Buying lowest strike price?

You seem to have a few different confusions. First, if you already bought a stock, do you understand that you would buy a put (not a call) to protect against a loss in that stock? A put would give you assurance that you could make someone buy that stock from you at the strike price (for the length of time until expiration). So buying at the lowest strike gives you the least amount of insurance, like insuring a $100,000 house for $30,000.

Second, the way you are speaking about not losing everything, and adding the value of the strike to the premium, I think you might be thinking about buying a call. Because I call would retain value if the price of the stock remained above the strike. Are you looking for insurance? or are you looking to make money on the appreciation of the value of the option?

Third, learn the difference between the intrinsic value of an option and its time value.

To QT,

You are correct. Buying CALL options with a low strike price (we call these in-the-money calls, or ITM) protects you from the potentially very large loss of seeing the stock go bankrupt and becoming worthless. However, your plan does not ‘protect you from a loss.’  It does limit losses to the premium paid for the option.

Here is where you are off to a good start in your thought process: Buying ITM calls instead of stock can be a conservative, risk-reducing idea for stock traders. This is easier to see with a $40 stock rather than a $6 stock. If you buy a 35-strike call option on a stock trading at $40, your cost is $500 PLUS some time premium. [That premium depends on two factors: time remaining to expiration and the volatility of the stock. More time or higher volatility results in a higher time premium].

Why would you want to pay that extra premium instead of buying 100 shares? There are two good reasons. The more common reason among trader newbies is that $4,000 is not available and 100 shares cannot be bought. However, the reason among more experienced traders is that they are willing to pay that extra time premium (call it an insurance policy) in return for the guarantee of limited losses. Sure, you are buying the stock because you are bullish, but your bullishness does not make the stock price move higher. If something unexpected happened and the stock tumbles to $30 per share, the stockholder loses $1,000. However, the owner of the 35 call option can never lose more than the price paid for that option. In this example, that would be the price paid for the option – and that would be much nearer to $500 than to $1,000.

However, you probably do NOT want to buy the call with the lowest strike price. In my example above, if we buy the Aug 25 call, it is 15 points in the money and that means we would pay a bit over $1,500 for the option. That does not offer much in the way of downside cushion. The vast majority of traders would pay a little time premium to buy the Aug 35 call and invest approximately $1,000 less.

The reason that some traders prefer to buy the $6 or $7 calls is that these options are at the money (ATM) or out of the money (OTM).  They are much less expensive, and it is possible to make a very high percentage return on capital invested (leverage). However, as you mentioned, there is also a good chance that they will become worthless.  It is a trade-off. Some traders prefer to buy less expensive options with the hope of a big return on investment. I, as you, prefer to buy ITM options, sacrificing the very high percentage return for the higher probability of earning a profit.

Options are versatile investment tools and there are many different ways that intelligent traders can use them. If you prefer one style over another, that’s fine – and you are not doing anything wrong. Other people prefer to use options differently, and they are not wrong either.


Mark D Wolfinger
Options for Rookies
June 21, 2012

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