Saturday, August 31, 2013

Should you buy in- or out of the money options?

Believe it or not, this is probably the most emailed question I receive in my inbox about option trading. When you look up options for most underlying securities you're usually presented with a long list of, you guessed it, options. But is it better to buy an option that is in-the-money or out-of-the-money. Out-of-the-money options are definitely cheaper, but does that automatically mean that it's a good idea? It really all depends on your trading strategy and how quickly you expect the underlying asset to increase in value - so keep in mind the time frame. An out-of-money option is cheaper for a reason; there's a greater chance that the option will become worthless upon expiration. But it also yields higher returns when the underlying security does trade in your favor, the option may jump from $0.10 to $0.20 in a day, that a 100% increase! You basically can insinuate that if someone who is choosing an out-of-the-money option over an in-the-money-option contract, he or she has a higher expectation that the price of the underlying asset will rise/fall in their favor drastically. For those who are more cautious, want to reduce risk and don't expect a whole lot of volatility, I recommend to use in-the-money options, the returns aren't that high and it's more expensive to buy, but there's less risk involved (remember, your in-the-money option already has intrinsic value from the moment you buy it. In order to fully understand the basics of ITM, OTM or ATM options it's best to look at a chart that gives a visual presentation how ultimately an option trades, like the chart below.
Visualization of an Out-of-the-money Call Option; courtesy of FuturesOptionsETC.com
When the stock price was $50 when the call option was purchased (strike price of $52.50), you won't break even when the stock price moves to $53.10. Anything beyond $53.10 is profit.

There is a way to calculate your trading strategy outcome before you make the trade. You can use a so called options calculator. For instance, this is my result when I use the following values:

the September 27th $18.00 call for the VXX. Price per option = $0.53, 1 contract = $53 (100 x 0.53). With the table below I'm able to see the following:

Estimated returns:
  • VXX at $17.04 on 31st Aug 2013
  • Initial outlay: $53 (net debit) see details
  • Maximum risk: $53 at a price of $17.15 on day 27th Sep 2013
  • Maximum return: infinite on upside
  • Breakevens at expiry: $18.53
Click image for a larger version.
You can use your own values and see what happens until the option expires at optionsprofitcalculator.com.

-Happy trading!

Disclaimer:

All opinions expressed, trade recommendations/advice on this website are solely of John van der Munnik and are not affiliated with any investment firm or any other organization. You should not make an investment only based using this website VDM Trading for your trading needs without seeking help from your own financial advisor.