The Most Important Lesson for Options Traders

Two Important Notes

1) An option's delta changes as the price of the stock changes.

This is because the deeper in-the-money that an option becomes (due to the price movement of the underlying stock) the higher the delta becomes. In other words, in the ExxonMobil example, when XOM moves up 5 points from $65 to $70, the delta of the Jan 65 Call would move up from 0.50 to 0.65.

Theoretically, at that point (with XOM at $70), if the stock moved up one point (from $70 to $71) then the call (which now has a delta of 0.65) would increase by 65 cents.

So don't mistakenly think that if a call option has a delta of 0.50, that the call option would only move up by 5 points if the stock moves up by 10. That is incorrect because, again, the call option's delta increases as the option moves further above its strike price.

The more the stock advances, the more sensitive the option's price will be to each one-point movement of the stock. In fact, if ExxonMobil traded up 10 points (from $65 to $75), the Jan 65 Call -- which currently has a delta of .50 -- would actually advance by approximately $7 (from $5 to $12).

By the time the stock is trading at $75, the delta would move up to about 0.78.

2) An option's price (and the option's delta) can be affected by other factors.

In the first part of this series, we are only discussing delta. But the two major factors that impact an option's price and delta are time decay and a change in volatility of the underlying stock, exchange-traded fund, index, etc.

Replacing Stock With Options vs. Gambling With Options

The reason that so many people shy away from options trading and think that options are so risky is because the option novice tends to be attracted to the lower-priced options, which are the options that are the most difficult to profit from.

This is similar to the situation when people say that they would rather buy a stock that trades at $2 instead of a stock that trades at $20. They make the mistake of ignoring the probability of the stock trading higher. This is a common mistake made by inexperienced investors, and it is one of the absolute WORST ways to approach investing.

The two reasons investors mistakenly think cheap options are better are:

1) If the investor is successful, the win will be greater, percentage-wise.

2) If the investor is wrong, then he or she will have only lost the small amount invested.

But clearly, you can't argue both. You can't say the percentage gain is larger and then make the argument for the loss that the absolute number is "all you would lose."

Sure, the percentage gain might be higher if everything works out. But when the odds of success are low, you wouldn't feel comfortable putting any real money behind the investment.

Personally, I don't care if it's $5 or $500,000. No matter how much money you are putting at risk, the odds of success should be good. If odds favor a loss, why invest even $1?

We must look at our investment portfolio as a business, and not a lottery ticket.

Is Purchasing Out-of-the-Money Options Ever a Good Trade?


More specifically, not if you're purchasing those options by themselves. However, if you buy them as a hedge, or as part of a multi-leg option position, that's a different story.

But we are talking about stock replacement here, which just involves buying an option instead of a stock. I'm going to show you how to take less risk than the traditional stockholder.

First, you should understand that an out-of-the-money call option is an option that has a higher strike price than the current price of the stock. (With put options, it's the opposite. With puts, the out-of-the-money options are those with a strike price that is lower than the stock price. But we'll stick with call options in our examples.)

Below you can see eight call options listed. The strike prices are circled in red. The stock is trading at $65.70. The call options that are highlighted in yellow are the out-of-the-money options. You can also see these are the cheaper options, and they get cheaper with higher strike prices.

The option that is the least likely to advance is the Jan 85 Call (at the bottom), and the option that is the most likely to advance is the Jan 50 Call (which is 15.7 points in-the-money).