Buy call options out of the money
Periodically I use this column to answer questions sent by readers. As a bullish position, can you compare the advantages and disadvantages of buying one contract of an in-the-money Call option with a Delta of 70, vs buying two out-of-the-money contracts with a Delta of 35 each also a Delta of 70 total? This is a sophisticated question. To answer it, we have to explain that Delta is the percentage of the next one-point price movement of the stock that will be experienced by the option.
So the value of a call option with a Delta of 70 would rise by 70 cents, if the underlying stock went up by one dollar. Are these positions equivalent?
The answer is that they are equivalent only for the next one-dollar move in the stock, and only if that one-dollar move happens today, with no change in market expectations. In other words, no they are not. On that day, a partial option chain for the March options looked like this:. The Bid and Ask prices for the strike calls, with a delta of.
The gold highlight at the strike shows the dividing line between calls that were in the money like this one, and calls that were out of the money. The Bid and Ask prices for the strike calls, meanwhile, with a delta of. This is so that we can compare different scenarios. In that case, the break-even price on the calls would be so high that it would be nearly impossible to make money on them, and that possibility would probably be dismissed.
But if each position is only held during the time in its life when its time value is not deteriorating too rapidly, as shown here, then a different picture emerges. The two delta calls make more, or lose less, at any SPY price level, than the single delta call, assuming no change in Implied Volatility; except where SPY is unchanged a month from now.
So far, a definite win for the delta calls. One potential disadvantage of the delta calls is that they have a higher Vega value, meaning that they will suffer more in case Implied Volatility drops. Many rookies begin trading options by purchasing out-of-the-money short-term calls.
For this strategy, time decay is the enemy. It will negatively affect the value of the option you bought. After the strategy is established, you want implied volatility to increase. Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.
Multiple leg options strategies involve additional risks , and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies. Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or the probability of reaching a specific price point.
The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that the forecasts of implied volatility or the Greeks will be correct. Ally Invest provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice.
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The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, are not guaranteed for accuracy or completeness, do not reflect actual investment results and are not guarantees of future results. All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns.
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