Ken Trester

Cheap Options Aren't Always a Smart Buy

by Ken Trester   08/13/08

While inexpensive option prices might get your attention, it's important to remember just how much stock you are actually controlling at any given time. Just because an option seems inexpensive doesn't mean you should get too wild and crazy.

You may see an inexpensive option and think, "Hey, that option over there only costs 80 cents ... I think I'll buy 40 contracts."

The $3,200 you spend on that one trade might seem like a small amount to you to invest, but remember you are actually controlling 4,000 shares of stock (as 40 contracts times 100 shares controlled per contract equals 4,000 shares).

If, in your right mind, you wouldn't normally trade so many shares of stock ... well then, don't buy so many doggone options!

I LOVE CHEAP OPTIONS MYSELF, BUT THEY HAVE TO BE THE 'RIGHT' ONES

The beauty of trading options is that you get an incredible amount of leverage for a relatively small investment. If you really wanted to control 4,000 shares of stock, indeed buying 40 options contracts is a great way to do it, compared to the cost of buying that many shares outright.

Those 80-cent options might be cheap because their chances of becoming profitable are a long shot at best. If the underlying shares are trading at $25 and you buy a call option at the $40 strike price, with an expiration date coming up in two months, what are the chances that the stock will rally $15 in that time period?

If there are a number of upcoming positive catalysts (i.e., a good earnings announcement, several product launches, etc.) in that time frame, the stock might have a shot at spiking $15. But for the most part, you should focus on more-realistic expectations and choose the best options to trade accordingly.

In reality, those options are probably not going to become profitable, especially when you're expecting such a big move from the stock in such a short time frame!