- 1 The Insider’s Guide to Cheap Options Are Expensive
- 1.1 Trader Lured to the Out of Money Options
- 1.2 Not Understanding Probabilities about Option Trading
- 1.3 Not understanding the Delta of an Option
- 1.4 Neglecting the Importance of Time Frames
- 1.5 Gambling with OTM Options
- 1.6 Nervous about Unlimited Losses
- 1.7 Gamma Positive for Option Buyers
- 1.8 Conclusion: What Experts Are Saying About Cheap Options Are Expensive
The Insider’s Guide to Cheap Options Are Expensive
You must have started your options trading with buying cheap Out Of The Money Options.
So did I.
And you would have kept looking at the option going down gradually.
Most first-time Option Trader who comes to me I ask them what kind of equities you buy. Most prefer buying cheap stock of stock priced below Rs. 50 since they are cheap.
This shows that most investors are nervous or fearful of paying a high stock price.
Something that strikingly attracts options trader is unlimed profit and limited loss.
This includes stock options as well as index options.
Trader Lured to the Out of Money Options
The Moment we Look at the Option Chain Out Of the Money Options is in plain white color.
The last traded price is also very small when compared to In The Money Options.
Another important aspect to notice is that the Open Interest and Volumes are also High.
Not Understanding Probabilities about Option Trading
The probability of an Out of Money Option ending In The Money is very important.
Since we are option buyers we expect the Out The Money to end In The Money.
Only then we gain from the transaction.
Understanding the Probabilities will help us to take the right decision. It also gives us the understanding of what are the chances that we can make money from the buying call or put options.
Probabilities of the Option vary according to the strike price of the options. Probabilities are not the same across all the strike prices. And for options especially the probabilities change over a period of time. This is because the options are decaying in value over a period of time.
Not understanding the Delta of an Option
Delta of the Option gives the idea of the movement of the underlying and how much it will affect the option price.
Call Option might not rise in price even though the underlying is moving up.
This phenomenon can be understood with the value Delta and Implied Volatility.
- Delta for In The Money is 1.
- Delta for Out of Money is .10
- Delta for At The Money is .50.
Neglecting the Importance of Time Frames
Gambling with OTM Options
Most of the Option Speculators buy Out Of Money options in various underlying expecting at least any one of giving your positive return.
The returns might be positive for gamblers when the entire set of OTM is highly volatile.
This will go against them when the volatility is very low.
Options keep eroding in value. Gambling with Out of Money long options option with your entire capital could see depleting over a period of time.
Nervous about Unlimited Losses
Most of the Traders are very nervous to trade with unlimited losses.
It is more of psychological reason than valuation sense. This is similar to investor buying a low priced stock thinking it will go up and give them good returns compared to high priced stock. The confidence they have is that low price stock has the opportunity to go up higher faster than high price stocks.
Gamma Positive for Option Buyers
This is a positive thing for Options Buyers.
Its benefit is limited only during the period of Volatility. In the absence of volatility, the option value keeps deteriorating and this brings down the probability of making a profit from the position.
To predict gamma advantage is very tough.
Conclusion: What Experts Are Saying About Cheap Options Are Expensive
Sudden Volatility could give an unexpected high return in short term.
But this is not the right strategy for consistent returns over a long period of time.
Make small tweaks in your current strategy.
This might not give your high profits but will definitely save you from losing your capital.
In stock trading and investing, capital preservation is the key to success.
Come back here and tell us about the before-and-after. I bet you’ll have something to say!
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