Should Options Traders Be Trading Out of the Money?
In options, you have the choice to trade at levels where price is now (at the money), where price remains passed the strike price, and where you think price will not move to (out of the money). Trading options at each of these three levels will produce a very different options trading strategy, with different risk and reward profiles. With so many strategies at your fingertips when you trade options, you may be wondering what is the best strategy to choose?
The answer to this question lies in your comfort with risk, and more specifically the amount of risk (Read: 3 Myths About Risk) you want to take on and how consistent your want your trading results to be. Trading at, in or out of the money will determine the likelihood of success when you place a trade, especially out of the money. While some traders may feel a sense of comfort buying cheaper out of the money options, because the initial cost of the contracts is low, the actual risk of the trade is higher due to the fact that these trades have a lower probability of being profitable.
Ways To Trade Out of the Money
Someone who is trading options at strikes that are out of the money are trading them with two general set ups, either buying or selling them. When an options trader buys an option out of the money, he or she is looking for the trade to reach or pass the option strike that she or he purchased. When the option moves from out of the money (an option without value) to an option that has value (an option in or at the money) the profit will change significantly. Trades will typically see large wins when the option moves from out of the money, to in the money. However, the odds of success of these trades are low as these options are cheap for a reason, it isn’t a likely trade to work in your favor.
If buying has a low probability of success, then the opposite side of the trade will have a high probability of success. Selling options out of the money is probably the most talked about trading strategy for out of the money options. (Watch A Video on Call Credit Spreads Here and Put Credit Spreads Here) Instead of needing the stock to move well beyond where it currently is trading, when you sell the option you need price to remain where it is or only move slightly. Instead of having to guess precisely where price needs to move, as a trader you are able to profit from where price does not go, which is a much larger zone of potential profit. If you ask yourself why do most of my long puts and calls lose money, remember that the trader with the short side of that trade is profiting each time.
Are Options out of the money, worth the risk?
When you choose to buy an option that is considered ‘out of the money’ you are basically buying a low probability trade, but you aren’t risking as much money compared to when you trade at the money or in the money. Trading cheap options can sound appealing at the beginning but it is something to make sure you are fully understanding before you buy. Sure, spending $0.30 per contract sounds like a small amount of money, but if the probability of success of your trade is very low, you may be throwing away your money more often than you realise. You might take the trade a few times before you get a winner. The lower the delta, the less expensive the option is and really the less likely the trade will have value by the time it expires. Now we aren’t going to get in to specific pricing models of options in this article, but I do want to stress that, just as the saying goes, if something looks too good to be true, it probably is…so the next time you find what you think is a smoking deal to purchase an option that is really cheap and way out of the money….consider why it is priced so cheaply in the first place. Perhaps we can find a better way to trade those options.
Options are usually priced fairly
The reality is that options are usually priced fairly, there may be a needle in the haystack so to speak occasionally, but if you are looking at a large sample of trades the pricing of puts and calls become a fairly reliable indicator of price movement, not to say that every week at expiry this will be the case but over many stocks and many weeks the market will prove to be correct more often that not. Why do most traders think the market is wrong and bet against it using out of the money puts and calls, this seems like a sure way to lose money. Thoughts of turning a $0.30 option in to a $2.00 option is the siren song that lures traders. Just like selling options is taking a bet that the market is fairly priced and will move with in the bounds set by supply and demand. Try trading with the market and not trying to outguess it, trade where you see other traders trading and pay attention to what the options chain is telling you about the possible direction of the market. For me personally I’d rather have a series of small winning trades then many losing trades in hope of hitting it big once and a while.
Keep these considerations in focus next time you see that out of the money out or call that looks too good to be true. Information like delta, open interest and pricing of puts and calls on the options chain can help you develop an overall picture of the market and help you make better trading decisions. If you are making money trading out of the money puts and calls then keep on with that strategy, but if you find that you are continually losing money on the long side of the market, then take a look at the short side and see if you can use selling out of the money to your advantage. Don’t keep repeating the same trades in hope of things eventually working, they probably won’t.
Return to Blog