Carrying the nickname of the Option Addict means that by law I am required to talk about options at least once in a while. You’ll see my archives are full of good stuff like this, but today I am going to go back and talk about some key points to consider when evaluating option prices.

Always remember that shopping for options is like shopping for anything else; you get what you pay for. Cheaper options are of lesser quality and expensive options are of better quality. I will define quality as…

Increased sensitivity to price movements

Decreased sensitivity to time decay

Decreased sensitivity to implied volatility

As a buyer of an option, this is what you are looking for. Since time decay and volatility are typically more of an enemy than a friend, you want to defeat their ill intent. This is why in the money options are so valuable. You get to leverage the stock at a fraction of the cost, while not having to put up with the problems that time decay and implied volatility present.

The downside?

They are so damn expensive! And if the stock moves against you, delta isn’t all that appealing on the flipside.

“So Jeff, if what you are saying is truth, which we know you speak, why do you always trade out-the-money options?”

Let me give you the considerations of selecting an option first.

#1- Expected price movement.

#2- Expected time frame

#3- Expected change in volatility

#4- Expected probability of success

#5- Expected risk

#6- Source of trade recommendation

Expected Price Movement

The first and most important consideration is what you are expecting the stock price to do. If you are staring down the barrel of a breakout, big shift in momentum or just a big price swing in general, you can afford to take on more risk. The reason I trade a lot of out-the-money options is because I try to put myself in front of big price moves. Despite the out-the-money option being of lesser quality and lower probability, I see tremendous returns in exchange for an insignificant cost. Even though these trades start off with an insignificant sensitivity to price movement, a heavier gamma gives me comfort in the fact that if I am right in my price prediction, my sensitivity will increase dramatically.

Expected Time Frame

The quicker my stock moves, the lesser time decay becomes a factor. I always encourage traders to buy adequate time, and even when in doubt, to go further out! For those that buy short dated options, you are in a race against time. This means you stock needs to move in larger amounts to offset this loss in time value. To enhance this part of your selection process, only buy short dated options on stocks that make quick moves. And always default to buying more time than you need. However, don’t buy TOO MUCH TIME! I loathe long dated options.

Expected Change in Volatility

I hammer on this in most of my option courses and classes since volatility is a major player in the selection process. I have several posts that expand on this in greater detail. Click here to get started.

Expected Probability of Success

Look at delta as a measurement of probability. This means that an out-the-money option will have the smallest chance of success, while an in-the-money option carries the greatest chance of success. As always, a higher probability comes with a lower reward while a lower probability of success comes with a higher reward.

Expected Risk

Always pay close attention to what is really at stake in the trade. This can be determined in several ways. I like to consider the drop I am willing to take in the stock price, and translate that into the general impact in the option premium. If you use stops, consider the difference between the purchase price of the contract and where your stop is set. Or if you are a gunslinger, consider the full option premium.

Source of the Recommendation

It is easy to select an option when it comes from a credible source.

This will probably open up a a big can of worms, so I will try to be as responsive as possible to incoming questions. For those that struggle with selecting options, hopefully this can act as a checklist when making your choice.

Recommendation: If you are like me, you hate reading long posts.

Long: Short posts

Short: Long posts

Disclaimer: I love options