An option is a derivative trading product that is best used
by investors as a hedging tool providing profit protection
and profit enhancement. Although it is a powerful risk
management tool, it can also be used effectively as a
stand-alone trading vehicle.
Under the proper conditions, options do not have to be
paired with stock or another option to be an effective
trading tool. To successfully trade naked options, an
investor must realize that certain options will fit certain
scenarios and certain options will not.
One of the major misconceptions that investors have about
options stems from the fact that most do not know how to
trade them properly. When they lose money trading them,
they feel that there is something wrong with the option.
They do not understand that options are on a higher, more
sophisticated level when compared to stocks.
Stock trading has fewer variables involved and is therefore
easier. No one is saying that the individual investor
isn’t smart enough to trade options. The problem is
not intelligence; it’s just education and experience.
Most investors have not been properly educated in the
proper use of options, and even fewer have had any real
experience trading them.
One of the biggest problems investors have is this: Even if
you buy a call and the stock goes up, you can still lose
money. Most investors tend to buy out of the money options
at a cheap price. The stock trades up a little, which is
the right direction, but the option still loses money and
the investor wonders why.
What the investor fails to realize is that in order for the
option to be profitable the options delta must out-pace its
rate of decay. Implied volatility also plays a key role if
the stock does trade up while implied volatility decreases,
the options delta must then outperform the decrease in
volatility. Remember, when volatility increases, the price
of all options goes up. When volatility decreases, the
price of all options goes down.
We have categorized options in several ways. One way is by
the option’s strike price, and its distance from the
stock price. We identified these options as either
in-the-money, at-the-money, or out-of-the-money.
In our discussion about trading naked calls and puts, we
will identify trading opportunities or situations that fit
each of these types of options, for both calls and puts.
But it is important to first review the definition of Delta
before continuing.
Remember, delta tells you how much the option will move
with a similar move in the stock and is given as a
percentage. For example, a 33 delta option means that the
option will move 33% of the movement of the stock and 70
delta option will move 70%. In-the-money options act like
stock. The deeper in the money the calls are, the more they
act like the stock. As the call moves deeper and deeper in
the money, the calls delta approaches 100 which means
it’s price movement will reflect 100% of the
stock’s movement.
In fact, deep-in-the-money options are sometimes even used
to replace stock positions. If you look at the charts
below, you can see how closely the in-the-money call mimics
the upward movement of the stock (2nd quadrant).
In the money options are best used for smaller stock
movements. The reason is that in-the-money options contain
less extrinsic value. The extrinsic value can work against
you when purchasing an option because extrinsic value is
affected by time decay.
As you wait for your stock movement, the in-the-money
option will decay less than either the at-the-money or
out-of-the-money options because it has less extrinsic
value. The amount of money you lose in time decay must then
be made back by additional stock movement.
Obviously, the less you lose in decay, the less the stock
has to move for you to be profitable because it has less
decay loss to make up for.
This is because an in-the-money call has a high delta and a
much higher percentage chance of finishing in-the-money by
expiration so they follow the stock more closely.
With less extrinsic value loss to make up for, a smaller
movement in the stock will produce a greater profit. For a
call example, as you can see in the chart below, the
in-the-money produces a profit with the least amount of
stock movement. With less extrinsic value, the ITM option
has a lower break-even point.
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Brett Fogle is the founder of Options University, a
training resource partner for traders. For a
comprehensive, free report on the 7 deadliest sins made
when options trading, visit
http://www.OptionsUniversity.com .
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