An at-the-money option has both advantages and disadvantagesover stock and in-the-money options. First, the at-the-moneyoption will be cheaper then both the stock and the in-the-moneyoption. So there is less capital requirement and less totalrisk.
Remember, when buying an option, you can only lose what youspend. The problem is the amount of extrinsic in theat-the-money option.
In order for you to profit from buying an at-the-money option,you need the stock to make a move very quickly. Because you haveso much extrinsic value, you will be battling against theoption?s daily rate of decay.
So, the movement of the stock must happen quickly enough andlarge enough to offset the amount of money you will be losingdaily as expiration draws near.
With this said, the best chance you have to make money whenbuying a naked at-the-money option is to use it as a short termtrade. The longer you hold onto this option, the harder it isfor you to be profitable due to the options decaying extrinsicvalue.
At The Money Call vs. In The Money Call
For chart below, stock price = $35.00
Strike Price Option Price Delta Breakeven Extrinsic Value$30 5.20 85 35.20 $.20$35 * 1.00 * 52 * 36.00 * $1.00 *$40 .30 20 40.30 $.30
An out-of-the-money option presents many of the same advantage &disadvantage parameters to the investor. The out-of-the-moneyoption is even cheaper then the at-the-money option which meansmore leverage and less risk.
However, with a smaller delta, the stock must move much morethan either the in or at-the-money options in order for theoptions to become profitable. Again, we need the option?s deltato outpace the option?s rate of decay.
Now, with the out-of-the-money option, there is less extrinsicvalue than the at-the-money option so the amount of totalpossible decay (cost of the option) and the rate of this decayis less than the at-the-money option.
By being further out-of-the-money, this option needs moremovement from the stock. As a naked option, thisout-or-the-money example is extremely speculative and shouldonly be used naked when the investor feels there is a very goodchance of a stock having a large percentage move.
An investor must understand that the odds of them profiting fromthe purchase of a naked out-of-the-money option is very slim.When purchasing a naked out-of-the-money option, be prepared tolose your entire investment.
Out of The Money Call vs. At The Money Call
For chart below, stock price = $35.00
Strike Price Option Price Delta Breakeven Extrinsic Value$30 5.20 85 35.20 $.20$35 1.00 52 36.00 $1.00$40 * .30 * 20 * 40.30 * $.30 *
Although options can be traded by themselves for directionalplays, and can perform well under the right conditions, they aremuch better used in coordination with stock or other options informatted strategies which will be discussed in the nextsection.
While buying naked calls and puts can provide some of thebiggest leverage and highest returns, they can also involve themost risk. This strategy should only be used by experiencedoptions traders or traders using risk capital.
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