Why Cheaper Isn’t Always Better

Nowadays, if you want to trade options, there are many selections to choose. This is especially true for highly liquid options.

For example, there are weekly options available for Cisco (NSDQ: CSCO) through mid-April, and February contracts are available for strike prices ranging from $35 to $60.

More and More Choices

As you move forward in time, weekly contracts will become available when you are about 60 days away. So in March, there will be May weekly options available. Additionally, available strike prices will also become available in smaller increments.

For instance, June CSCO calls and puts are now available only in $2.50 strike price increments, but February and March contracts offer them in $0.50 increments. In other words, for June options the next available strike price after $45 is $47.50. But for February and March options, you can find strike prices of $45, $45.50, $46, $46.50, etc.

That’s a wide variety of options contracts! It’s therefore understandable if beginner options traders feel overwhelmed.

To be a successful options trader, you need to cut through the noise and find the options contracts that give you the best chance to make money for the least amount of risk.

Low Price: Not Always Good Value

One common mistake to avoid is thinking that cheaper is always better.

Who doesn’t want to buy low and sell high? But the harsh reality is that the market isn’t stupid. An asset is cheap for a reason. Sometimes if you buy low, you could end up selling even lower.

Since an option has an expiration date, there’s even greater urgency to make the right decision. There’s a limited amount of time for the option price to make its move. If it fails to move into the money, an option contract will expire worthless.

If you are long an option, you don’t want that to happen. On the other hand, if you are short an option (i.e., you wrote, or sold, an option) you want the option to just expire.

You Get What You Paid For

Other things being equal, options that are very much in the money and have a long time to go before expiration will be priced higher than those that are out of the money and have little time until expiration.

As an example, let’s say you buy an option that is 20% out of the money and expires in two weeks. Even if you only pay $0.05, chances are it will expire worthless and you incur a 100% loss. After all, the option is priced at virtually nothing because there’s a very slim chance that the stock will move enough in two weeks to move the option into the money.

Of course, it could happen. A major unexpected event (e.g., an out-of-the-blue sudden takeover announcement or a surprisingly good or bad quarterly earnings report) could cause a huge jump or drop and result in a big win. This is why certain traders will buy way out-of-the-money calls or puts around quarterly earnings events to try to catch lightning in a bottle.

As long as you realize the long odds and understand that you will probably lose 100% in the trade, there’s no problem with making these speculative bets. After all, you wouldn’t be risking very much and you could stand to make big percentage gains.

The key is to know what you are getting into and not assume that just because an option is cheap it’s automatically a great deal.

Perspective From the Short Side

On the other hand, if you are on the short side of the option trade, you don’t necessarily want to sell the highest-priced option because the odds favor the option being exercised.

As an option seller, the ideal scenario is for the option to expire, but you also don’t want to sell options that have an extremely low chance of being in the money because you won’t get enough in premium to make it worth your time. Thus, it makes sense to find a balance between getting a nice premium and having a small chance of the option getting exercised.

Selling options can result in a steady stream of income, but if the options are exercised, you will be forced to sell (if you have a call) or buy (if you have a put) the stock. In that scenario, it’s possible to incur a big loss on the trade. Conservative option strategies are to sell calls against stocks you already have or to sell cash-secured puts on stocks that you like anyway.

The bottom line: Don’t take options prices at face value. Study the underlying stock and analyze the risk and reward of the available options choices.

Editor’s Note: Our colleague Scott Chan just provided you with valuable insights into profitable trading. But other members of the Investing Daily team can help you make smart investing decisions, too.

Consider Jim Pearce, chief investment strategist of our flagship publication, Personal Finance. Jim has a stellar track record at picking profitable investments. These days, he’s setting his sights on the so-called Streaming Wars.

As consolidation and rapid technological change revolutionize the media industry, many investors are asking: What replaces cable TV? What comes after “cord-cutting”? And more to the point, how can they get rich from it? Those are all good questions and Jim has made it his job to answer them.

“The Streaming Wars” are more than just a quadrillion-dollar battle between giant media corporations. They’re also an historic opportunity to make money. Want to leverage these trends for market-beating profits? Jim has pinpointed a hidden trade that’s poised to reap a windfall. Click here now for details.