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Cheap Options are Expensive

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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.

When I ask the New Option Traders. Most of them tell they are comfortable with Buying Cheap options.
The reason for being comfortable with cheap options is that unlimited profit and limited loss. This is the most important thing that draws most of the option traders. There is a saying which goes like in trading and investing what is comfortable is hardly profitable.
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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.

NSE India Option Chain Nifty Index AlphaTrading

This is another confirming reason that the Out Of Money Options traders think that cheap options are better.
What they fail to understand is that most of the professional traders carry out Spreads.
Spread is buying and selling of the same expiry and different strike prices to gain from the difference in premiums.

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

Alphatrading Right Time Frame in Option Strategy is as Important as Strategy Itself
Selecting the wrong time frame can prove your strategy to be wrong.
Usually, I have seen that Out of Money options perform positively when it is 20 – 30 days to expiry(DTE).
As the time comes close to the expiry dates the same options start making losses.
Selecting wrong time to buy the options can work against your strategy. But since Gamma is positive for the long options it can work in your favor. Positive Gamma can give amazing returns if does properly.

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.

Once the traders have an understanding that the Options are hedging tools and they experience and implement options spreads that would be a positive note for their trading activity.
The way unlimited profit is in theory same way is the unlimited loss.
This is especially true for short call option since the maximum a stock price can go is Rs. 0.

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.

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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!

If you enjoyed this post, I’d be very grateful if you’d help it spread by emailing it to a friend or sharing it on Twitter or Facebook. Thank you!

 

 

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