| An option is a derivative trading product that is best | | | | of Delta before continuing. |
| used by investors as a hedging tool providing profit | | | | Remember, delta tells you how much the option will |
| protection and profit enhancement. Although it is a | | | | move with a similar move in the stock and is given as |
| powerful risk management tool, it can also be used | | | | a percentage. For example, a 33 delta option means |
| effectively as a stand-alone trading vehicle. | | | | that the option will move 33% of the movement of |
| Under the proper conditions, options do not have to | | | | the stock and 70 delta option will move 70%. |
| be paired with stock or another option to be an | | | | In-the-money options act like stock. The deeper in |
| effective trading tool. To successfully trade naked | | | | the money the calls are, the more they act like the |
| options, an investor must realize that certain options | | | | stock. As the call moves deeper and deeper in the |
| will fit certain scenarios and certain options will not. | | | | money, the calls delta approaches 100 which means |
| One of the major misconceptions that investors have | | | | it's price movement will reflect 100% of the stock's |
| about options stems from the fact that most do not | | | | movement. (This is discussed in more detail later in |
| know how to trade them properly. When they lose | | | | "The Stock Replacement Covered Call Strategy"). |
| money trading them, they feel that there is | | | | In fact, deep-in-the-money options are sometimes |
| something wrong with the option. They do not | | | | even used to replace stock positions. If you look at |
| understand that options are on a higher, more | | | | the charts below, you can see how closely the |
| sophisticated level when compared to stocks. | | | | in-the-money call mimics the upward movement of |
| Stock trading has fewer variables involved and is | | | | the stock (2nd quadrant). |
| therefore easier. No one is saying that the individual | | | | In the money options are best used for smaller stock |
| investor isn't smart enough to trade options. The | | | | movements. The reason is that in-the-money options |
| problem is not intelligence; it's just education and | | | | contain less extrinsic value. The extrinsic value can |
| experience. Most investors have not been properly | | | | work against you when purchasing an option because |
| educated in the proper use of options, and even | | | | extrinsic value is affected by time decay. |
| fewer have had any real experience trading them. | | | | As you wait for your stock movement, the |
| One of the biggest problems investors have is this: | | | | in-the-money option will decay less than either the |
| Even if you buy a call and the stock goes up, you | | | | at-the-money or out-of-the-money options because |
| can still lose money. Most investors tend to buy out | | | | it has less extrinsic value. The amount of money you |
| of the money options at a cheap price. | | | | lose in time decay must then be made back by |
| The stock trades up a little, which is the right | | | | additional stock movement. |
| direction, but the option still loses money and the | | | | Obviously, the less you lose in decay, the less the |
| investor wonders why. | | | | stock has to move for you to be profitable because |
| What the investor fails to realize is that in order for | | | | it has less decay loss to make up for. |
| the option to be profitable the options delta must | | | | This is because an in-the-money call has a high delta |
| out-pace its rate of decay. Implied volatility also plays | | | | and a much higher percentage chance of finishing |
| a key role if the stock does trade up while implied | | | | in-the-money by expiration so they follow the stock |
| volatility decreases, the options delta must then | | | | more closely. |
| outperform the decrease in volatility. Remember, | | | | With less extrinsic value loss to make up for, a |
| when volatility increases, the price of all options goes | | | | smaller movement in the stock will produce a greater |
| up. When volatility decreases, the price of all options | | | | profit. For a call example, as you can see in the chart |
| goes down. | | | | below, the in-the-money produces a profit with the |
| We have categorized options in several ways. One | | | | least amount of stock movement. With less extrinsic |
| way is by the option's strike price, and its distance | | | | value, the ITM option has a lower break-even point. |
| from the stock price. We identified these options as | | | | For chart below, stock price = $35.00 |
| either in-the-money, at-the-money,or | | | | Strike Price Option Price Delta Breakeven Extrinsic |
| out-of-the-money. | | | | Value |
| In our discussion about trading naked calls and puts, | | | | $30 5.20 85 35.20 $.20 |
| we will identify trading opportunities or situations that | | | | $35 1.00 52 36.00 $1.00 |
| fit each of these types of options, for both calls and | | | | $40 .30 20 40.30 $. |
| puts. But it is important to first review the definition | | | | |