OPTIONS
Which One Is Hotter?
Which Strike Is Best?
by Ihor Vysotskyy
Here's a method for selecting advantageous options.
Purchasing call options is often considered to be the simplest strategy when it comes to trading options. The method is based on the assumption
that when the price of the underlying financial instrument goes up, the call option will also rise, generating a profit.
However, this is not always the case. Most beginners in the options market
start out by purchasing a call option, but are disappointed when they discover
they have been misled into believing no risk is involved. Instead of profits,
they experience enormous losses. This can cause them to think that trading
options is such a risky activity that they turn away from options trading
altogether.
THERE ARE OTHER METHODS
Most of the disappointment arises when new options traders buy out-of-the-money
(OTM) call options. In addition, beginners often choose the nearest series.
Their motivation is simple: the low price of the options. Deep out-of-the-money
options of the nearest series can bring benefits if the price of the underlying
displays a strong move accompanied by an increase in implied volatility.
However, research has shown that the market rarely makes such strong moves.
Moreover, in the case of a rise in the underlying, it is possible for
OTM options to remain unchanged or even decline in price. This is especially
true for the nearest series as the expiration day of the contract approaches
and implied volatility declines. This leads to a situation in which the
OTM call holder will not benefit.
FIGURE 1: OPTION QUOTES FOR IBM. A quick upward move will result
in a rise of every strike to the price of the next highest strike.
...Continued in the May 2003 issue of Technical Analysis of STOCKS
& COMMODITIES
Excerpted from an article originally published in the May 2003 issue
of Technical Analysis of STOCKS & COMMODITIES magazine. All rights
reserved. © Copyright 2003, Technical Analysis, Inc.
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