls of a new options trader, consider the following when buying options:
- Buy options that have AT LEAST 30 days until expiration.
- Stick to ATM or ITM options, unless your goal is to risk money on low probability “home run” trades.
- Know exactly how much you are paying for TIME.
- Have a strategy for determining the direction of the market (like the Power Crossover Method)
- Determine the risk and reward of a trade before you buy an option.
With fixed risk and unlimited reward trades, buying options is an excellent alternative to simply buying stock. But not all options are the same. Understanding real value and putting these 3 tips to use will help you avoid some of the typical rookie option buying mistakes, and maximize your investment potential.
For more information on buying options, check out this video: