Which options are the best to trade?

From time-to-time, we either receive great questions or see interesting ones asked online in various forums. We realize that these are probably very common questions for both new and experienced traders alike.

When trading options, you have the ability to make trade-offs using both the trade direction (long vs. short) and strike price. As a trader, your decision is to trade-off between 1) the amount you can possibly gain, 2) the cost or max loss of the trade, and 3) the likelihood of trade success.

Out-of-the-money (OTM) options are option contracts that have no intrinsic value. If expiry were to occur today, these options would be worthless. With long OTM options, the cost is low but the likelihood of trade success is also low because the underlying will need to move in order for them to be valuable on expiration. Long OTM options will also only have extrinsic value so time decay will have a greater proportional impact compared to in-the-money (ITM) contracts. In-the-money options have intrinsic value unlike out-of-the-money options. With ITM (and at-the-money) options, the cost is higher but so is the likelihood of trade success. Also, in-the-money and at-the-money options will have a higher delta value. Delta is an option Greek that represents the option price sensitivity to an underlying price change. So, if the underlying moves favorably, an ITM option will see a larger price impact than that of an OTM option because the ITM option will have a higher delta.

The challenge with long options is that there is still an upfront premium you are paying. In order to profit at expiration, the underlying needs to move by at least the amount of what you paid. This is where there is an advantage to option selling. By collecting a credit, you are profitable as long as the underlying stays within a certain price band. Historically, option selling has a higher chance of trade success. Of course, the trade-off is that selling options can have substantial risk (max loss) and will have high margin requirements.

Something to consider: If you are concerned about trade success rates, a way to improve this for directional (long call or long put) trades is to use spreads. For example, you believe the Nifty will go up in the next few days. Instead of only buying a long call, you can also sell a call with a higher strike price. This sold option will reduce the total cost of the strategy thus lowering the break-even point and increasing the trade success likelihood (because the Nifty doesn’t have to move as much in order for you to break-even). The drawback is that you are capping your gains at the strike price of the sold call.

Here is a quick example of using spread to improve success likelihood. This is the option chain for Nifty Bank. The underlying price is 46058.20 and you decide to purchase a call option at the 46000-strike price that expires in one-week. This will cost you ₹470.00. To breakeven, the Nifty Bank needs to move up enough to cover the cost of entering into the strategy. In this case, it needs to move to 46470 (strike price + call option cost). This means that the Nifty Bank needs to move up +0.89% in the next week to start profiting.

Alternatively, you could enter into a 46000 / 46500 call spread. You would still purchase the 46000-strike call option for ₹470.00. However, you would also sell a corresponding call option at the 46500-strike price. This option is trading at ₹228.05. This credit of ₹228.05 would reduce the cost to enter into the bullish trade. Your net cost is ₹241.95 (470.00 – 228.05). To breakeven, the Nifty Bank needs to move up to 46241.95 (lower strike price + net strategy cost). The Nifty Bank needs to move up +0.40% in the next week to start profiting. This is definitely lower than the breakeven move of +0.89% required of the call option. The trade-off is that your gains are capped once the Nifty Bank moves above the upper strike price of 46500.

In summary, the most interesting part of trading options is the flexibility: the flexibility to select your strike price, expiration date, underlying, and whether you want to go long or short. In doing so, this gives traders the ability to make their own trade-offs so your option strategies can match your risk tolerance and style of trading.