Financial Literacy

How to Use Option Chains: Here’s How To Pick Your Ideal Option

How to Use Option Chains: Here’s How To Pick Your Ideal Option

By Lee Lowell, Stock and Commodity Options Expert
Tuesday, February 14, 2006: Issue #283

Let’s say you’re bullish on a company and want to use call options instead of buying the stock because it’s a great way to use leverage and cut down on your risk. That’s true. But few things with a potential upside are risk-free.

That’s why options players always have to assess their risk. Are you the super-leverage type, unaffected by high-stakes betting? Or do you take 90% of your winnings off the table and risk just 10%?

Put another way, how much are you willing to lose? That’s where the strike price and expiration month that you choose within option chains will determine whether you’re a 10-rated highest risk investor or a one-rated, close-to-the-vest player.

These are tough decisions. Who knows how long it might take for the stock to make its intended move? The strike price is a different story, with the same questions about risk. Do you want something that’s going to move almost lockstep with the stock, such as an in-the-money (ITM) call, or do you want to pick a strike that’s farther out-of-the-money, but will cost you less up front?

Once again, it’s up to the individual to make that choice. Let me take you through the concept of option chains…and a few steps that might help you decide on these two tough choices.

Option Chains: Finding The “Sweet Leverage” Play

First, you must look at option chains. There’s no way to know what the options are worth without looking at their prices. For example, say we’re bullish on Intel (Nasdaq: INTC). We need to figure out which options are right for our portfolio, so let’s review the chart below…

The option chain above shows the March 2006 INTC call options, which expire in about five weeks. That’s very short-term. Are you looking for a quick pop in the stock? If so, then these options might be for you. Are you looking to leverage your money to the max? That means you’re looking to get a lot of bang out of your buck. If so, then you can choose an out of the money option (OTM).

Let’s say you opt for the March 2006 $22.50 calls, which have an ask price of $0.30. That means for every option contract you buy, it will only cost $30. Each option contract is the equivalent of 100 shares of stock and the option multiplier is $100, therefore our $0.30 option costs us $30 ($0.30 x $100 multiplier).

What does that get you? Well, for the next five weeks you get to control 100 shares of INTC for every option contract you buy, and it only costs $30 per contract to do so. Pretty sweet leverage.

You’re feeling pretty good that you only spent $30 on your option while everyone else who wants to buy 100 shares of INTC outright has to shell out $2,131 in cash. Plus, your risk is capped at $30 per contract. Not a bad deal at all.

But INTC has to get above $22.80 for you to at least reach break-even by expiration. Break-even is calculated by adding the premium to the strike price ($0.30 + $22.50 = $22.80). You need to remember with an OTM call, you’re buying something that doesn’t have value yet. If INTC trades at $21.31 today, why would you want to buy it at $22.50 (your strike price)? That’s because you’re speculating that INTC will go up in price, but you’re only willing to spend a few dollars to see if it happens.

The only other issue at this point is whether or not your option will perform, and what your chances are of being profitable.

How To Predict Performance by Using the Delta

One of the best ways to tell is by looking at the “Delta” column. For the March $22.50 call, the Delta is listed at .28. This number tells us two things. 1) How much the option price should move in relation to the stock making a $1 move in either direction, and 2) our chances of the option being in-the-money (ITM) by option expiration.

If INTC shoots up one dollar to $22.31/share, your $22.50 call will theoretically only gain $0.28. Not much movement. Also, the Delta is telling us that you only have about a 28% (.28) chance of the option being ITM by expiration. Being ITM is something that you definitely want to happen. Is a .28 Delta good enough for you? Only you can decide. If spending $30 for a 28% opportunity is a good tradeoff, then by all means, you could trade this option.

The next option chain shows us the January 2008 options, which expire just under two years from now. That’s some serious time to be right. Do you want to pick the same $22.50 option strike? Or go with something with more movement? The $22.50 strike will cost you about $320 per option now and it’s got a .60 Delta. The reason these are higher is because of the extended time you have now to be right in your prediction.

You could also look at the $15 call for a viable trade. Yes, it will cost you about $760 (splitting bid/ask) per option, but you’re getting 98% of the movement of INTC. If INTC goes up one dollar, that $15 call should gain very close to one dollar as well. Plus, it’s telling you that you have a 98% chance of your option being ITM at expiration.

Even though the option will cost $760, that’s still the most you can lose. All stockholders still have $2,131 at risk if INTC tanks.

The point is to get you to weigh your timeframe against how much movement of the option you’re willing to pay for. If you’re looking for a quick, cheap, speculative trade, stick to the close-to-expiring options that are slightly OTM. If you need more time to be right and you want solid movement from your option, stick to the LEAPS (long-term equity anticipation securities) that are deep ITM.

Good investing,

Lee Lowell

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