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Many people have written to me in the last two weeks asking, “How do you use options in your trading?” I hope to answer that question in this blog entry.

I use options for almost all of my trades. The only time I don’t use options is when the position I am trading does not have options available, or when there are not deep enough in the money options available for me to trade (more on this later).

Before I get started with the details, I want to be clear that I do NOT use options to increase my position size. Meaning, I don’t buy more of a certain position because I can (because the options are obviously cheaper than the stock). I don’t use the options to get into more of any certain position (leverage). I calculate my position sizes just as I would if I was buying the underlying stock and not the option. I use the options to control risk. I believe that “risk is the currency of the markets.” Therefore, a natural extension of that thought, is that... if I am reducing my risk with options, and I can still get the same reward from the option as I do from the stock, I am getting the same position for less (risk). And, risk=currency.

I also want to do a simplified review of options so that you can see what I’m talking about (you need to know some basics though). The bottom line is:

CALL is the OPTION to BUY a given stock at a defined STRIKE (stock) price on or before a given EXPIRATION date.

PUT is the OPTION to SELL a given stock at a defined STRIKE (stock) price on or before a given EXPIRATION date

So, I generally play the long side; hence, I mostly trade CALLS. The next concept is, “How are the options priced?”

OPTION PRICE=INTRINSIC VALUE+ EXTRINSIC VALUE. That’s it! Intrinsic value is easy to figure out. It is how far the strike price of the option is below the stock price (It has "real" value). Take a look.

If the STOCK PRICE=40, here is what the Intrinsic Values look like for a series of strike prices for calls.

STRIKE--- INTRINSIC VALUE
30 ----------10
35 ----------5
40 ----------0
45 ----------0
50 ----------0

Now, extrinsic value is a whole different animal--it really involves multiple factors, which I won’t go into here. For the way I trade--I just use the options in place of the stock. Therefore, I don’t want to pay for any EXTRINSIC value. I only want to pay for intrinsic value or real value. Therefore, I find the options that have virtually no extrinsic value, and all/only intrinsic value. Those options are the options that are deep in the money. In other words, the options whose strike prices are well below the actual stock price. It should make sense, if you bought a CALL option whose strike price was 10, and the stock price was 60, the intrinsic value of the option would be 50 (and the extrinsic value 0), which really is almost the same as paying for the stock at 60 dollars per share. There really is no EXTRINSIC VALUE of that option. I am not advocating that you buy call options that deep in the money--this example is an exaggeration. What you need to know is that there is a point that as you go deeper in the money (lower and lower strike prices below the stock price) where you find that the option is priced with all intrinsic value and maybe 10 cents of extrinsic value. For example, if the stock price is at 50, the call option with a strike of 50 may be priced at 4 dollars/1 share (all extrinsic value), the call option with a strike of 45 may be priced at 6 dollars/1 share (5 dollars of intrinsic value and 1 dollar of extrinsic value), and the call option with a strike of 40 may be priced at 10.10 (10 dollars of intrinsic value and 10 cents of extrinsic value)--BINGO that’s the one I want.

Why do I want that option? For three reasons, first, the EXTRINSIC portion of an option’s value decays (or decreases in value), thus, because I only have 10 cents of extrinsic value-there is essentially negligible decay. Second, when the stock goes up 1 point, these deep in the money options go up 1 point (point for point). You get all of the gains (this is not true of the options whose strike prices are closer to the option price). So, in terms of return, you get everything (just about) that the stock holder gets. The third reason is really the most compelling reason for using the deep in the money call options. If the stock price drops--THE OPTION DOES NOT LOSE POINT FOR POINT WITH THE STOCK (when the stock drops 5 points, the option does not lose 5 points). For example, if the stock is priced at 50, and you own the call with a 40 dollar strike price--you will pay approximately $10.10 (10 dollars of intrinsic value and .10 of extrinsic value) if the stock drops down to 40 (a 10 dollar loss), your option is now “at the money” (the same price as the stock)--this is where the options have the most extrinsic value (and no intrinsic value). Therefore, the stock may drop 10 points, but you only lose maybe 6 points (see the example above...) (this also varies with time, I will touch on that). And, if you are unlucky enough to have a position that really tanks, let’s say 25 points--the most you will lose is the $10.10/share that you originally bought the position option for.

Keep in mind, that I am talking about options that expire in the closest month. My average position holding time is about a week, so I use options with virtually no extrinsic value with about a week or more to go until the expiration. If there is either 1) less than 5 days left until option expiration, or 2) there is not an option that is deep enough in the money to have little extrinsic value, then I buy an option from the following month. And, what ones do I buy?--I buy the options that are deep enough in the money so that I am not paying for extrinsic value. For more volatile stocks that will be deeper in the money than for less volatile stocks. The bottom line is that you want to buy the option that has almost no extrinsic value...that’s it.

What is the whole purpose of this? To buy the same position that you would have bought using stocks, but using options instead--and get the same potential gains as you would have if you were holding the stock, but with reduced risk. In other words, “spend” less risk for the same potential gain. If you are using a trading methodology that is successful--using options should help. Now keep in mind that there is a minimum 5-10 cent spread (think 10 cents) for options so if you are trading a strategy that goes for 1% gains or scalps--this will not work! But, if you are trading a strategy that usually goes for gains that are in the 50 cents to 1 dollar plus range, I believe that options can really add to your performance.

Happy Trading,

Steven

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