Trading Low-Priced Options

 

The Dos & Don'ts

One of the most discouraging mistakes a beginner can make is to confuse a "cheap" option with a low-priced option. As with most things in life, "inexpensive" is not necessarily synonymous with "value" in the world of options trading. To learn how you can get the most bang for your options buck -- without going bust -- read on for our insider tips.

 

DO target smaller stocks with the potential for big gains. It's easy to get caught up in the excitement surrounding big-name, high-dollar stocks like Apple (AAPL), Google (GOOG), and Amazon.com (AMZN). These names are in the news a lot, since their earnings reports and product launches tend to attract a lot of coverage from the media. While there's certainly a time and a place for a well-timed options play on these corporate titans, it's important to remember that high-priced stocks typically generate lower percentage returns than their lower-priced counterparts.

 

Think of it this way: A stock trading at $10 per share needs to rise only 10 points to double in value. A stock trading at $500, meanwhile, needs to gain another 500 points to double. Generally speaking, that 10-point move is much more easily achievable -- and much likelier to occur within the time frame of a typical options trade.

 

DON'T be tempted by the cheapest option available. This is a trap that many novice options traders have stumbled into. At first, it may seem appealing to "reduce" your risk by playing very short-term, out-of-the-money options, which offer a lower cost of entry compared to longer-term, in-the-money alternatives. However, bear in mind that you're actually increasing your risk of incurring a 100% loss with this approach, since the "cheapest" options are those that have the least probability of finishing in the money at expiration.

 

DO buy higher-delta options. Instead of gravitating toward "cheap" calls and puts, seek out those with relatively higher chances of expiring in the money. You can compare those odds by examining an option's delta. The closer the delta is to 1.00 (for a call, or negative 1.00 for a put), the likelier it is that the option will retain some intrinsic value at expiration -- thereby offering you some insurance against the possibility of a total loss. As an added bonus, higher-delta options behave more like the underlying stock, which means they'll gain value quickly as the stock moves.

 

DON'T short-change yourself on time. The selection of the proper time frame for your trade is just as crucial as picking the appropriate strike. Again, it often comes down to a matter of investing a little more capital up front in exchange for potentially greater rewards down the road. An option with six months of shelf life will command a higher premium than a front-month contract, but that's because the longer-term bet offers more time for the shares to move as you expect. It's important to remember that stocks don't move in straight up-and-down paths. For example, there will be periods of consolidation, or "backing and filling," within broader uptrends. By purchasing a healthy amount of time value at the outset, you've lessened the chances that your option will expire before the predicted price swing has a chance to play out.

 

DO trade stocks with a favorable sentiment backdrop. At Schaeffer's, we use sentiment analysis to determine whether a stock's current trend is likely to continue. When shares are moving higher, we prefer to see this positive price action occur against a backdrop of elevated short interest, skeptically skewed analyst ratings, and put-heavy option activity. In our view, these bears represent future buyers, as they're likely to throw in the towel and unwind their losing bets as the stock's rise continues. However, widespread optimism toward a strong stock may signal that nearly everyone has bought into the trend already, which could mean it's a less-than-opportune time to bet on a continuation of the uptrend. Conversely, we prefer to see optimism levied against a struggling stock, as it means that there are still some lingering bulls who have yet to capitulate to the downtrend. However, once sentiment turns unanimously negative on a downtrending security, it could mean the ultimate bottom is within sight.

Understanding Leverage

Just as lower-priced stocks are likelier to reap big percentage gains than their higher-priced counterparts, options are more likely than stocks to deliver big winners for investors. That's because each option costs only a fraction of the underlying asset from which it derives its value. In other words, options allow you to amplify your potential investing returns by minimizing the amount of capital you commit to the trade upfront -- a benefit known as leverage.

 

It works like this: Stock XYZ is trading at $25 per share, which means it would cost $2,500 to buy 100 shares. On the other hand, a front-month 25-strike call option is asked at just $0.65. Since each contract is based on 100 shares of stock, it would cost $65 (0.65 premium x 100 shares per contract) to purchase one of these at-the-money call options.

 

If XYZ then rallies to $30 per share at expiration, the 100-share stake would be worth $3,000. Subtracting the initial investment of $2,500, the profit on the stock trade would be $500 -- or 20%.

 

On the other hand, the 25-strike call would carry five points of intrinsic value, which means it could be sold to close for $500 (5 points of intrinsic value x 100 shares per contract). Accounting for the initial cash outlay of $65, the profit on this options trade would be $435 -- or 669%.

 

So, while the options trade returned a smaller cash profit, the percentage gain was many times greater than the straightforward stock play. What's more, the total dollars at risk were $2,500 in the stock strategy, compared to the maximum possible loss of only $65 on the option.

 

And, as noted, lower-priced stocks are already more likely to reap big percentage wins than their higher-priced peers over comparable time frames. By purchasing options on these under-the-radar names, the profit power of leverage is effectively magnified.

Putting it into action with Schaeffer's Options Under $5

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