By Brad Levi
We know that when we buy options contracts, we use the appropriate strategy and then attempt to make money either on the intrinsic part of the option premium (where Delta matters most) or on the extrinsic part of the option premium (where volatility matters most), beyond that, there are also other factors that can have an enormous impact on the option premium, such as; Strike price relative to stock price, (ITM or OTM), and the stocks own Beta parameter, Beta measures the volatility of the stock and its correlation to the stock index its listed on. A stock with a Beta of 1 will move 1% if the index moves 1%, a stock with a Beta of 2 will move 2% if the same index moves 1%. So high Beta stocks are inherently more volatile and therefore their options will have higher premiums.
ITM and OTM options
If you are looking to profit from short term movements in the market, you can either, deal with the extrinsic value part of the premium and trade Out-of-The-Money (OTM) options, in which case you trade volatility. Or you can deal with both, by getting volatility on your side and then trading At-The-Money (ATM) options that will become ITM very soon! As soon as options are near the money, that is their strike price is approached by the stocks price, they become more expensive, and once in the money, they become even more expensive, even if it is for just a day or two!
This is an actual options chain, it shows the options available on the Qualcomm (QCOM) stock, in this example we have around 40 days to expiration, depending on your trading idea and how many days you expect it will take for the stock to hit your price target, you might as well use options that have longer or shorter time left. Notice the options in the highlighted screenshot parts are in the money, they are way more expensive than those out of the money.
Notice the options in the red circles, on the Call options we have the second option in the money (SP=$36), costs $2.22 to buy and we can sell it $2.19, the second option out of the money (SP=$39), costs $0.73 to buy, and it can easily double its premium in a single day!
You may think that short term options trading is complex and that volatility may ruin your plan even if the stock moves as expected, that is true to an extend, but as long as you watch your trading calendar and the expected volatility of the markets, you can combine it with what the stock in question is expected to do, the necessary price swings for your profit objectives are more than possible!
Heres a technical chart for the stock in question, (QCOM)
As you can see some moves take around 10 days, some other moves take a lot less, the combination of detailed technical analysis and near the money options is a very profitable strategy, of course, you have to adjust your strategy to every specific price move, and stay protected from the effect of time decay, if you trade options with a month or less to expiration, it can be fine for a trade lasting one or two days, but not longer, if you wish to capture a ten day move you have to choose options with more time available, the principle of making money as the option becomes In-The-Money still works on the more expensive, further away from expiration options .
The bottom line is, always make sure you have more than 30-35 days to expiration, and always watch the trading calendar, this ensures getting a cheaper deal!
The Beta parameter concept
Suppose that you find 10 stocks that technically provide excellent trading opportunities, and you are looking to capture a quick movement, within a parallel channel or between some other kind of support and resistance, or you just expect an X amount of points of price move either up or down, in this case you have to analyze the profit margin on all 10 stocks, take into account their current price and potential percentage gain as well, then take a look at their Beta parameter, the stocks that have lower Beta will have lower volatility, lower option premiums, but will still make the expected price move, the same move percentage-wise or point-wise, and that means you will be paying lower premiums.
Now suppose you had the 10 stocks of the previous example, but you wanted to implement an extrinsic value strategy, and profit from a sudden rise in volatility, what you do is pick the stocks with the highest Beta, ideally ones with a Beta over 2, check their historical volatility, and technical charts for trend strength not just direction. Then you look for days where implied volatility is the lowest, and pick OTM options, buy them and hold them until a day of high volatility, that will be a news release day, or a technical breakout day on the stock chart. Since the options are 100% OTM, not only you will profit from the volatility rise, but you will notice that the rise in implied volatility will be at least twice that of the major market indices, since you are dealing with high Beta stocks, of over 2. This strategy requires longer option contract terms, ideally 3 months or more, this way you are a lot safer from the effect of time decay.
This is not just buying at a better price, the whole trading strategy depends on better price!
Analyzetrade.coms scanning tools do just that, very fast and accurately, they can give you a series of accurate data on Beta, Implied Volatility, Historical Volatility and more, giving you an edge over less prepared traders.
Other ways involve pricing the option yourself using the software your broker may offer or using the tools available here at Analyzetrade.com, using the actual Black Sholes formula will reveal right away if the option you are about to purchase is overvalued or undervalued.
Savvy option traders always look for options priced below $1.50, regardless if they want to profit from intrinsic value or extrinsic value, in the case of intrinsic value they want to be near the money, by picking options that have strike price close to the underlying stocks price, if they want to profit from volatility, they will look for the elements that will cause surprise volatility, as I mentioned earlier you need to watch the trading calendar for important news / economic indicator release days, as well as earnings release weeks, or anything on the technical charts that suggests a breakout is bound to happen.
About the Author: Option Software from Asio Investment Tools gives you the opportunity to practice on historical charts and test against actual market conditionswithout risking a penny of your money!
Intuitive, simple to use, Options Softwarecboe.com/LearnCenter/default.aspxoptionseducation.org/