Trading Strategy: How to Avoid This Mug’s Game (Part Two)

Who doesn’t love a bargain? There’s nothing like picking up something you’ve always wanted for a fraction of its original price.

Perhaps it’s just our inner desire to ‘beat the system’. To get one over on a system that gouges us at every opportunity.

But as we discussed in last week’s article, sometimes a bargain is not as cheap as it seems. Particularly when it comes to shares. And even more so with options.

At least if we buy shares, there is always a possibility, however remote, that the share price may recover. If nothing else, there is always time.

With options, though, time is always in the equation. As every option has a limited lifespan, time is always working against the buyer.

That’s why a trader has to be even more careful not to buy an option because it looks ‘cheap’. There is a reason it’s cheap: it’s probability of success is likely to be low.

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It’s all about motivation

When you buy something — a car or whatever — it’s easy to only think about it from your own perspective. The motivation of the seller might never enter your head.

With shares, especially smaller-cap stocks, you might be more inclined to think about why someone is selling. Do they know something that you don’t?

When you buy an option, though, you should always think about it from the seller’s perspective.

Typically, when you buy an option, you are dealing with a market maker. As the name implies, their job is to make a market — that is, provide liquidity — so that investors can freely trade in and out.

While their motivation might be purely commercial — that is, to generate multiple trades and profits — the price they quote is not subjective at all. It comes from their pricing models, which gives them the ‘true’ value of the option.

They then place their bid and offer prices either side of that. Unlike in earlier times, thankfully, the ASX limits how far this spread (the gap between bid and offer) can be.

By creating this spread, if you buy at the offer price, you are technically paying above its value. And, if you sell/write an option at the market maker’s bid price, you are selling your option below its true value.

Because of that, hitting the bid or offer price puts you behind on the trade. And that’s before time decay starts to kick in.

Whether you are a market maker, or a private trader writing/selling options, you both have one big thing in common. That is, the desire not to be exercised. You do not want the option buyer to exercise their option.

The aim of an option writer is to keep selling options — to keep generating premiums — without being exercised. That way, any premium they receive remains theirs to keep.

An option writer’s price is the minimum they will accept for the obligation they are taking on. However, it is more than that.

As I wrote last week, it’s a game of probabilities. The higher the chance of exercise, the more premium the option writer will want to collect.

Meaning that options that are trading at only a handful of cents, have minimal chance of success. Still a chance, mind you, but the probability is low. 

So what is an option buyer to do?

There is perhaps nothing in the financial markets that attracts more jargon than options. From weird and wonderful strategies, through to even the most basic definitions. It can put you off before you even begin.

Plus, there are the so-called ‘Greeks’, which might put you off even further.

However, one of these Greeks is particularly helpful in working out an option’s probability of success: It’s called ‘delta’.

An option’s delta tells you how much the option’s price should move in relation to a move in the underlying share price.

A delta of 0.5 means that the option will move half that of the underlying share. In other words, with a delta of 0.5, an option’s price will move 50 cents, per $1 move in the share price.

A delta of one means that the option will move the same as the share price. And a delta of 0.1 means that the option will only move 10 cents per $1 move in the share price.

This is where an option’s delta can be so helpful in working out your probability of success.

An at-the-money (ATM) option usually has, as our example above, a delta of 0.5. All an ATM option means is that the strike price is at (or very close to) the current share price. So, if a stock is trading at $5, a $5 call option’s delta will be around 0.5.

And that makes sense. There is roughly a 50% chance that the share price could be above or below that price when the option expires.

However, an option that is way out-of-the-money (OTM) might have a delta of 0.1. For example, a call option with a $7 strike price when the shares are trading at $5. It will take a big move, in a short period of time, before this option has any true value (goes in-the-money, ITM).

That makes it extremely cheap, but with little chance of success.

On the flipside, an option that is a long way ITM, will have a delta maybe as high as 0.9 or closer to 1. And that makes sense too. If that same stock is trading at $5, a $2 call option is almost certainly — though not guaranteed — of finishing ITM.

That is, it would take an incredible, and perhaps unprecedented fall, for the option not to have any value at expiry.

That’s why option traders find delta such a valuable tool. It gives them a quick snapshot of their trade’s chance of success. And it is why you should also check out an option’s delta before placing a trade.

Options trading is one of the most overlooked investment strategies that you can take advantage of right now. Get started with expert help — free!

Regards,

Matt Hibbard,
Editor, Markets & Money

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