Directional Corner - Articles

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. This is discussed in more detail later in "The Stock Replacement Covered Call Strategy.")

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 (2^nd 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 in-the-money option has a lower break-even point.

For chart below, stock price = $35.00

An at-the-money option has both advantages and disadvantages over stock and in-the-money options. First, the at-the-money option will be cheaper then both the stock and the in-the-money option. So there is less capital requirement and less total risk.

Remember, when buying an option, you can only lose what you spend. The problem is the amount of extrinsic in the at-the-money option.

In order for you to profit from buying an at-the-money option, you need the stock to make a move very quickly. Because you have so much extrinsic value, you will be battling against the option's daily rate of decay.

So the movement of the stock must happen quickly enough and large enough to offset the amount of money you will be losing daily as expiration draws near.

With this said, the best chance you have to make money when buying a naked at-the-money option is to use it as a short term trade. The longer you hold onto this option, the harder it is for you to be profitable due to the options decaying extrinsic value.

At The Money Call vs. In The Money Call

For chart below, stock price= $35.00

An out-of-the-money option presents many of the same advantage & disadvantage parameters to the investor. The out-of-the-money option is even cheaper then the at-the-money option which means more leverage and less risk.

However, with a smaller delta, the stock must move much more than either the in or at-the-money options in order for the options to become profitable. Again, we need the option's delta to outpace the option's rate of decay.

Now, with the out-of-the-money option, there is less extrinsic value than the at-the-money option so the amount of total possible decay (cost of the option) and the rate of this decay is less than the at-the-money option.

By being further out-of-the-money, this option needs more movement from the stock. As a naked option, this out-or-the-money example is extremely speculative and should only be used naked when the investor feels there is a very good chance of a stock having a large percentage move.

An investor must understand that the odds of them profiting from the purchase of a naked out-of-the-money option is very slim. When purchasing a naked out-of-the-money option, be prepared to lose your entire investment.

Out of the Money Call vs. At the Money Call

For chart below, stock price= $35.00

Although options can be traded by themselves for directional plays, and can perform well under the right conditions, they are much better used in coordination with stock or other options in formatted strategies which will be discussed in the next section.

While buying naked calls and puts can provide some of the biggest leverage and highest returns, they can also involve the most risk. This strategy should only be used by experienced options traders or traders using risk capital.