Buying Only Out-Of-The-Money Options : Common Option Trading Mistake

Many trader try to make quick money by buying cheap out of the money options, if they have a directional bias on the stock/UL.

Although it may sound lucrative to be able to ‘control’ 100 stocks by paying a tiny premium, but generally speaking, it’s an illusion. It might works in short term for few trades but when it comes to consistency in long term, this approach might not give you very fruitful results.

Time decay is the one factor that can potentially hurt all option buyers. Keep in mind that ATM (at-the-money) and OTM (out-of-the-money) options are entirely comprised of time premium. Every option completely lose its time value by expiration. When you buy an OTM, the stock/underlying security must move in your favor quickly and far enough to be in-the-money by the time of option expiration, otherwise you lose 100% of your investment.

In short, OTM option is a ticking bomb, losing it’s value day by day because of time decay.

Let’s take an example..

XYZ stock currently trading at $50 per share would have to invest $5,000
to buy 100 stocks. Alternatively, you can buy the 55 call option for $100, means getting leverage of 50-to-1.

This sounds cool but remember that you only has about a 1 in 5 chance (because of 20 delta) of making money on the trade. Another choice would be to reduce the
amount of leverage while greatly increasing the probability of making money. Instead of that, if you buy 50 call option for say $500, you still get leverage of about 10-to-1. And now your breakeven is 55 (not 61, as it was in case of buying OTM). So once the stock rises above $55, you would make a dollar for dollar profit with the stock upmove.

 

Please note that the purpose of this discussion is not to say that you should never “take a shot” in option trading by buying a cheap out-of-the-money option. The purpose is to point out that if this approach makes up the bulk of your trading activity, the chances are higher that you will lose money in the long run because probability is not in your favor.

 

So odds are batter in case of ATM options than OTM but most savvy option trader are ‘net sellers’! Being a ‘net seller’ gives you an edge! You have time is your favor and you have batter control on the positions.

 

If you are interested in learning various ‘net selling’ options strategies via live 1-2-1 sessions, please contact us – info@bullishoption.com/*54745756836*/

Abhi is a Certified Equity Market Analyst (CEMA) from NSE Academy
He is an investment banking professional, based in London, UK.
He has worked as IT Consultant with several investment banks like Bank of America, CA CIB, Barclays, RBS, UBS focused on trading platforms on derivatives and fixed income products...
He has over 10 years of experience of trading and investing in financial markets including FX, Equity and Options.
He loves learning and he loves teaching!!
Key Skills: Stock/Options Trading, IT QA/BA/Banking experience.

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