Out of the Money Options – Stock Option trading strategy

Option trading is not something you want to do if you just started out in the stock market. But when used properly, options allow investors to gain better control over the risks and rewards depending on their forecast for the stock. No matter if your forecast is bullish, bearish or neutral there’s an option trading strategy that can be profitable if your outlook is correct.

The temptation to violate this advice will probably be strong from time to time. Don’t do it. You must make your plan and then stick with it. Far too many traders set up a plan and then, as soon as the trade is placed, toss the plan to follow their emotions.

The long call will profit from the stock price rising, all else held equal. The position will lose as the stock price moves down, but that loss is capped at the price paid for the position. Because implied volatility is a significant part of the premium paid for an option, if implied volatility goes down, the long call will lose value, and if implied volatility goes up, it will gain. This is only the case before expiration, because at expiration profit and loss is fixed. Time is against you with a long call, so every day you are losing value from time decay.

Individual stocks can be quite volatile. For example, if there is major unforeseen news in one particular company, it might well rock the stock for a few days. On the other hand, even serious turmoil in a major company that’s part of the S&P 500 probably wouldn’t cause that index to fluctuate very much.

Early assignment is one of those truly emotional, often irrational market events. There’s often no rhyme or reason to when it happens. It sometimes just happens, even when the marketplace is signaling that it’s a less-than-brilliant maneuver. It usually only makes sense to exercise your call early if a dividend is pending. But it’s trickier than that, because human beings don’t always behave rationally.

Not surprisingly, though, these options are cheap for a reason. When you buy an OTM “cheap” option, they don’t automatically increase just because the stock moves in the right direction. The price is relative to the probability of the stock actually reaching (and going beyond) the strike price. If the move is close to expiration and it’s not enough to reach the strike, the probability of the stock continuing the move in the now shortened timeframe is low. Therefore, the price of the option will reflect that probability.

You think XYZ stock is going to go up in the near future. You don’t really want to tie up all the capital necessary to profit, and you don’t want to pay margin rates. But you still want leverage. As one top hedge fund manager said, “the only way most people really do well in the markets is to be long and leveraged”. Buying calls is the best way to be “long and leveraged”.

As a result of this combination of lower cost and greater leverage it is quite common for traders to prefer to purchase out-of-the-money options rather than at- or in-the-moneys.

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