Help! I Can't Figure Out Which Option Strike To Buy
That's a comment I get quite often from readers who are trying to choose amongst the hundreds (literally) of available option contracts to trade.
It can definitely be daunting to a newcomer, especially when you throw in the multitude of expiration dates to choose from, as well.
I was once there myself as a new trader about 30 years ago. I understand your frustration. Well, have no fear. In this blog post, I'll give my best answers, which are actually quite simple.
Are You Investing or Speculating?
One of the first things new option traders need to figure out is if they're an investor or trader, because it will greatly influence the decision on which option strike to choose.
For the sake of simplicity, I will only discuss the choices from the option buyer's perspective.
What's the difference between investing or speculating?
In the financial world, "investing" tends to mean that the security will be held for a considerable amount of time. In our hyper, short-attention-span world of today, I would define a considerable amount of time to be at least six months in duration or longer.
There's a certain type of option contract to choose if you fall into the investing category.
"Speculating", on the other hand, tends to mean the position is held for hours, days, or weeks, at most. The trader is looking to make a quick hit, hoping the security will move in their favor in short order to gain a high return-on-investment (ROI). In my opinion, this type of trading is more in tune with gambling.
Unfortunately, the speculator mentality runs rampant in the options market because the cost of entry is very cheap, and the trader seems to be over confident with his/her stock picking abilities. Most of the time those contracts end up expiring worthless because the stock assessment and/or the timing ends up being wrong.
Which Strike Should I Choose Then?
If you're a stock buyer, you typically believe that the stock will go up over time, yes? There's really no other reason why you would buy it.
If you are a call option buyer (bullish), you also believe that the stock will go up.
But how do you decide which call option strike would best fit your outlook, and which expiration month should you choose?
It's intuitive to believe that you should pick an option strike that would most closely mimic whatever the stock does. Why choose anything else, right?
Here's the problem with that - each option strike has its own characteristic and will move at various speeds compared to the stock's move. Beginner option traders are under the false assumption that every option contract will move in their favor just because the stock moves in their favor. Not so!
That false assumption will cause many beginners to typically opt for the cheapest dollar-cost option contracts.
These are what's called out-of-the-money (OTM) options, and they have the lowest probability of paying off. But since they're so cheap, traders still flock to them like moths to a flame. It's the lottery type play - small cost, potential huge payoff.
How do you figure out how much the option will move compared to the stock? Well, it's by looking at the Delta, silly. Didn't you read my last blog post? It's all about Delta.
Deltas range from 0-100 and each option contract has its own delta. The higher the delta, the more the option price will change in conjunction with a stock price change.
So you would think that buying call options with high deltas would be the smart play, as their price would move in your favor when the stock moves in your favor. High delta options are categorized as in-the-money (ITM) options. And it's the smart trader's weapon.
The trade-off is that ITM options will cost more compared to OTM options, so it tends to repel many new option traders who are thinking more with their wallet than about the probability of profiting.
What's The Probability?
Take a stock that costs $100 per share. If you buy 100 shares of that stock, the breakeven will be $100 per share and the cost would be $10,000.
Take an ITM call option with a $70 strike that costs $31 per contract. Buying that call option would cost $3,100 and the breakeven would be $101 per share ($70 strike price + $31 option cost).
Take an OTM call option with a strike of $130 that cost $.10 per contract. Buying that call option would cost $10 and the breakeven would be $130.10 per share ($130 strike price + $.10 option cost).
The stock and ITM call option have very similar breakeven levels. Once the stock moves above $101, the ITM call option would be making a profit. Only a $1 move is needed - a very likely and attainable probability.
The OTM call option needs the stock to move from $100 per share all the way up to $130.10 per share just to breakeven (if held to expiration). That's over a $30 move.
Would a move like that even be possible?
Well, look at the screenshot below. It shows the probability of a typical stock moving above $130.10 within 60 days.
The calculator shows that the chance of the stock moving above $130.10 within 60 days has less than a 1% chance. Put another way, it has over a 99% chance of not moving to profitability. Bad!
On the other hand, here are the chances of the stock moving above the $101 breakeven price:
The probability jumps up to 46% that the stock can move above $101 within 60 days. If you think about it, that's just slightly less than the stock's chances of moving above its own breakeven ($100 in this case) - which is never more than 50%. The stock and ITM call option will act almost identical.
The OTM call option - not so good.
But new option traders will argue - the OTM call option only costs $10 compared to the ITM call option that costs $3,100. Why would I want to spend so much more money?
Because it's all about probability and picking an option that closely mimics the stock. Yes, the OTM call option costs a heck of a lot less. But 99 times out of 100, you're going to lose.
Why not spend the $3,100, which is $6,900 less than the stock cost ($10,000) and give yourself more bang for your buck?
This is the way investing should be done using call options.
Sure, I have nothing against taking a gamble from time to time. It's fun to buy the lottery trade. But don't make it a habit.
It's too hard to know whether a stock will move from $100 to $130 in 60 days. No one is that good at predicting a big move like that. But it's so much easier for a stock to move from $100 to $101 in 60 days. The odds are so much higher for that type of small move happening. Yes, it costs more to buy the ITM option, but you'll be smiling all the way to the bank when your directional prediction pays off.
Lastly, let's say in 60 days the stock moves to $129.90 per share.
The stock buyer will make a $29.90 per share profit and an ROI of 29.9%.
The ITM call buyer will make a profit of $28.90 per share and an ROI of 28.6%.
The OTM call buyer will lose their $10, and have a ROI of -100%.
The conclusion here is that sticking to ITM options with high deltas (I like 90% deltas) will greatly improve your odds of winning as long as the stock moves in your intended direction.
And since you're investing, look for expiration dates of at least six months out, preferably longer.
Remember, don't fall for the speculation trap. As I said, it's fun every once in awhile, but trying to make it the main source of your trading income is a fool's game. No one is good enough to predict the where and when of stock moves with regularity.
Until next time...