Evaluation metrics

• Identifying your time objective

• Your reward-to-risk ratio

• Planning your exit

Choosing a Strike Price

Once you have identified a stock that is poised for a strong

upside move, you must decide what strike price you intend to use.

For any given stock that offers options trading, you can purchase call options with strike prices that range from deep in-the-money

65 to highly out-of-the-money. The strike price you pick will go a long

way to identifying whether your options trade is very aggressive or more conservative. Because the strike price can have a large impact on the profitability level of your trade, you should develop trading rules that dictate your approach.

Purchasing in-the-money call options is a conservative approach to options trading because of the intrinsic value of these contracts.

Intrinsic value, or the difference between the current price of the stock and the strike price of your call option, can act as a buffer to minimize some of the loss you will deal with if the stock moves against you. Of course, in order to take advantage of this feature, you have to pay more money. In-the-money options are more expensive than out-of-the-money options. This higher cost also means that if the stock moves the way you want, your profit will be smaller as a percentage of your initial investment. In-the-money call options are considered more conservative, then, because they aren’t as volatile; the leverage they provide in a given trade is less than what you can get from out-of-the-money options.

Out-of-the-money options provide a higher degree of leverage than in-the-money contracts primarily because of the fact that they are cheaper. An out-of-the-money call option has no intrinsic value because the strike price is higher than the current price of the stock;

in order to have intrinsic value, the stock must rise in price past the option’s strike price. The further away from the current stock price the strike price is, the smaller the chance that the stock will rise past it, which is why out-of-the-money call options are so cheap.

Your trading rules must reflect your attitude about risk and the efforts you intend to make to minimize that risk. As they relate to an option’s strike price, you need to find a balance between cost, risk, and opportunity. There isn’t a single best way to determine where that balance lies. Some traders will always purchase the first in-the-money call option on any trade they make, while others might prefer the at-the-money call, regardless of whether it is actually in or out-of-the-money. Still others will stick to purchasing the first out-of-the-money contract in an effort to maximize their opportunity.

Defining your approach will probably take some experimentation.

You will have to make a few options trades each with in, at, and out-of-the-money contracts before you develop a sense for the approach you prefer and that works best for you. Make sure you

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try a few trades with each type of strike price so that your attitude isn’t unduly influenced by the success or failure of a single trade.

Taking a losing trade with an out-of-the-money contract, for

example, probably won’t be enough to determine if that approach is wrong for you. You will have a better idea of what works best if you have winning and losing trades in each approach so you can make a proper comparison among them.

Using the delta value of an options chain is one way that you can get a good sense for how much leverage an option has, as well as the concurrent risk. This can be a good guide to follow for identifying the type of strike price you prefer. Look at Figure 3.2.

Figure 3.2

Suppose you had a signal to buy AAPL today, which is why you’re considering buying a call option on the stock. The stock last traded at $147.53, which means that every contract with a strike price below that level would be considered in-the-money. The $140 strike price, for example, is the closest in-the-money call to the current price of the stock. Every strike price above $147.53 and higher is out-of-the-money.

Many conservative options traders like to look for options that carry a delta value as close to 1.00 as possible. In this event, the $100 call offers a delta value of .99, meaning that for every dollar AAPL moves, the $100 call will also go up in value by nearly a dollar.

Does this mean that this is the option you should use? Maybe, but first a little more evaluation is in order before you decide. Look at

67 the Last column in the table. This is the last trading price for the

option you are considering and will give you a good idea of how much the option will cost you. The $100 strike price will cost you approximately $48.15 per share, or $4,815 in total capital. A $1 increase in this option will give you a return of just over 2%.

By the same token, the $120 call option offers a delta value of .90, which is about .9 short of the delta offered by the $100 call, yet it last traded at $29.10. A $1 move in the stock would move the option

$.90, this option would yield a return of close to 3% on your $2,910 investment. In this case, the differences are not that dramatic.

However, this sometimes is a very valuable drill especially when dealing with options one and two strike prices in-the-money.

Evaluating the out-of-the-money call options works the same way.

The $150 call option, which is the first out-of-the-money call option available, carries a delta of .48 against a current price of around

$8.70, giving you a potential return of 5.5% if the stock moves higher by $1. The $155 call is even cheaper, going for only $6.60, while its delta of .4061 provides a return of 6.1% if the stock moves up by $1. Of course, this option is much further out-of-the money than the others.

Many traders new to options make the mistake of picking out-of-the-money contracts because of the enticing combination of lower cost with higher potential returns. Why is this a mistake? As a society, we are used to trying to get the best possible deal we can on any purchase we make. We want more features and benefits for every dollar we spend, and when we can get them for a cheap price, we pat ourselves on the back for finding a good deal. The problem with this mentality in options trading is that cheaper options mean higher risk. The contracts in Figure 3.2 expire in just over one month. With the stock currently just below $148, what is the likelihood the stock will rise above $150 in just over one month?

In the case of Apple, it could happen tomorrow but you also run the risk that Apple will choose to rest the next two months and the considerable money you’ve spent buying out-of-the-money options will make a large flushing sound as it goes in the toilet. You will find that it is usually worth the extra money required to buy options that are closer to the current price of the stock.

The decision of whether you should go in-the-money or out-of-the-money lies solely with you. Using the delta can help you try to find

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the best mix of risk and reward for your temperament, needs, and trading style, but you will still need to prove your decision out over time by applying it to your trades and evaluating the results.