Options are one of the greatest ways to earn consistent streams of income.
No wonder it’s become the most popular trading methods to date. So much so that since 2007, average trading volume in options exploded from 11.7 million to 16.5 million in 2017.
Fact is options are far more advantageous than a stock, and cheaper, too.
For example, I can buy 100 shares of Apple (AAPL) for $15,200. But with a call option, I can spend as little as $700 to control those same 100 shares.
The best part – with an option, I never have to take ownership of the stock.
Not only can an option provide me with a lower point of entry, but it’s also offering me the leverage I want. Plus, it’s much easier for me to double my money on a $700 trade than it is to do with a $15,200 trade.
Another great thing about options is that they offer us flexibility. While stock traders are limited to long or short positions, options trader can profit from any situation – bullish, bearish, sideways and sometimes in between.
The problem comes when traders try to buy the cheapest option they can find.
But that’ll cost you… BIG. Let’s understand why.
When it comes to trading options, one of the key terms to understand is the strike price, or your target price for the underlying stock. For example, right now Apple trades at $152. If I believe the underlying Apple stock can reach $155 by a set date, I can choose a $155 strike price.
Unfortunately, many folks don’t know how to choose the right strike price.
They never took the time to understand other key terms such as in-the-money (ITM) and out-of-the-money (OTM) options. A call option is considered ITM if the underlying stock price is lower than the strike price. A put option is considered ITM if the underlying stock price is higher than the strike price.
A call option is OTM if the strike price is above the underlying stock price. A put option is OTM if it is lower than the underlying stock price.
For example, Apple trades at $152. A call option is ITM if the strike price is lower than $152. So, for example, a September 15, 2017 150-call option would be ITM. Meanwhile, a September 15, 2017 155-call option would be out of the money.
Here’s where it gets a bit tricky. Please stay with me.
The best thing you can do when buying an option is buying one that is ITM.
The second you begin to buy an option that is OTM simply because it appears cheaper, you stand to lose big money or reduce your earnings potential.
Let’s use Apple options again for example.
If I were to buy the Apple September 15, 2017 150 call option at $7 ($7 x 100 shares in a contract = $700), I can make $0.6872 for every $1 shares of Apple move higher. At the same time, I also know that for every day I hold this option contract, I will also lose $0.0293 until expiration based on further analysis.
At the same time, the Apple September 15, 2017 155 calls sure do look appealing at $4.45. We can spend less money per options contract doing so. But it’s OTM. Instead of making $0.6872 for every $1 Apple moves higher, I can only make $0.4243 for every $1 higher with an OTM. Plus, I’ll lose more money ($0.0306) for every day I hold the option contract.
Folks may even be inclined to buy the September 15, 2017 170 call, which is $15 OTM simply because it trades at 74 cents (or $74 a contract). Problem is you won’t begin to make any real money from this trade until Apple begins to pick up steam and get anywhere near $170. In the case of this call option, you only make $0.0188 for every $1 Apple moves higher right now, while losing $0.0034 for every day you hold the contract.
These are just some things to keep in mind as you begin to trade options.