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