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How to Optimize Your Wins by Choosing the Right Options Contracts

With an understanding of these concepts, you can avoid fatal mistakes new option traders make

Hey there! My name is Nate and I write for WOLF Financial. If you enjoy learning about trading, I guarantee you’ll also enjoy my content on 𝕏 @tradernatehere. Thanks for reading!

This service is for general informational and educational purposes only and is not intended to constitute legal, tax, accounting or investment advice. These are my opinions and observations only. I am not a financial advisor.

A common mistake many new traders make is to focus on trading out-of-the-money (OTM) options because they are less expensive and are a better fit for your account size.

Simply buy what you can afford, right? Actually, this is very wrong.

Finding options that appear inexpensive can be appealing but dangerous, especially if you do not know what you are looking for.

When buying options, you should not be trying to find an option that fits a budget. Instead, you should be looking for the right options at the right price.

Yes, this does mean that you will be limited with some trades. I will take limited trades over losing trades any time.

New traders should instead be looking at all types of options contracts, including those that are in-the-money (ITM), which are lower risk and have some intrinsic value.

So, what does all of this mean? We need to go over a few definitions:

  1. Intrinsic Value: The value of the option if exercised today ($10 stock - $8 option strike price = $2 intrinsic value).

  2. Extrinsic Value: The value of the option derived by time value (time to expiration) and implied volatility. If the $2 option above is priced at $2.50, there is 50 cents of extrinsic value.

  3. Implied Volatility (IV): An estimate of the future variability of the underlying asset (stock). Higher IV leads to higher extrinsic values.

  4. ITM Options: The share price is past the strike price of the option, giving the option intrinsic value in addition to extrinsic value.

  5. OTM Options: The share price has not yet reached the strike price of the option, meaning it has no intrinsic value. The option price is 100% extrinsic value.

When you buy an ITM option you know exactly what the intrinsic and extrinsic values are because you can calculate them.

If a call option has a price of $2.50 with an $8 strike price and the underlying stock is priced at $10.00, we know the intrinsic value is $2 ($10-$8) and the extrinsic value therefore must be $0.50.

Conversely, when you buy an OTM option you are only buying extrinsic value.

A call option with an $11 strike price option for the same $10.00 stock might only be priced at $0.20 and 100% of that is extrinsic value.

Without going into a lot of complicated math, it is hopefully easy to see that ITM options require less of a move from the underlying stock to make a profit.

ITM options are also relatively less volatile and give you better probability of returning at least some of your capital.

Going back to the example, let’s assume the $10.00 stock drops to $9.50. The $8 strike price option still has intrinsic value of $1.50. That is the minimum it will be worth.

Looking at the OTM call option with a strike price at $11 tells a different story. If the stock is lower by expiration no matter by how much, the $11 strike option is worthless.

In fact, if the stock drops, stays flat, or increases by less than $1.00…the OTM option with the $11 strike is worthless. The odds are stacked against it.

Meanwhile, buying the ITM call option in this example would allow for some return of capital if the share price dropped and most of the capital returned if the stock is flat.

Profits show up if the share price is above $10.50, only a 50 cent move higher rather than the necessary $1.00 move higher to break even for the OTM option.

Putting the odds in your favor is always a good idea and when you are learning how to trade options, I recommend doing as much as you can to improve your chances early on.

I also recommend using ITM or at-the-money (ATM) options instead of OTM options when you are less certain about a trade.

Again, help improve the odds of executing a favorable trade whenever you can.

I hope these definitions and overview of ITM and OTM options is helpful.

Have a great week of trading ahead and study those options!