Understanding Your End Goal With Options

One of the first concepts to grasp with options is your “breakeven.” It refers to the level a stock needs to be trading at where you aren’t losing money on your option trade.

For example, say you buy a call option with a $100 strike price for $10. The stock needs to get to $110 for you to break even on the trade.

That’s the option’s strike price ($100) plus enough to recoup the cost of the option ($10).

That seems straightforward in theory. But the reality can get a bit trickier.

So today, let’s check out some of the other factors to consider when choosing which option to buy…

Managing Risk With Options

One of the reasons I’m so passionate about options is that they enable me to tightly control my risk. With options, my risk is clearly defined.

When I buy an option, the most money I can lose is the premium I paid. That’s why I consider them such a valuable tool for retail traders.

Of course, while your risk is capped when you buy an option, the option premium might be more than you really want to lose…

If I bought an option contract at $10, I run the risk of losing $1,000 if my trade doesn’t go as planned. (An option contract is for 100 shares, so you take the option’s cost – $10 – and multiply it by 100 to get what you’ll pay.) That might be more than I’m comfortable losing.

My preferred cost for my trading advisories is usually around $3 (or $300 per option contract). That often means we need to buy call options where the strike price is higher than the current market price.

So instead of buying the $100 call option, I might recommend a call option with a strike price of $130, for example.

In this trade, my breakeven point would be $133 – the $130 strike price plus the cost of the option ($3). Yet the odds of the stock rising that far might not be great.

But here’s the thing…

Just because you pick a particular strike price doesn’t mean that the stock price has to reach that level for your trade to be a success…

Other Factors at Play

Multiple factors drive an option’s value – and granted, the primary one is the underlying stock price.

If the stock price rallies, call options typically go up in value. But the higher the option’s strike price, the less sensitive it is to that underlying move.

However, if you get the stock’s direction right, you can still trade higher-strike options for profit. That’s because another major factor is volatility…

When volatility picks up, it increases the value of option premiums. That compensates the option writer (who sold you the call option) for the extra risk they’re taking on since the option has a higher chance of being exercised.

A ramp-up in volatility typically affects all options’ valuations. Even an option with a higher strike price benefits when volatility rises.

So we can buy a “cheaper” option and still turn a tidy profit. The goal is to capture an up move in the underlying stock along with an increase in volatility.

This gives you greater flexibility in which option you choose. 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 the potential reward.

Happy Trading,

Larry Benedict
Editor, Trading With Larry Benedict