The Most Important Lesson for Options Traders

Many option traders lose money trading out-of-the-money options because they are overly confident in their prediction.

For example, they may think a stock will trade from $65 to $80 in a given period of time. But, most of the time, markets and stocks trade plus one or minus one standard deviation from the mean.

That is why time decay tends to be a factor that new, out-of-the-money option, traders learn about very quickly (and painfully).

An out-of-the-money option's delta will trend toward zero as time passes. And remember, the lower the delta is, the less the price of the option will be impacted by the movement in the stock.

Therefore, the underlying stock can trade much higher over time, but the call option with a very low delta could still trade lower, even to zero, even though the stock traded higher.

I'm sure many of the people reading this have bought an out-of-the-money call option because they thought the stock was going to advance, and they were right because the stock advanced, but disappointed because the call options traded lower anyway. That's because they bought the wrong call option. At the same time, other call options traded higher with the stock.

Trading With a Low Delta

Suppose XOM is trading at $80, and a trader is looking to buy call options because he is looking for a move of one point from $80 to $81.

If the trader were to buy the Oct 85 Call (which is 5 points out-of-the-money), the trader would pay $2.35 for the call option.

This call option has a delta of 0.37. That means that if XOM traded from $80 to 81, (all other factors being equal -- such as ZERO time decay -- so we assume that the stock moved the very same day), you could assume that the Oct 85 Call options would move approximately 37 cents higher.

The Argument for Buying Low Delta Options

If you bought the option at $2.35 and sold it 37 cents higher (within a day or two) at $2.72, then you would realize a fast 15.74% return on our money. Not bad.

If you have $7,050, you could buy 30 call options (representing 3,000 shares), and you would make $1,110 within a day or two.

If you got lucky, and you underestimated XOM's upside move, and it happened to trade to $95 (instead of $81), then you would make a killing (more than $30,000 on your $7,050 investment).

However, before you start mentally spending those profits ... STOP IT!

I can see the greed seeping out of your ears right now. A wise man once told me that the traders who make the HUGE profits like that are the same ones that take LOTS of big losses.

Remember, the low-delta options are the out-of-the-money options, and it's very likely that they don't end up profitable.