Smart Option Trades
In the previous two blogs we have gone thru option basics, terminology and some strategies. In this blog I plan to shed some light on executing smart option trades.
What should be the strike price?
Most of the folks buying options are focused on buying out of the money calls or puts. For example we will focus on call options. On 12 Jun BAC closed at $13.72. A ton of folks will speculate by buying say Nov 2009 $15 calls @ $1.79/ share. You have to realize that BAC has not yet reached $ 15 (strike price of the call). The option price of $1.79/ share is purely premium (time value). So investor will see intrinsic value in this call only after BAC stock hits $16.79 ($15 striker price + 1.79/ share spent on call option). Now let’s say that investor buys in the money option of BAC, Nov 2009 $ 9 Call @ 5.40/ share. Yes the investor does put in more money upfront to buy this call as compared to the out of the money call but the premium (time value) for a call having strike price of $9 is $0.68 vs. the premium of $1.79 paid for call having strike price of $15. The rationale for buying the in the money options similarly applies to puts too. So if the investor is confident that the stock price will move in the expected direction then putting more money in and buying in the money options makes sense. But out of the money options make sense for a speculative play where the speculator is not confident of the direction of the movement and wants more leverage.
In the previous two blogs we have gone thru option basics, terminology and some strategies. In this blog I plan to shed some light on executing smart option trades.
What should be the strike price?
Most of the folks buying options are focused on buying out of the money calls or puts. For example we will focus on call options. On 12 Jun BAC closed at $13.72. A ton of folks will speculate by buying say Nov 2009 $15 calls @ $1.79/ share. You have to realize that BAC has not yet reached $ 15 (strike price of the call). The option price of $1.79/ share is purely premium (time value). So investor will see intrinsic value in this call only after BAC stock hits $16.79 ($15 striker price + 1.79/ share spent on call option). Now let’s say that investor buys in the money option of BAC, Nov 2009 $ 9 Call @ 5.40/ share. Yes the investor does put in more money upfront to buy this call as compared to the out of the money call but the premium (time value) for a call having strike price of $9 is $0.68 vs. the premium of $1.79 paid for call having strike price of $15. The rationale for buying the in the money options similarly applies to puts too. So if the investor is confident that the stock price will move in the expected direction then putting more money in and buying in the money options makes sense. But out of the money options make sense for a speculative play where the speculator is not confident of the direction of the movement and wants more leverage.
Tracking stocks using options
In one of my previous blogs I had explained examples of how dollar cost averaging helps investors. I believe that such disciplined and planned investment strategies are helpful as they reduce the guess work. Let’s learn how we can apply similar strategy to buy options.
As of (13 Jun 2009) the stock market is coming out of recession (hopefully). We can argue all day long if the recent rally is a rally in a bear market or it’s actually a bull market. All I will say is there is lot of upside which will be realized thru a lot of fluctuations instead of a straight shot price move.
Rising floor method of buying options
In one of my previous blogs I had explained examples of how dollar cost averaging helps investors. I believe that such disciplined and planned investment strategies are helpful as they reduce the guess work. Let’s learn how we can apply similar strategy to buy options.
As of (13 Jun 2009) the stock market is coming out of recession (hopefully). We can argue all day long if the recent rally is a rally in a bear market or it’s actually a bull market. All I will say is there is lot of upside which will be realized thru a lot of fluctuations instead of a straight shot price move.
Rising floor method of buying options
Example: As of 12 Jun 2009, BAC is at $13.72/ share. An investor believes in the upside and buys in the money (say in the money by about $5) call options. The investor buys 10 Calls Aug 09 strike price $9 for 5.00/ share. Initial investment for 10 calls is $5000. Now if the stock price increases to $18 (price increased by $4.28) in early August, price of these calls will now be about $8.70. This future estimated value of the call is based on the call price close to strike price of $4.72 (original strike price $9- $4.28 (stock price increased by). Let me tabulate these transactions to show you how to execute the rising floor method.
After selling the 10 Aug 09 calls, in the rising floor method the investor should again invest the profits (same number of calls) or the sales proceeds (more number of calls) with strike price of 13 (about 5 dollars in the money compared to then current price of $18). A conservative investor can remove the initial investment ($5000 in the above case) and only invest the profits. Using this method an investor can take advantage of the uptrend in the stock price till the point where the investor feels that the stock price has reached its peak and is showing some signs of reversal. It’s recommended to use options about 2 to 3 months or more out in the future to avoid any near term stock fluctuations. Similar method can be applied while buying put options which can be called as falling floor method. The calculations shown above do not include brokerage commissions which will also influence your profit or losses.
I personally believe that such planned investments will produce more repeatable and reproducible results than just speculation. You can get lucky once or twice but bringing in results most of the times requires a strategy.
Play safe!
I personally believe that such planned investments will produce more repeatable and reproducible results than just speculation. You can get lucky once or twice but bringing in results most of the times requires a strategy.
Play safe!
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