The Secret Advantages of Trading Options

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There's Cheap and There's Inexpensive

The other mistake option buyers make is they think an option’s price is an indication of whether it’s cheap or expensive. Rather than buying the at-the-money $25 call that is selling for $1.75, they buy the $30 call that is selling for 50 cents. They could buy three of those $30 calls for the price of just one $25 call! All too true, but there’s a reason for that apparent cheapness.

You see the mathematical models that have been created to price options are very similar to actuarial tables that insurance companies use to figure the risk they take on writing policies on life, health and automobiles. But you don’t need to understand how the tables work, you just need to know there are sophisticated computer programs that have already done the work for us, and neither professional traders nor casual investors need be overly concerned about how or why such formulas work.

Read Ken Trester's "Cheap Options Aren't Always a Smart Buy"

The models predict the future price of the stock based on historical trading patterns much like the insurance company’s models project the longevity of a particular demographic. Thus, buying that out-the-money $30 call that looks cheap, but what you are really doing is betting the stock will trade outside the expected range of projected prices. Don’t get me wrong, sometimes the outcomes are indeed outside the range predicted by the models, but you should understand you are betting against the odds!

Next: Don't Bet Against the Odds, Bet with Them!