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Four Things to Consider Before Placing an Option Trade
02/16/2010 12:01 am EST
Boring markets are made for long-term stock investors—as long as their shares are staying steady or inching upward, they are happy.
But option traders fare best when there is frenzied market activity and volatile price action. Market volatility can be the option investor's friend because it can drive up premiums and make profitable positions even more valuable.
However, it can also impact the true value of option premiums, as cash-flush institutions and fund managers sweep big dollars into and out of positions in the fraction of a moment that it takes for them to point and click.
So, how can you determine the "real" value of a position you want to enter?
The single biggest advantage stock options have over other investments is that you can measure their value and the probability of profit before you even initiate a position in the trade. This is not true of any other type of investment.
Options—due to the fact they have a time limit and specific contract terms—can be measured mathematically. While most professional option traders mathematically analyze option plays, most individual investors do not.
I'm always in search of that super play on an overvalued or undervalued option with an excellent risk/reward picture. That is what successful options trading is all about.
Every option investor should do some analysis before entering a trade, but you do not need to be a math genius to do so.
Here are the four factors to look at before entering an options trade:
1) What is the option's fair value? Make sure you buy undervalued and sell overvalued options—it enhances your probability of profit.
2) What is your probability of profit if you hold the position to expiration? Because options can be inexpensive, many individuals don't thoroughly examine their potential performance. Barring some dramatic move in the lifespan of the trade, an option that is too far out of the money to realistically become profitable is probably not worth betting on.
3) What is your probability of hitting a stop loss or profit goal during the life of the option? While "cheap" options can seem like a "long shot" at face value, it's still real money that you're putting into them—capital that you need to have a plan to protect and grow.
4) What is the delta? If you are an option buyer, you want a higher delta. If you are an option writer (seller), you want a lower delta.
These four factors are all you need when comparing different option trades to determine the best play or whether you should pass on a trade, because there will always be new trading opportunities coming along.
MORE: How to Use an Option's Delta to Help Your Trading|pagebreak|
Bridging the Delta
Let's talk more about an option's delta, as that may be a newer concept to you and it is one that you may find helpful as you become more experienced, and maybe even advanced, at trading options.
There are many factors that go into determining the value of an option: The price of the stock, the historical impact of volatility (i.e., how the stock price typically behaves around regular events like earnings announcements), and dividends and interest, if applicable. After all, options are created—and their available strike prices are set—around the current value of the underlying stock.
Although option values don't always trade directly proportionate to the underlying stock, we can use the delta to gauge the options' sensitivity toward movements in the stock. For instance, you might have held a call option at one time or another with a $35 strike price in your investment portfolio. But then perhaps the stock traded up through that number, but your option didn't follow it toward profitability. And that can be frustrating because you made the right "call," so to speak, yet the profits didn't follow.
Option delta refers to the ratio of change between the underlying asset's price in relation to the change in the option's price, which can help to explain why an option makes corresponding moves with the underlying stock or why it might refuse to go along for the ride in lockstep.
One of the benefits of trading options is that you can capture huge swings (in the double or even triple digits) on a simple single-digit spike in the underlying security. An option's delta aims to approximate how much an option will change in price for every $1 move in the underlying stock.
The deeper in the money the option is, the higher the delta, and thus, it's more likely that the option moves in tandem with the stock. (That is, if the stock jumps $1, the option could also go up $1.) This is the ideal situation for profitability— when the option movement directly mirrors the stock movement.
This ratio of change between the price of the underlying asset and the option is reflected as a percentage, where a delta of 1 for the underlying instrument (i.e., stock, index or exchange traded fund) equals 100%. In turn, an option's delta can never exceed 100% of the stock's movement and is instead conveyed as a positive number (with bullish plays) or a negative number (in bearish trades).
In other words, it measures how much an option's price will change in tandem with every $1 move in the underlying security. If the stock jumps $1 and an in-the-money call option also goes up $1, that option has a positive 100 delta. But if the option goes up 50 cents against the stock's $1 increase, then the option's delta is a positive 50 (or, it has matched 50% of the underlying's move).
A delta of 50 is typical for an at-the-money option; that is, if you're holding a call at the $100 strike and the stock is trading at $100.
Simply put, the option has a 50% chance of going in your favor. Thus, the deeper-in-the-money calls have higher deltas because their chances of finishing profitably are, of course, higher, and lower deltas correspond to an option's chance of being profitable by expiration.
But what if the $100 stock goes down to $99? Then an option with a delta of 50 goes down 50 cents, or half of that $1 drop. However, if it's a put option that drops 50 cents with a $1 spike in the stock, it would have a negative 50 delta, as it drops 50 cents for every dollar that the stock price increases.
Delta is one of many tools that can help option investors to gain a statistical advantage over other traders, because it helps us to determine whether we have an undervalued or overvalued situation or a good risk/reward picture.
Otherwise, we pass on the trade. Why invest in an option trade that "might" do well when we can instead identify trades that have the odds stacked in their favor?
By Ken Trester of Options-inc.com
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