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Aug
7
The Sweet Spot
If you’re going to buy a call, it’s best to buy one that will closely mimic the movement of the stock. This philosophy pretty much demands that option traders buy in-the-money calls. Of course, in-the-money calls cost more than out-of-the-money calls. But the question then arises, “how far in-the-money is optimal?”
In the Options Mastery Class offered by Options University, they talk about “the sweet spot”. This is an area where we combine the two important factors involved in a stock replacement strategy. We want to mimic the stock as close as possible but at the same time move far enough away or down the ladder in terms of total dollar price.
When we try to mimic the stock’s movement and also move away from the at-the-money option price, the option is filled with all that extrinsic value, all that money that decaying premium demands that the option has to outperform and at the same time is going to decay while we’re waiting for it to go into-the-money. During this time, the out- of-the-money option is susceptible to movements in volatility, which we’re obviously not playing here, we’re trying to get away from at-the-money but we don’t want to go too far in-the-money either because then we get into higher dollar values.
What we want to do is look at an in-the-money option and hunt for the “sweet spot”. How do we do that? Well, we look far enough from the at-the-money option price where we can get rid of any extrinsic value in the price without getting too deep into-the-money. As a result, normally the sweet spot is located right around 80-85 Deltas; just far enough from the at-the-money and not too deep into-the-money. No need to do complicated calculations, just look for 80-85 Deltas. If you do that, you will be at or near the “sweet spot”.
Along with locating the sweet spot is optimizing your timing. In other words, how far do you want to go out in time? First thing, look at the chart of the stock and see if your projected movement has happened in the past and how long it took to take place; in other words, what‘s a reasonable rate of movement for the stock? Can this rate of movement take place within the option expiration period? In effect, you are trying to use historical movement as an indicator of future movement. Of course, you need to investigate what had caused the past movements and determine if the reasons are related to your analysis. You want to understand if past large movements were caused by unusual events or events similar in today’s scenario. If it is, then the comparison has more validity.
Also, you want to try to give enough time for your forecast movement to take place but not too much because of the cost of Theta decay. So, take a look for the type of stock movement you anticipate and use that as a guide and provide enough pad on front and back end of the expiration period you choose to allow for a variance in time.
For more information on all things stock option, contact the Options University at www.optionsuniversity.com
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