Thursday, December 20, 2007

Money Talks

Money Talks

Advantages and disadvantages of at-the-money option, in-the-money option and out-of-the-money option

Advantages and disadvantages of at-the-money option, in-the-money option and out-of-the-money optionAn at-the-money option has both advantages anddisadvantages over stock and in-the-money options. First,the at-the-money option will be cheaper then both the stockand the in-the-money option. So there is less capitalrequirement and less total risk.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 have so much extrinsic value, you will bebattling against the option's daily rate of decay.

So, the movement of the stock must happen quickly enoughand large enough to offset the amount of money you will belosing daily 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 shortterm trade. The longer you hold onto this option, theharder it is for you to be profitable due to the optionsdecaying extrinsic value.

At The Money Call vs. In The Money Call

An out-of-the-money option presents many of the sameadvantage & disadvantage parameters to the investor. Theout-of-the-money option is even cheaper then theat-the-money option which means more leverage and less risk.However, with a smaller delta, the stock must move muchmore than either the in or at-the-money options in orderfor the options to become profitable. Again, we need theoption's delta to outpace the option's rate of decay.Now, with the out-of-the-money option, there is lessextrinsic value than the at-the-money option so the amountof total possible decay (cost of the option) and the rateof this decay is 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 andshould only be used naked when the investor feels there isa very good chance of a stock having a large percentagemove.An investor must understand that the odds of them profitingfrom the purchase of a naked out-of-the-money option isvery slim. When purchasing a naked out-of-the-money option,be prepared to lose your entire investment.

Out of The Money Call vs. At The Money Call

Although options can be traded by themselves fordirectional plays, and can perform well under the rightconditions, they are much better used in coordination withstock or other options in formatted strategies which willbe discussed in the next section.While buying naked calls and puts can provide some of thebiggest leverage and highest returns, they can also involvethe most risk. This strategy should only be used byexperienced options traders or traders using risk capital.

About the Author:Brett Fogle is the founder of Options University, atraining resource partner for traders. For acomprehensive, free report on the 7 deadliest sins madewhen options trading, visit .

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