The options arena has a tendency of inundating newcomers with choices. Unlike the equities market which essentially provides a single choice for each company, the options mart provides participants virtually limitless ways to express their bullish or bearish viewpoints. While the plethora of expiration months and strikes to choose from makes trade selection appear a daunting task, it’s actually quite simple once one grasps the basics of option theory such as the interplay between risk, reward, and probability.
Take expiration month selection for example. Currently AAPL offers options expiring in nine different months. How might one narrow down the list and select the optimum time frame? For starters, traders must understand the relationship between price and time decay sensitivity. Longer dated options are more expensive, yet suffer from lower rates of time decay. Shorter dated options are cheaper, yet suffer from higher rates of time decay. If a trader was focused on finding an acceptable balance between cost and sensitivity to time, they would likely select an option residing somewhere in the middle of the nine months available.
Yet another key factor is the expected duration of the trade. If you’re primarily a swing trader with the average trade lasting anywhere from a few days to two weeks, you probably don’t need to buy a one year option. Two to four months would suffice.
Now, what of strike selection? The process depends in part on the strategy in question. An iron condor trader will use different metrics than a trader employing debit spreads. Suppose we’re keeping it simple and discussing strike selection for a trader looking to buy a straight call or put option.
At any given time, a particular stock may offer hundreds of different strike prices. Fortunately the narrowing of choices is quite simple using the process of elimination. Buying in-the-money options provides a more conservative, higher probability bet than buying out-of-the-money options. Additionally, the behavior of an in-the-money option better mimics the price of a stock due to the higher delta. Traders set on buying options outright, then, would likely be better served by focusing on purchasing in-the-money options.
Rather than using different months and strikes for each trade, most option buyers adopt a certain approach and use it time and time again.
For related posts, readers can check out:
Risk Reduction – Pick a Door
Step Into a New Dimension
{ 3 comments… read them below or add one }
Hey Tyler,
Off subject, but I was reading a bit on the Facebook doing a public offering of shares. First person I thought to ask was you… what kind of plays would you think about doing on Facebook’s stock?
Thanks,
Chris
http://www.clevergrip.com
Let’s say I just want to do OTM options to reduce my risk capital. How do I judge how far out of the money & the time period I should buy? I realised that time decay on these options work really fast closer to expiry.
Nick,
In general I’m not a fan of buying OTM options. They have a very small margin of error and require you to be impeccable in your timing. A trader would want to make sure they have a solid track record of accurately forecasting market direction before deciding OTM options are the way to go. And even then they’d still probably be better off using ITM options.
If cost is a factor, then buy less contracts of an ITM option. For example, I’d rather buy a call option 1 strike ITM for $500, than buy two call options a few strikes OTM for $250 apiece. If your account isn’t big enough to buy ITM options without risking too much capital, then I’d say your account is not big enough to trade. Save up more and paper trade in the meantime. Option spreads may also provide a more cost effective approach.
Now suppose your still set on buying OTM options. I would probably just buy the first strike OTM. Go much further and you’re pretty much purchasing a lotto ticket. How much time you buy depends on the duration of your trade. But, even on shorter term trades, I’m not a fan of buying front month options due to the higher rate of time decay.
{ 2 trackbacks }