Critical Options Investing Tip When Trading Naked Calls and Puts

An option is a derivative trading product that is best used by investors as a hedging tool providing investing profit protection and profit enhancement. Although it is a powerful risk management tool, it can also be used effectively as a stand-alone trading vehicle.

Under the proper conditions, options do not have to be paired with stock or another option to be an effective trading tool. When investing, to successfully trade naked options, an investor must realize that certain options will fit certain scenarios and certain options will not.

One of the major misconceptions that investors have about investing in options stems from the fact that most do not know how to trade them properly. When they lose money trading them, they feel that there is something wrong with the option. They do not understand that options are on a higher, more sophisticated level when compared to stocks.

Stock trading has fewer variables involved and is therefore easier. No one is saying that the individual investor isn’t smart enough to invest in trade options. The problem is not intelligence; it’s just education and experience. Most investors have not been properly educated in the proper use of investing options, and even fewer have had any real experience trading them.

One of the biggest problems investors have is this: While investing and even if you buy a call and the stock goes up, you can still lose money. Most investors tend to buy out of the money options at a cheap price. The stock trades up a little, which is the right direction, but the option still loses money and the investor wonders why.

What the investor fails to realize is that in order for the option to be profitable the options delta must out-pace its rate of decay. Implied volatility also plays a key role if the stock does trade up while implied volatility decreases, the options delta must then outperform the decrease in volatility. Remember, when volatility increases, the price of all options goes up. When volatility decreases, the price of all options goes down.

We have categorized options in several ways. One way is by the option’s strike price, and its distance from the stock price. We identified these options as either in-the-money, at-the-money, or out-of-the-money.

In our discussion about trading naked calls and puts, we will identify trading opportunities or situations that fit each of these types of options, for both calls and puts. But it is important to first review the definition of Delta before continuing.

Remember, delta tells you how much the option will move with a similar move in the stock and is given as a percentage. For example, a 33 delta option means that the option will move 33% of the movement of the stock and 70 delta option will move 70%. In-the-money options act like stock. The deeper in the money the calls are, the more they act like the stock. As the call moves deeper and deeper in the money, the calls delta approaches 100 which means it’s price movement will reflect 100% of the stock’s movement. (This is discussed in more detail later in The Stock Replacement Covered Call Strategy).

In fact, deep-in-the-money options are sometimes even used to replace stock positions. If you look at the charts below, you can see how closely the in-the-money call mimics the upward movement of the stock (2nd quadrant).

View Graphic

In the money options are best used for smaller stock movements. The reason is that in-the-money options contain less extrinsic value. The extrinsic value can work against you when purchasing an option because extrinsic value is affected by time decay.

As you wait for your stock movement, the in-the-money option will decay less than either the at-the-money or out-of-the-money options because it has less extrinsic value. The amount of money you lose in time decay must then be made back by additional stock movement.

Obviously, the less you lose in decay, the less the stock has to move for you to be profitable because it has less decay loss to make up for.

This is because an in-the-money call has a high delta and a much higher percentage chance of finishing in-the-money by expiration so they follow the stock more closely.

With less extrinsic value loss in the options investing to make up for, a smaller movement in the stock will produce a greater profit. For a call example, as you can see in the chart below, the in-the-money produces a profit with the least amount of stock movement. With less extrinsic value, the ITM option has a lower break-even point.

For chart below, stock price = $35.00 Strike Option Delta Breakeven Extrinsic Price Price Value

$30 5.20 85 35.20 $.20 $35 1.00 52 36.00 $1.00 $40 .30 20 40.30 $.30

-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-
If You Would Like to Learn More About Investing
Responsibilities Then Discover How to Protect Your Investments
With the Leveraged Power of options & Learn How to Trade Options
Like the Pros..

Click Here --> http://www.options-university.org
-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-

---

Have You Ever Seen A Map of the World Turned Upside Down?

For those accustomed to viewing things a certain way, it... Read More

Buying a Home - Your BIGGEST Investment

This column has often focused on intangible investments like stocks... Read More

My Way Or The Highway: Give Your Financial Professionals A Good Talking To!

All this talk about Investing is encouraging lately. Over the... Read More

Caveat Emptor: You May Owe Taxes Despite 401(K) Losses!

One among many ways you lose money in non-indexed mutual... Read More

Invest To Make Money, Not To Get Rich

The technology boom of the '90s romanticized the "rags-to-riches" ideal... Read More

What is an Investor Ready Business Plan

A Business Plan, as all good entrepreneurs starting out in... Read More

5 Ways To Protect Your Bond Portfolio From Rising Interest Rates

The Federal Reserve recently raised its target federal funds rate... Read More

Investor Guide to Financial Health

Step 1: Spend less than you earnPerhaps the simplest financial... Read More

Investing in World Markets

There are many different ways to invest in world markets:... Read More

June 2005: Weather Forecasts for Weather Traders

If Johannes Kepler, the renowned 17th century astronomer and discoverer... Read More

Creating a Financial Future--Putting Your Plan Into Action Part 2

Real Estate can be a useful tool for investing. The... Read More

Out-Of-State Investors Check List of Questions

The following lists of questions are suggested questions to ask... Read More

To Retire Rich, Save and Invest Early

If you want to retire rich, start saving investing early.... Read More

Penny Stock Investing

The Nature of Penny StocksFor anyone new to investing in... Read More

Investing for Retirement - Not an All or Nothing Play

In 1519, Hernando Cortes, beached on the shores of unexplored... Read More

Real Estate Clubs Hot Among Investors

Six or seven years ago, the stock market was booming,... Read More

How To Create Wealth In The Stock Market

First and foremost, an opportunistic strategy for creating wealth in... Read More

Preholiday Trading

The Light Crude Continuous Contract closed at $66.13 a barrel... Read More

Choosing A Financial Advisor

With so many financial advisors trying to woo you with... Read More

Finding False Gold in Penny Stock

As far as traders go, many do not see the... Read More

Press Release Scams and Successes: Reading Between the Lines

Press releases are a means through which companies can keep... Read More

Wit and Wisdom on Money, Wall Street and Success - Part #2

Here are ten more WISDOM packed GEMS that ooffer very... Read More

Trading Commodity Futures Using Support and Resistance - Paper Trading

Setting Up a Paper Trading AccountQuestion: I cannot trade with... Read More

Is a SEP Plan Right For Your Business

A SEP is a special type of IRA. Under a... Read More

Profitability And Stock Turn Rate

The inventory of the typical store represents the largest single... Read More