Lessons from the Pros

Directional OTM Option Trading?!?

In one of my previous newsletters, I addressed the issue of the intrinsic value of option premium as well as the extrinsic (Time) component of it. However, no matter how obvious and self-evident those concepts appear to me, to my students, they seem to be extremely confusing. During my most recent class in Northridge, California, I encountered a student who needed an in-depth explanation as to why I discourage directional trading using OTM (out of the money) options on the high flyers such as Google.

In this example, which is intended for educational purposes only, I will go through my usual procedure of evaluating a possible trade which involves several steps such as doing Fundamental and Technical Analysis and then moving on to the examination of Implied Volatility. I will just briefly run through all three of them. Fundamentally, GOOG is not having a stock split in the near future, for this particular stock is well-known for its unwillingness to even consider stock splitting. Technically speaking, I have found GOOG, at the time of the writing of this article, to be in a formation known as an Ascending Triangle. The chart below shows the strong zone around 427 to 428. I marked it on the chart with a solid blue line, and it is apparent that that zone has acted multiple times as both resistance and support. The price, at the time of writing, was at 409.60 and I have marked with a black line a diagonal uptrend that was in play. I personally did not see any trade set up based on what the chart was telling me. However, for educational purposes only, the students and I continued our scrutiny of whether it would even make sense to trade GOOG directionally with OTM options.

Figure 1

The third step I take after Fundamental and Technical Analysis is the (I.V.) Implied Volatility check. With my students, we pulled up the website of the Option Industry Council which showed us that the current volatility on GOOG was 40.38%, while its extremes were: High of 94.12% and Low of 27.18%. When the I.V. is compared to itself, the current I.V. is at its lower range. High volatility is associated with the overpriced premium, while lower volatility tends to have somewhat less expensive premiums.

Next, I have moved on to the option chain evaluation. Figure 2 below shows the option chain on my TradeStation platform. I have customized the set up in such a way that it presents the information which is relevant for this newsletter. Reading the tabs from the left to right for the calls in the month of August include: Volume for individual strike prices, Open Interest (or outstanding contracts) on the individual strike prices, Time Value (or extrinsic value of the option premium), Intrinsic Value, Bid, Delta, and Ask. Notice that I have colored several columns in different colors. The Intrinsic Value is colored in green, Time Value in red, as well as Delta in blue. (In this discussion, I will skip discussing the Delta).

Figure 2

In white are the Bid, Ask, Open Interest and Volume on the individual strike prices. Hence, let me start by observing that the strike prices listed on GOOG are in 10 point increments: 440, 430, 420, etc. The fact that they are so wide makes it extra difficult for the option trader to time the entries as ideally as possible. This is the first strike/wallop. Next, observe the Bid and Ask spreads; they fluctuate between the tightest spread being 20 cents (on the OTM 440 call – Bid 8.70 and Ask 8.90) to the widest being 50 cents (on the deep in the money 380 call – Bid 39.20 and Ask 39.70). I personally prefer penny or nickel wide Bid and Ask spreads as they are on the major ETFs (Exchange Traded Funds – SPY, QQQQ, IWM, & DIA). This is the second strike/miss. The third one comes from the low open interest. Observe that both volume on the individual strike prices and the OI are only in the double and triple digits. On the ETFs, mentioned above, I am accustomed to seeing liquidity which is way greater than on GOOG. The near the money 410 call has OI of 862 and volume of 232. In baseball, we say – three strikes and you are out. In short, GOOG has failed my test of bare minimum standards which includes (1) the strike price increments, (2) tight Bid and Ask spread on the individual strike prices, and (3) the liquidity of individual strike prices.

The table below, Figure 3 presents the data for the various August strike prices at the moment of expiry when the time component is completely taken out of the equation and we are left only with the true intrinsic value of the options.
Observe that instead of calling the Time (Extrinsic) Value by its name, I used the term Fluff.

Let me start by reading what each column stands for from left to right. Strike or Exercise price is the first one; I have selected only the call side for simplicity’s sake. It was not necessarily the direction of the trade that I was focusing on at the time, but the explanation of what all those different numbers in the option chain really mean for OTM options. The second in line is the Premium; the third is the Break Even Point at the time of expiration; the fourth is the Strike price versus the Current stock price. Notice that in that column I have also given the information as to whether the strike price was ITM (in the money), ATM (at the money), or OTM (out of the money). The fifth column is designated for the simple translation as to whether there will be any intrinsic value in those specific strike prices and if there is, I specified exactly how much. The last two columns are Fluff and To be profitable. Fluff, as already mentioned above, is the Time or Extrinsic Value. The last one named To be profitable is the simple explanation of what must happen in order for that specific strike price to be a winning trade if the trades were held until the expiry. In that column I have added two numbers (the Strike Price and the Premium Price) which in turn provides me with the BEP (Break Even Price) at expiry. It is from that price that I have subtracted the price where the stock was at the time of the entry. In the case presented above, GOOG was at 409.60.

The point of this table is to show that buying calls that are OTM (out of the money) is the easiest way to lose money when trading options directionally. For instance, buying the 440 call, which is over 30 points away from the current GOOG price, would cost 8.80 and at the time of expiry GOOG would have to be 448.80. At that level the directional option trader of the OTM options would hardly breakeven, not counting the cost of the two commissions. By buying the 440 call, the trade would force a 39.20 move on GOOG. The next lower strike price or 430 call would still be "forcing GOOG" to me, but this time only 32.40. The 420 call would require a move of 26.40 and so on and so forth. In other words, buying an OTM option is not the best way to trade options – period. Spread trading is a much better choice – period.

In conclusion, I have given my stand on directional option trading of OTM options by utilizing the example of Google. I looked at both Fundamentals, Technicals and then I zoomed in on the volatility of GOOG. Finally, I looked on the option chain in order to analyze how an OTM option must perform in order to become a profitable play. This led to the observation that the easiest way to lose money on options is to be a buyer of OTM premiums. Stay away from buying the OTM calls or puts. Enjoy the rest of the summer and keep the sizes small.

- Josip Causic