Note: Don’t forget to go here to automatically add your name to Jeff Brown’s guest list for his urgent “Project MAFA” briefing.
Tomorrow evening, he’s getting into all the details of President Trump’s new initiative that Jeff believes could return America to a “new” gold standard… smash our debt… and unlock a Golden Century.
Jeff’s even sharing one of his top picks to profit as Project MAFA plays out… That’s happening this Wednesday, July 16, at 8 p.m. ET. Just go here to sign up with one click.
There are plenty of concepts to get your head around when starting out with options.
One of those relates to “breakeven.” It’s the level a stock needs to be trading at before you break even on an option trade.
Take, for example, you’re buying a call option (it benefits from a rising stock price). If you pay $10 for a call option with a strike or exercise price of $100, then the stock needs to get to $110 by expiration for you to break even on the trade…
That’s the option’s strike price ($100) plus what you need to recoup the cost of the option ($10).
But while this might all seem pretty straightforward in theory, the truth is that option buyers rarely hold options through until expiration. This gives them greater flexibility in which option they choose.
So today, let’s dive into some of the other factors I consider before choosing which option to buy…
Misconceptions Around Options
One of the reasons I’m so passionate about options is that they enable me to tightly control my risk.
When I buy options, my risk is clearly defined. The most money I can lose is the premium I paid. That’s why I consider them such a valuable tool to retail traders.
But while my risk is capped when buying options, it might be more than I’m prepared to lose. An option contract is for 100 shares. So, if I bought an option contract at $10, following our example above, I run the risk of losing $1,000 if my trade doesn’t go as planned.
And that’s way more than I’m typically prepared to lose…
So, to get my risk back to my preferred level of around $3, or $300 per option contract, I need to buy options with a higher strike price – where the call option’s strike price is further away from or higher than the market price.
So, instead of buying the $100 call option, I might buy a call option with a strike price of $130.
Now, if I had to ride that through until expiration, then that would likely drastically reduce my chance of hitting breakeven. In this trade, that would be $130 (strike price) plus the cost of the option ($3).
But here’s the thing…
Picking a particular strike price doesn’t necessarily mean you’re aiming for the stock price to get there. And your trade’s success isn’t dependent on reaching it.
|
Tune in to Trading With Larry Live
Each week, Market Wizard Larry Benedict goes live to share his thoughts on what’s impacting the markets. Whether you’re a novice or expert trader, you won’t want to miss Larry’s insights and analysis. Even better, it’s free to watch. Simply visit us on YouTube at 8:30 a.m. ET, Monday through Thursday, to catch the latest. |
Other Factors at Play
There are a number of key factors that drive an option’s value – the primary one being the underlying stock price.
If the stock price rallies, all call options typically go up in value. But not at the same rate…
The higher the option’s strike price, the less sensitive it is to that underlying move. But you can still trade these options for profit.
Another major factor is volatility.
When volatility picks up, it increases the value of option premiums. That’s to compensate the option writer who sold you the call option for the extra risk they’re taking on. That is, they have a higher chance of being exercised.
A ramp-up in volatility typically affects all options valuations – though again, not all equally. But even an option with a higher strike price than the current market price will still benefit when volatility rises.
So even if we buy a cheaper (but higher strike price) option, we can still turn a tidy profit. The goal is to capture an up move in a stock along with an increase in volatility.
And if we get that right and close our trade out for a profit, we don’t need to concern ourselves with where the stock is trading at expiration. By then, we’re already well out of the trade.
So when you next consider buying an option, be clear about your ultimate goal. If it’s to capture a move in the underlying stock (and an increase in volatility) and exit for a profit, then you don’t need to worry about where the stock’s trading at expiration…
Even an option a long way from the current price action can be highly profitable if you catch the right move.
The trick, as always, is to find the right balance between risk and reward…
Determining what you’re prepared to pay – and potentially lose – for the option against the likelihood of profiting (and the size of that profit) from your trade.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
|
Free Trading Resources Have you checked out Larry’s free trading resources on his website? It contains a full trading glossary to help kickstart your trading career – at zero cost to you. Just click here to check it out. |