4 Factors in Play With Options Trades

4 Factors in Play With Options Trades
by Ken Trester 07/31/08

1. What is the option's fair value? Make sure you buy undervalued and sell overvalued options -- it enhances your probability of profit.

2. What is your probability of profit if you hold the position to expiration? Because options can be inexpensive, many individuals don't thoroughly examine their potential performance. Barring some dramatic move in the lifespan of the trade, an option that is too far out-of-the-money to realistically become profitable is probably not worth betting on.

3. What is your probability of hitting a stop-loss or profit goal during the life of the option? While "cheap" options can seem like a "long shot" at face value, it's still real money that you're putting into them -- capital that you need to have a plan to protect and grow.

4. What is the delta? If you are an option buyer, you want a higher delta. If you are an option writer (seller), you want a lower delta.

These four factors are all you need when comparing different option trades to determine the best play or whether you should pass on a trade, because there will always be new trading opportunities coming along.

BRIDGING THE 'DELTA'

Let's talk more about an option's delta, as that may be a newer concept to you and it is one that you may find helpful as you become more experienced, and maybe even advanced, at trading options.

There are many factors that go into determining the value of an option -- the price of the stock, the historic impact of volatility (i.e., how the stock price typically behaves around regular events like earnings announcements), and dividends and interest, if applicable. After all, options are created -- and their available strike prices are set -- around the current value of the underlying stock.

Although option values don't always trade directly proportionate to the underlying stock, we can use the delta to gauge the options' sensitivity toward movements in the stock. For instance, you might have held a call option at one time or another with a $35 strike price in your investment portfolio. But then perhaps the stock traded up through that number, but your option didn't follow it toward profitability. And that can be frustrating because you made the right "call," so to speak, yet the profits didn't follow.