It is often said that the financial markets are driven by two human emotions: And there is a great deal of truth to this thought.
When an investor acts out of fear or greed, there is a level of aggressive motivation attached to it that — when done en masse — can push a market sharply higher or lower, as the case may be. Take advantage of stock movements by getting to know these derivatives. For more information, check out Understanding Option Pricing. Nowhere is this manifestation of human emotion more prevalent than in the options market. Thanks to the relatively low cost of entry when considering many trades, individuals often flock to the option market to attempt to take advantage of a particular market opinion.
And the good news for those who do so is that, if they are in fact correct about their opinion, they do stand the chance of achieving outsized returns. However, human nature — and the lure of easy money — being what it is, it is quite common for traders to "overreach" by applying maximum leverage to a speculative position.
Failure often results when key variables, such as profit probability and option premium time decay , are not carefully considered. The result of this overreach is often a situation whereby an individual may be correct about the direction of price movement, yet still end up losing money on a given trade.
While this is not the end of the world if a trader is risking only a reasonable amount of capital on each individual trade, there still can be a psychological impact that can affect a traders' psyche for many trades to come. This is the real long-term danger. These options are known as long-term equity anticipation securities LEAPs options.
A call option is considered to be "out-of-the-money" if the strike price for the option is above the current price of the underlying security. A put option is considered to be "out-of-the-money" if the strike price for the option is below the current price of the underlying security. The lure of out-of-the-money options is that they are less expensive than at-the-money or in-the-money options. This is simply a function of the fact that there is a lower probability that the stock will exceed the strike price for the out-of-the-money option.
Likewise, for the same reason, out-of-the-money options for a nearer month will cost less than options for a further-out month. On the positive side, out-of-the-money options also tend to offer great leverage opportunities.
In other words, if the underlying stock does move in the anticipated direction, and as the out-of-the-money option gets closer to becoming - and ultimately becomes - an in-the-money option, its price will increase much more on a percentage basis than an in-the-money option would. As a result of this combination of lower cost and greater leverage it is quite common for traders to prefer to purchase out-of-the-money options rather than at- or in-the-moneys.
But as with all things, there is no free lunch , and there are important tradeoffs to be taken into account. To best illustrate this, let's look at a specific example. Being both short and long has advantages.
Find out how to straddle a position to your advantage. Buying the Stock Let's assume that, based on his or her analysis, a trader expects that a given stock will rise over the course of the next several weeks. The most straightforward approach to taking advantage of a potential up move would be to simply buy shares of the stock. The expedited gain or loss for this trade appears in Figure 1. This clearly illustrates the effect of leverage. The expected gain or loss for this trade appears in Figure 2.
A trader could purchase eight of these 50 strike price calls for the same cost as buying one of the 45 strike price in-the-money calls. The expected gain or loss for this trade appears in Figure 3. The catch in buying the tempting "cheap" out-of-the-money option is balancing the desire for more leverage with the reality of simple probabilities. The breakeven price for the 50 call option is This price is 6.
So to put it another way, if the stock does anything less than rally more than 6. Comparing Potential Risks and Rewards Figure 4 displays the relevant data for each of the three positions, including the expected profit — in dollars and percent.
Such a large swing is often unrealistic for a short time period unless a major market or corporate event occurs. Conclusion As stated at the outset, it is perfectly acceptable for a speculator to bet on a big expected move. The key however, is to first make sure and understand the unique risks involved in any position and secondly to consider alternatives that might offer a better tradeoff between profitability and probability.
Dictionary Term Of The Day. A conflict of interest inherent in any relationship where one party is expected to Broker Reviews Find the best broker for your trading or investing needs See Reviews. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education.
A celebration of the most influential advisors and their contributions to critical conversations on finance. Become a day trader. Optionetics Platinum The catch in buying the tempting "cheap" out-of-the-money option is balancing the desire for more leverage with the reality of simple probabilities.
A conflict of interest inherent in any relationship where one party is expected to act in another's best interests. Passive investing is an investment strategy that limits buying and selling actions. Passive investors will purchase investments How much a fixed asset is worth at the end of its lease, or at the end of its useful life.
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