Buying out-of-the-money (OTM) call options
The lowest premium you pay is when you buy the short term Out of Money call Options. Since the trader wants to start small, he wants to play volume buying the Out of Money Short term call Option.
This can be good strategy if you are buying just 1 notch above (the first strike) the current price. If you are fortunate, and the stock moves in expected direction, you may make good profit from it. But making the winner trade may not be always true.
The workshop where I was introduced the concept of Options; my instructor specifically mentioned this mistake and asked all the participant to avoid this when trading Option. But guess what. Most of the people don’t understand from other’s mistake. They learn when they burn the fingers themselves.
What you don’t know?
It is too difficult to predict the direction of the stock. Assuming that you are expert in equity trading and know that this is going to do well, do you know when it will hit the expected price. Unlike equities, timing is another important factor in Options. So if you are wrong about any one of them, you made loss. Unlike equities, where you lose a % when stocks go down, in Options, you may lose the whole premium if the Stock does not hit the Strike Price.
As mentioned above, the time value of Option is like an ice cube in the scotching sun. The value keeps evaporating as time passes if the stock does not move in the anticipated direction.
If they bought option is out of money and stock does not make any move for couple of days when close to expiration, the value may shrink very fast.
What to do to avoid this?
You can make money by buying calls and selling it when it moves in the anticipated directions.
The new trader should do the paper trade and analyze the trade for couple of weeks before making the real trade. It is a better idea to sell the out of money call than to buy it. If you sell the call without owning the underlying stock, it is called “Naked Call” and has substantial risk. That strategy should be followed only by experts. For the starters, you should sell the calls for the stock that you own, generally called “Covered call”. You can also try to follow the strategy of “Buy/Write”. If you are bullish on the stock, you can buy the stock and sell the out of money call.
The benefit of using the covered call strategy is that the risk is limited to the downturn in the stock price if the stock moves in the downward direction. But a part of that loss may be compensated by the premium received for selling the call option. The other flip side is that the gain is limited once the call has been sold. You have the obligation of selling the stock at the strike price if called even though the stock has gone substantially up.
If the market remains flat or below the Strike price, you can keep the premium and sell the call again.
So selling the covered call is relatively low risk with a limited gain and also gives you the experience of Options trading and price movement. It helps you to understand the impact of Volatility, time decay and stock price movement on the Options pricing.
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