The Dangerous Lure Of Cheap Out-Of-The-Money Options

By Jay Kaeppel AAA

It is often said that the financial markets are driven by two human emotions: fear and greed. And there is a great deal of truth to this thought. While investors and traders often make calm, rational, well thought out decisions and then act on those decisions in the marketplace, what really gets the markets moving is a good solid dose of fear and/or greed. When an investor acts out of fear or greed, there is a level of aggressive motivation attached to it that – when done en masse – can push a market sharply higher or lower, as the case may be. (Take advantage of stock movements by getting to know these derivatives. For more information, check out Understanding Option Pricing.)

Nowhere is this manifestation of human emotion more prevalent than in the options market. Thanks to the (relatively) low cost of entry when considering many trades, individuals often flock to the option market to attempt to take advantage of a particular market opinion. And the good news for those who do so is that, if they are in fact correct about their opinion, they do stand the chance of achieving outsized returns. However, human nature – and the lure of easy money – being what it is, it is quite common for traders to "overreach" by applying maximum leverage to a speculative position. Failure often results when key variables, such as profit probability and option premium time decay, are not carefully considered.

The result of this overreach is often a situation whereby an individual may be correct about the direction of price movement, yet still end up losing money on a given trade. While this is not the end of the world if a trader is risking only a reasonable amount of capital on each individual trade, there still can be a psychological impact that can affect a traders' psyche for many trades to come. This is the real long-term danger. (These options are known as long-term equity anticipation securities (LEAPs) options. Read on to learn more about these options in Rolling LEAP Options.)

Why are Traders Lured to the Out-of-the-Money Option?
A call option is considered to be "out-of-the-money" if the strike price for the option is above the current price of the underlying security. For example, if a stock is trading at $22.50 a share, then the $25 strike price call option is currently "out-of-the-money."

A put option is considered to be "out-of-the-money" if the strike price for the option is below the current price of the underlying security. For example, if a stock is trading at a price of $22.50 a share, then the $20 strike price put option is "out-of-the-money."

The lure of out-of-the-money options is that they are less expensive than at-the-money or in-the-money options. This is simply a function of the fact that there is a lower probability that the stock will exceed the strike price for the out-of-the-money option. Likewise, for the same reason, out-of-the-money options for a nearer month will cost less than options for a further-out month. On the positive side, out-of-the-money options also tend to offer great leverage opportunities. In other words, if the underlying stock does move in the anticipated direction, and as the out-of-the-money option gets closer to becoming - and ultimately becomes - an in-the-money option, its price will increase much more on a percentage basis than an in-the-money option would.

As a result of this combination of lower cost and greater leverage it is quite common for traders to prefer to purchase out-of-the-money options rather than at- or in-the-moneys. But as with all things, there is no free lunch, and there are important tradeoffs to be taken into account. To best illustrate this, let's look at a specific example. (Being both short and long has advantages. Find out how to straddle a position to your advantage. Refer to Straddle Strategy A Simple Approach To Market Neutral.)

Buying the Stock
Let's assume that, based on his or her analysis, a trader expects that a given stock will rise over the course of the next several weeks. The stock is trading at $47.20 a share. The most straightforward approach to taking advantage of a potential up move would be to simply buy 100 shares of the stock. This would cost $4,720. For each point the stock goes up, the trader gains $100 and vice versa. The expedited gain or loss for this trade appears in Figure 1.

Figure 1 – Expected profit/loss from buying 100 shares of stock (Source: Optionetics Platinum)

Buying an In-the-Money Option
One alternative would be to purchase an in-the-money call option with a strike price of $45. This option has just 23 days left until expiration, and is trading at a price of $2.80 (or $280). The breakeven price for this trade is $47.80 for the stock ($45 strike price + $2.80 premium paid). At any price above $47.80, this option will gain, point for point, with the stock. If the stock is below $45 a share at the time of option expiration, this option will expire worthless and the full premium amount will be lost.

This clearly illustrates the effect of leverage. Instead of putting up $4,720, the trader puts up just $280, and for this price – and for the next 23 days – if the stock moves up more than 60 cents a share, the option trader will make point for point profit with the stock trader, who is risking significantly more money. The expected gain or loss for this trade appears in Figure 2.

Figure 2 – Expected profit/loss from buying in-the-money option (Source: Optionetics Platinum)

Buying an Out-of-the-Money Option
Another alternative for a trader who is highly confident that the underlying stock is soon to make a meaningful up move would be to buy the out-of-the-money call option with a strike price of $50. Because the strike price for this option is almost three dollars above the price of the stock with only 23 day left until expiration, this option trades at just 35 cents (or $35), to purchase one call. A trader could purchase eight of these 50 strike price calls for the same cost as buying one of the 45 strike price in-the-money calls. By so doing he would have the same dollar risk ($280) as the holder of the 45 strike price call; with the same downside risk (which comes with a higher probability), there is a much larger profit potential. The expected gain or loss for this trade appears in Figure 3.

Figure 3 – Expected profit/loss from buying out-of-the-money option (Source: Optionetics Platinum)

The catch in buying the tempting "cheap" out-of-the-money option is balancing the desire for more leverage with the reality of simple probabilities. The breakeven price for the 50 call option is 50.35 (50 strike price plus 0.35 premium paid). This price is 6.6% higher than the current price of the stock. So to put it another way, if the stock does anything less than rally more than 6.6% is the next 23 days, this trade will lose money.

Comparing Potential Risks and Rewards
Figure 4 displays the relevant data for each of the three positions, including the expected profit – in dollars and percent.

-- Stock -- 45 Call -- 50 Call --
Price $47.20 -- $2.80 -- 35 cents --
Quantity 100 -- 1 -- 8 --
Cost $4,720 -- $280 -- $280 --
-- -- -- -- -- -- --
Stock at expiration: Stock $ Profit Stock
% Profit
45 Call $ Profit 45 Call
% Profit
50 Call
$ Profit
50 Call
53 +$580 +12% +$520 +185% +$2,120 +757%
50 +$280 +6% +$220 +70% (-$280) (-100%)
47 (-$20) (0%) (-$80) -29% (-$280) (-100%)
44 (-$320) (-7%) (-$280) (-100%) (-$280) (-100%)
41 (-$620) (-13%) (-$280) (-100%) (-$280) (-100%)
Figure 4 – Position Comparisons

The key thing to note in Figure 4 is the difference in returns if the stock goes to $53 as opposed to if the stock only goes to $50 a share. If in fact the stock rallied to $53 a share by the time of option expiration, the out-of-the-money 50 call would gain a whopping $2,120, or +757%, compared to a $520 profit (or +185%) for the in-the-money 45 call option and +$580, or +12% for the long stock position. And this is all well and good, however, in order for this to occur the stock must advances over 12% in just 23 days. Such a large swing is often unrealistic for a short time period unless a major market or corporate event occurs.

Now consider what happens if the stock closes at $50 a share on the day of option expiration. The trader who bought the 45 call closes out with a profit of $220, or +70%. At the same time, the 50 call expires worthless and the buyer of the 50 call experiences a loss of $280, or 100% of the initial investment - despite the fact that he was correct in his forecast that the stock would rise.

As stated at the outset, it is perfectly acceptable for a speculator to bet on a big expected move. The key however, is to first make sure and understand the unique risks involved in any position and secondly to consider alternatives that might offer a better tradeoff between profitability and probability. (For more related reading, check out Selecting A Hot SPOT Option.)

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