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About Mark Hodge
Expertise
Questions related to technical analysis, strategies, risk, trading plans, trading psychology and money management. Experience in trading all markets and timeframes with expertise in futures (e-minis, currency futures, commodities, European Markets-DAX) and equity options. Unfortunately I am not allowed to offer any specific trading advice (i.e. should I go long the DAX today).
Experience
I have been involved in the industry since 1995 working for Morgan Stanley Dean Witter and American Express Financial Advisors before becoming a full time trader. As Head Education Coach with Rockwell Trading I have coached hundreds of students around the world to achieve their trading goals with simple strategies, a sound trading plan and proper money management for the leveraged markets.
Organizations
Currently serving as Rockwell Trading's Head Education Coach www.rockwelltrading.com and moderator for Rockwell's Day Trading Forum at www.rockwelltrading.com/forum
Education/Credentials
Formerly licensed as a financial advisor with Series 6, 7, and 63 licenses. B.A. in Organizational Communications with a Business Minor from California State University, Sacramento.
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I have worked with institutional traders, brokers, proprietary trading firms and private traders but respect their anonymity.
One of the few distinguished World Cup Advisors www.worldcupadvisors.com
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You are here: Experts > Money > Day Trading > Day Trading > OPTION PREMIUM
Expert: Mark Hodge - 9/17/2008
Question
I am looking @ GS options but the premium is unbelievably expensive.
What is the most prudent way of buying a stock option when the premium is very high?
Is there a “too much” threshold with regards to getting involved with an option purchase?
Joseph Anthony
Answer
Hello Joseph,
It has been a wild week on Wall Street and when uncertainty hits, option premiums typically go up. This is because uncertainty will be priced into an option based on the option's implied volatility. If a stock typically averages a $2 swing and is currently averaging $10 swings, this is going to be priced in. This is why options typically go up even if the stock doesn't before earnings or FDA announcements. If the swings continue and you are right about you analysis, you can still make money. However, one of the biggest option killers is volatility crush. This is when the move you expect happens, but after the move volatility comes down and the option value decreases, and you haven't made money even though the move occured.
(FYI - Options are generally priced higher when the market is going down because of these factors.)
So, what can an options trader do? Well there are a few options (no pun intended), but the three easiest things to do are as follows:
1) Buy in-the-money (ITM) options. At the money and out of the money options will be most sensitive to time decay, and you are paying more for the option's extrinsic value (intrinsic=real value based on the stock price, extrinsic value=time value or extra premium beyond the real value...for a simple explanation if you're not familiar with these terms). By looking at options in the money, or deep in the money, you can still participate in a directional move. Implied volatility is still priced in but typically has a smaller impact, IF you are right about your forecast.
EXAMPLE:
Stock is at $42, you expect it to go to $50
35 call=$10
45 call=$6
50 call=$3
If implied volatility is much higher than historical volatility, there is the chance that you are paying MUCH more for the option, regardless of the strike. HOWEVER, even if you are paying more for the 30 call, a move to 50 will lock in a profit. With the 45 and 50 calls there is no guarantee.
2) Buy LEAPS. Typically the further you go out, the less expensive the premium is if you look at the price you are paying per day. This is what makes LEAPS and possibly calendar spreads attractive. If the 30-90 day options have extreme implied volatility priced in you can buy a LEAP and sell the premium on the front months. Leaps would be appropriate, but calendar spreads wouldn't be the best strategy if you felt the stock was going to increase or decrease substantially.
3) Buy a spread. If you are bullish on a stock and want to buy a call option but premiums are high, consider selling an option at a higher price. You still need to be right about the direction of the stock, but selling an option against the option that you have purchased will help offset this extra premium.
If cost is the biggest concern for you, scenario #3 is probably the most appropriate consider researching bull call or bear put spreads or ask your broker about the type of spreads that would be best for you. Many traders like to be option sellers, not buyers when premiums are high, but buying spreads to profit from directional moves when premiums are high can be very effective.
Happy Trading!
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