Sometimes it pays to go back to basics. I got an email recently from a TradeKing customer who laid out three big questions that every new options trader wrestles with. I'll quote Cathy here:
1) When is the best time to buy an option? I've read one to two months OR 32 days.
2) Do I buy an option "in-the-money" OR "out-of-the-money"?
3) What strategy would you recommend for someone like me?
Naturally there are a lot of moving parts to each of these, but the next move depends mainly on you. What's your outlook for the underlying stock or index? What are you trying to accomplish, and what sorts of tradeoffs are you willing to negotiate? If you're looking to speculate with options, and you feel reasonably confident your prediction is right, buying the near-term (30 days or less) at-the-money or just out-of-the-money options will give you the best return. But keep in mind there will always be a trade-offs when it comes to doing one option strategy over another. In this case the trade-off for the high potential return is theta or time decay. If your prediction doesn't pan out, or the underlying just does not move, you'll see huge rates of time decay in these options. In other words, you have to be right, in a hurry, if you were to buy the above-mentioned options.
In regards to the Greeks, options traders are always pitting gamma against theta. Gamma, like acceleration, measures how fast your option increases in value, while theta measures the rate of their decay in value. I wrote an article for Options Trader Magazine, appearing in their January 2007 issue, that goes into great detail about this relationship. Options Trader is a free online magazine, so I'd encourage you to sign up and take a closer read.
What if you're not buying options for pure speculation, but instead as a proxy for owning stock? If that's your approach, it makes more sense to go further out in time, 6 months to a year, and look for options 10% to 15% in-the-money. The Greek you should be seeking here is Delta. We want the delta to be around .80, that is, for every one-point movement in the stock, your options will move .80 cents. These options will trade for much more than the near-term, at-the-money options, but the upside is that they have slower rates of time decay and they act or move much like the underlying stock does. In my opinion, these are the options to consider for investing as opposed to speculating. You can read my blog series on delta to learn more.
Of course, all of the above is a pretty generalized discussion, and anyone new to options trading would benefit from reviewing the risks and characteristics of option trading. Keep in mind that buying options involves considerable potential risk, including the risk of losing your entire initial investment.
Regards,
Brian (OG)
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
While Gamma represents the consensus of the marketplace as to the theoretical rate of change of Delta relative to the underlying security there is no guarantee that this forecast will be correct.
While Theta represents the consensus of the marketplace as to the amount a theoretical option's price will change for a corresponding one-unit (day) change in the days to expiration of the option contract there is no guarantee that this forecast will be correct.
While Delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security there is no guarantee that this forecast will be correct.
