The Potential of Low-Priced Options

12/08/2014 8:00 am EST

Focus: OPTIONS

For option traders unsure of the differences between low-priced options and cheap options, Ian Harvey, at Investopedia.com, highlights what sets them apart and shows traders the ins and outs of how to avoid cheap options and only select low-priced options instead.

When considering trading options with a low cost, it is vital to understand the difference between cheap options and low-priced options. Essentially, cheap options have very little likely potential and are therefore priced accordingly, whereas low-priced options are those that are considered undervalued and are therefore priced lower than their real potential could warrant.

Learning how to pinpoint genuinely low-priced options, as opposed to cheap options, is the basis for any successful trading in the arena of options that require a less than typical initial outlay.

One advantage of trading low-priced options is that they generally produce a higher percentage return than is produced by most higher-priced options.

Options strategies exploiting market volatility are a key to profiting from trading low-priced options. Generally, a higher volatility means a higher options price, and if a trader is able to identify a situation where an option price has not risen in keeping with its increased volatility, they may have spotted an undervalued option offering a potential for a greater profit with a low outlay.

The two basic ideas behind options trading are either speculation or hedging, and low-priced options could be applicable in either of these cases. While speculation—which is betting on the future direction of the market—is often seen as a somewhat questionable practice, it could be argued that hedging—or using options to protect an investment—is still a form of speculation, as, if the movement which is being hedged against does not occur, the money invested in creating the protection is lost. Using low-priced options as a method of hedging can, at least, ensure that the amount of money being outlaid to protect an investment is not such a substantial amount to risk, regardless of the outcome of the strategy. 

Areas to Understand When Trading Low-Priced Options

1. Leverage as Applied to Options:

Leverage in trading options is about making the same amount of capital work more effectively and profitably.

While the actual cash amount received as a return on an options trade is smaller, the percentage increase is often substantially higher than the percentage increase of the return on the equivalent stock investment. The trade on the option also carries a risk of losing only a fraction of the amount that could be lost on the stock.

What this effectively means is that the same amount of capital could be used over the same time frame in a significantly wider diversity of investments with a greatly higher potential return and a much smaller risk per investment, which is truly valuable use of leverage. 

2. Future Volatility:

In options trading—and especially in trading low-priced options—it is important to understand how predicted future volatility, or Implied Volatility, is used to measure how relatively high- or low-priced an option’s premium is.

3. Odds and Probabilities:

Using a comparison of the implied volatility of an option in relation to its historical volatility can allow a trader to gauge the likelihood of a future stock movement ensuing. This assessment of odds and probabilities helps the trader to determine whether a low-priced option is really a good deal and to best place a trade with a reasonable expectation of a certain outcome.

NEXT PAGE: More Areas to Understand and Strategies to Undertake

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4. Technical Analysis:

Using technical analysis tools, such as chart and candlestick patterns, or volume, sentiment, and volatility indicators, provides a rational and concrete basis for making options trading decisions.

Using technical analysis tools will provide the insight needed to construct a successful trading strategy, applying a criterion such as the following:

In the instance that the implied volatility is low compared with the historical price movement of the stock, this can be taken as an indication that a worthwhile potential trade could be made on this option. If the stock continues to move at the rate of its historical volatility, rather than slowing to the current implied volatility, a return could be expected that is in keeping with the higher price that the higher volatility would have commanded, meaning the lower price paid could be considered a bargain, provided that the market behaves accordingly with this strategy. 

5. Market Optimism and External Influences:

A major news event can create a dramatic stock price movement and this is usually accompanied by a big increase in implied volatility. In the months following this drama, the stock will usually stabilize to some degree, while further news developments are awaited. The frequently experienced tighter trading range normally results in a drop in implied volatility. If a trader believes that a price breakout is imminent, they may buy options at the current lower cost, and if their prediction is correct, then the purchase can be considered a bargain. Conversely, a loss may be incurred if the price fails to break out of the narrow trading range within the trader’s time frame.

6. Using the Black-Scholes Model:

Another method of determining the actual value of an option compared with its price in order to ascertain whether the option is indeed, a low-priced option, or simply a cheap option, is using the Black-Scholes Model, a mathematical options pricing model.

Strategies to Undertake

1. Focus on smaller stocks that offer the potential of greater profits:

While it can be tempting to get swept up in the buzz generated by high profile stocks, big-name, big-money stocks don’t always produce big percentage returns. In fact, the opposite is generally true, with low-priced stocks usually having a greater probability of making high percentage increases than the high-priced choices.

2. Avoid short-term, out-of-the-money options:

Although these types of options have a lower cost than longer-term, in-the-money options, they are usually cheap options and not low-priced options. It is often tempting, especially for inexperienced options traders, to trade the cheapest options obtainable. They rationalize that they are reducing their risk, and while trading cheap options may certainly reduce the amount of capital outlay, the risk of a 100% loss is greatly increased as these cheap options have a very high probability of expiring worthless.

3. Buy higher-delta options:

Simply stated, a higher-delta option is an option that has a higher likelihood of expiring in-the-money. An option that is already in-the-money has a high delta, and if this type of option can be purchased at a relatively low-price, then this is the best scenario for a potentially winning and worthwhile trade. Another advantage of higher-delta options is that they perform more similarly to the underlying stock, meaning that when the stock moves, the options will rapidly gain value.

NEXT PAGE: More Strategies to Undertake and the Bottom Line

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4. Buy options with an appropriate time frame before expiry:

The reason that options with a shorter time to expiry are cheaper is that they have a small window of opportunity in which to realize a profit. Although the investment may seem appealing because it does not require a large capital outlay, the low probability of the close-to-expiry option returning a profit, means that this type of trader is betting against the odds. Buying options with a reasonable amount of time before expiration is part of a successful trading strategy when trading low-priced options.

5. Consider sentiment analysis:

When selecting stocks to buy low-priced options on, sentiment analysis can be used to establish the likelihood of the continuation of a current trend. When the upward movement of prices is accompanied by negative or bear-like activity such as increased trading of put options, greater short interest, and less-than-optimistic analyst rating, this can often signal a good time to buy. As the stock price continues to climb, the naysayers often become potential buyers who finally climb on the bandwagon after abandoning their doom and gloom. Alternatively, widespread enthusiasm for an upward moving stock may indicate that most players have already entered the trend and that it may be reaching its peak.

6. Implement underlying stock analysis:

The implementation of technical analysis can provide a sound basis for selecting and timing a trade to capitalize best on market movement and conditions when trading low-priced options. A clear perspective of the underlying stock always offers an advantage to the trader seeking to make a successful trade.

7. Avoid complacency and greed:

Low implied volatility means lower option prices and is often a result of either greed or complacency in the market. To successfully identify and trade low-cost options, it is vital that a trader does not fall into this same trap of complacency or greed. Don’t become complacent and assume that low implied volatility and the accompanying low option price means that it is automatically a good deal. Make sure that it is genuinely a low-cost option, and not a cheap option that you are buying into. In all types of trading, greed can be the trader’s worst enemy, so making rational, reasonable and consistent decisions, rather than dreaming of huge profits, is the way to succeed.   

8. Use mean-reversion trades:

The theory of mean reversion is that stock prices, after a dramatic movement, will revert to their mean or average. As placing trades on the principal of mean-reversion is, of course, not an infallible strategy, it makes sense to enter the potential snapback price action of a stock that has reached its snapping point with low-priced options rather than the underlying stocks.

The Bottom Line

Understanding the difference between an option that is cheap, simply because it has little chance of becoming profitable, and an option that is genuinely low-priced for reasons of undervaluing or volatility discrepancies is the key to successfully trading options with lower-than-typical premium costs. By effectively applying the strategies outlined in this article, and gaining a sound understanding of the principles listed above, a trader can become skilled at making consistent winning trades and leveraging their investment capital effectively by trading carefully selected low-priced options.

By Ian Harvey, Contributor, Investopedia.com

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