is it better to buy at the money options or in the money options?
an option contract that is deeper in-the-money will have less time value than one that is less in-the-money. coud you please advise?
Could you please advise how much time value would be reasonable to pay for any call or put contract? i know it is better to use an option that has very little time value. but i would like to have a parameter to know if i am paying too much for that optoin.
thanks a lot .
thanks
Answers
437 points
NYInvestor answered 3 months ago …
Check out this answer from a previous question on a similar topic:
http://www.tickerhound.com/questions/detail/20080876d9860/how-can-individu al-investors-determine-if-an-option-premium-is-worth-paying-in-ditm-calls-p uts
205 points
Sensei answered 3 months ago …
First off, thanks NYInvestor for referring to my previous answer.
The answer to this question is, in a word, impossible. As I said in the previous article, it depends. Moreover, are you talking about puts or calls? How volatile is the underlying stock? How close is the exercise date? Is this a "covered" option (i.e. do you already own the stock)?
You should also be aware that the time premium "degrades" and that it has been shown that the degradation is exponential within the 90-day period to expiry - that is, for example, the time premium on a February option will not change much from August to September, but will degrade dramatically from November to December and even more so from December to January and even faster from January to February. From this you can see that your statement, "I know that it is better to use an option that has very little time value." is ... FALSE! In fact, the exact opposite is true. To wit ...
Assume that today is the Thursday before the third Friday (options expire on the third Friday of the month.) XYZ is selling at $ 32. Which is better, a call at 35 with a 2 cent time premium, or a call at 30 with a 20 cent premium? Your statement would imply the former. But we both know it would be the latter - if we were even disposed to buy either of them which is another question entirely. If the stock went to $ 34 tomorrow, the first option would be worthless, but the latter option would not only have value, but would create a profit.
Sadly, there is no "quick and dirty" formula that you can use to determine if you're paying too much premium. It's a judgment call and it should be the least of your concerns in determining the "value" of the option.
Think of what you're doing. You're buying the right to buy or sell the stock at a determined price some time in the future. How do you hope to profit? By the manipulation of the time premium? Or by the stock going up (or down as the case may be) before the expiration date? If the former, you have no business playing options. If the latter, who cares about the time premium?
If the stock goes from 32 to 42 you're a winner. And which is more likely - that that move will happen in the next 30 days? Or the next 90 days? Which has the greater time premium? The latter of course. Given that, are you really going to cry about the extra few cents you paid in time premium? Of course not.
In short, keep your eye on the ball. It's the stock that matters. There's only one question that counts ... Did you make money on the trade? If you did, the time premium is irrelevant. If you didn't, the small added loss of paying "too much" for the time premium should be irrelevant too.
246 points
engcomp answered 3 months ago …
Have a look at the option pricing spreadsheet here
http://www.futuresandforex.info/strategies1.shtml
With a bit of trial and error you can work out the volatility the market maker has put in the prices of call and put options (the volatilities usually are the same for puts and calls because arbitrageurs will pounce on any mis-pricing).
When you know the market maker's assumed volatility, use your judgement whether it is higher or lower than what you expect from the market. If you expect volatility to be higher, you can safely buy the option - puts if you expect the market to go down or calls if you expect the market to go up.
Say you are bullish. If you buy the stock and the market takes a dive, you get stopped out. Then the market turns around and you were right all the time. If you buy the call option, the most you risk is the premium (sometimes less than your stop-loss), and you are still in the market when it proves you right.
726 points
alanj answered 3 months ago …
To give you a quick and simple answer. If safety is your concern then buy in the money in the area of 3,4,5 months out. ( This would be a good time, as the farther out you go the more expensive the option is. The volume also goes down. And that's also important, you want good volume)
Do not get a 1 month expiration date. If the underlying stock moves against you the 1 month option will move more than the longer time period option. Your loss will be greater. And the 1 month option doesn't give you much time for the option to work in your favor.
An in the money has less risk than an at the money. For an in the money option to be profitable at expiration the underlying stock doesn't have to move as far then the at the money option. If you go to far into the money the volume goes way down. You need volume when it comes time to sell. And the option moves about the same as the underlying stock. So you might as well buy the underlying stock outright.
So you want to be at least 3 months out. And no farther than 4 or 5 strike prices away from the at the money strike price in most cases. (This would also apply to out of the money options.) An exception would be something like the S&P 500 index where the volume level is good at quite some distance from the at the money strike price. Volume is an important component in determining the strike price or the strike price you should not get.
In comparison of all strike prices for a particular stock, most options are right in line with each other. It's very rare to find one that is underpriced or overpriced. And if you do happen to come across one that is mispriced it's usually not by much. Don't concern yourself with paying to much, it will probably never happen, if you use a limit order within the Bid and Ask price. (Don't use Last price, it may be too old) What's important to make a profit is the price movement of the underlying stock.
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