| Choosing
the Right Option to Buy
Using Gold as an example if you
bought August, October and December options with the same exercise
price, how would they behave if one month later the market is unchanged?
The August options would lose most value due to time decay, followed by
the October options with December losing the least.
If the price of gold rallied strongly what would happen? The August
options would make the biggest gains followed by October with December
the least. If a decline occurred the August options would lose the most,
the October the second most with the December options losing the least.
What can we learn from this exercise? The option with the least time to
expiry will make the biggest gains with a short sharp rally. They offer
the greatest leverage but also will lose the quickest on a stagnant
market or a decline. These options are therefore the most speculative.
The options with the most time to expiry will give you more protection
against an adverse move or a stagnant market but will not give as great
leverage as the closer to expiry options. Therefore only use short dated
options when you expect an immediate sharp move and longer dated options
to benefit from a trending market over time.
When buying options to benefit
from a move in the underlying market, there are four principles to
consider which will give you a much greater chance of success. Match
your market view with these four elements:
1. Closer to Expiry Options.
The closer the option is to expiry the faster it will appreciate in
value if your view is correct. Conversely if wrong this option will lose
the quickest.
2. Longer Expiry Options.
The more time an option has before expiry, the better it will hold its
value if the market moves against it. These options will not appreciate
as quick in value if the market goes your way unless it is a big move.
3. Close To-The-Money Options
The closer to the current price an option is (close to the money) the
more expensive it will be. It will however have more chance of being
profitable in normal market conditions.
4. Out Of-The-Money Options
The further from the current market price an option is (out of the
money), the more leverage that the option has. It has the potential of
making the greatest returns, but will need a large move in the market to
do so.
We've looked at four principles
that we said were important when considering which option is the most
suitable to buy.
The first principle was that of trading options with a short amount of
time to expiry. You may have read or heard about the need to counter the
effects of time decay, by buying options with plenty of time to expiry.
There are however times when
buying options with little time to expiry (two weeks or less) can be a
worthwhile strategy.
When? When you firmly believe
that a major market break will take place within a very short space of
time. During the last two weeks to expiry of an option, big moves in the
underlying market can cause these markets to increase in value
phenomenally.
The main point to realise here
is that this type of trade is highly speculative. Follow these
guidelines to give yourself the best chance for success:
- Buy close to the money
options.
- Take profits on half your
positions if the option doubles in value.
- Use extreme market moves to
exit the trade at a favourable price.
The second principle of option
buying is knowing when to use options which are long dated (three to six
months to expiry). The basic characteristics of these types of options
are that they are more expensive to purchase than shorter dated options.
Time is a valuable asset when
buying options. The more time you have before an option expires the more
chance you give the market of making a favourable move that will make
the option profitable.
Secondly you need to understand
that a longer dated option will give you less leverage than a closer to
expiry option. However they will also hold their value better if the
market remains unchanged or goes against your position.
Ideally look to initiate buying longer dated options when volatility is
low (options are undervalued) and the technical pattern of the market
suggests a breakout is possible.
- Buy options as close to the
money as possible.
- Exit if option trades 2 or 3
strikes in the money as these options can become illiquid and
difficult to trade or turn into a free trade.
- Set risk point to exit at a
pre-determined point.
After determining the most
appropriate option to buy (choose short term to expiry for a more
aggressive move or longer term to ride the trend), the next step is
selecting the exercise or strike price. This is an important
consideration and should be looked at carefully. Many people will buy an
option based on how much money they can afford. This may not be the best
approach to take.
There are two of factors to consider. Firstly it is not advisable to buy
options that are too far away from the current market price (well out of
the money) even if they are cheap. This is because the further out of
the money an option is, the less likely that it will become profitable
over time. You may require an extreme market move to be profitable in a
relatively short space of time. Secondly when selecting between option
strike prices, look at the risk/reward between them.
In other words work out the dollar cost difference to purchase them
against the extra potential profit available. For example if a closer to
the money option costs an extra $100 for an extra $2,000 profit
potential then clearly this is the most appropriate option to purchase.
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