Author: Chris Hood
Be sure to check out new episodes of my video podcast each week, where my ace pupil Brian Jones and I talk the ins and outs of options trading- and give you insights and strategy that you can immediately put to work for you in the markets.
Everyone loves saving money.
Just think of how exciting it is to walk into a store or log onto your favorite site and see that stereo system you’ve been eyeing for 20% off this week.
The universe just gave you an opportunity. Take advantage of it.
But imagine if you that same super-popular system was on sale for 20% more.
You get to pay $1200.00 rather than the regular $1000.00.
What? That’s ridiculous. Why would you buy it?
Of course, you shouldn’t, yet that’s one of the critical mistakes novice options traders make. Paying too much for their long calls or bull call spreads.
It’s an issue of poor timing or chasing a trade.
Before we discuss the guidelines for selecting long options, we need to look closely at what goes into an options price.
I’ve said this before, but it bears repeating.
Options are not stocks.
Though they’re based on underlying equities, and the share price is a vital component of the value, it isn’t the only factor.
Options have both intrinsic and extrinsic values.
Intrinsic value is simply the difference between the strike price and the stock price.
So, if you buy an Oct 21st, 2021 310 call option on FB, which is currently trading at 354.34, then the intrinsic value of that option is $44.34.
Stock Price – Strike Price = Intrinsic Value
So, 354.34 – 310.00 = 44.34
That part is relatively simple to grasp for most people – if you can exercise your contract to buy a stock for less than it’s currently worth, it has value.
The option’s extrinsic value is a bit tricker.
Extrinsic value is based on time and volatility. The further away from the expiration date and the higher the implied volatility (IV) of the stock, the more expensive the option.
Pay close attention to both when you purchase options.
Don’t buy extremely long-dated options to capitalize on short-term moves; otherwise, you’ll pay for time you don’t need.
Always match the expiration to the time frame of the trade.
Similarly, it’s best to buy during periods of low volatility.
A helpful guideline is to buy when IV is below 0.50. If the volatility is higher, you’d be better served using a bullish selling strategy like a put credit spread.
Pullbacks to key moving averages or other support areas during a strong uptrend allow you to get your calls cheap.
This is why it’s important to get into the trade BEFORE the big move.
After the run-up begins, call prices swell, and chasing gains will leave you missing out on the profits. So you’ll be buying in just as smart traders are getting out.
An excellent tool provided by Think or Swim (and most other professional platforms) is the ability to display the intrinsic and extrinsic values on the options chain.
All you need to do is customize the layout.
When in doubt about whether or not to buy, use this simple rule of thumb:
If the option’s extrinsic value exceeds 30% of the total option price, it’s too pricey.
Wait for a better entry.
Over the past couple of days, AMZN has made a couple of big moves up.
Now is not the time to get into the trade out of FOMO. Instead, keep it on your watchlist and wait for the inevitable pullback.
Don’t buy your stereo system at the 20% more sale.
Wait for the sale that makes sense, and watch your profits grow.