Secret 28ANALYZE YOUR OPTION POSITION

Beware of the “any horse in a barn” approach to option buying.

Ninety percent of all option buyers approach the option markets

totally wrong. They think a stock or futures will move up or

down and randomly select any option they can find on that stock

or futures without carefully analyzing the option position and determining

whether it is a good or bad play.

A classic error made by option buyers is to see the underlying

stock, index or futures move the way they have predicted but

to purchase an underlying option that does not increase in value

at all. One option buyer bought a call with a strike price of 20 for

a price of 1 when the stock was 13. The stock did rise to 20 at expiration,

but the option never rose above the price paid for it and

expired worthless. Options have their own risk-reward picture,

and you must understand that picture before entering a position.

The beauty with options is that you can mathematically

measure what an option is worth and what your probability of

profit will be. In fact, the mathematical model for measuring the

real worth of an option won a Nobel Prize in Economics in 1997.

We will discuss option analysis in future chapters, but the

process of option analysis is easier than you think. To do it properly,

a computer is required, but even a Palm hand-held computer

would do for about a $100 investment.

These three items are what you need to know as you compare

options in order to select the best one to buy:

1. The fair price of an option

2. The probability of profit

3. The delta

How do you use this information? Try to buy options where

the option is under the fair price. Know that the higher the probability

of profit and the higher the delta, the better the play.

But, what is the delta? The delta tells you how the option

will move if the stock or futures increases 1 point. For example, if

the delta is .30 and if the stock increases 1 point, the option will

increase 30% of a point or .30.

There are many computer programs that will provide this

output, including Option Master®, which also works on a Palm

system.

If these three items do not look good, look for another option

or create a strategy that has a good risk-reward picture, (to

be covered in a future chapter). If I can’t find a good play on the

underlying stock or futures, I pass the position or just play the

underlying stock or futures without using options.

Beware of the “any horse in a barn” approach to option buying.

Ninety percent of all option buyers approach the option markets

totally wrong. They think a stock or futures will move up or

down and randomly select any option they can find on that stock

or futures without carefully analyzing the option position and determining

whether it is a good or bad play.

A classic error made by option buyers is to see the underlying

stock, index or futures move the way they have predicted but

to purchase an underlying option that does not increase in value

at all. One option buyer bought a call with a strike price of 20 for

a price of 1 when the stock was 13. The stock did rise to 20 at expiration,

but the option never rose above the price paid for it and

expired worthless. Options have their own risk-reward picture,

and you must understand that picture before entering a position.

The beauty with options is that you can mathematically

measure what an option is worth and what your probability of

profit will be. In fact, the mathematical model for measuring the

real worth of an option won a Nobel Prize in Economics in 1997.

We will discuss option analysis in future chapters, but the

process of option analysis is easier than you think. To do it properly,

a computer is required, but even a Palm hand-held computer

would do for about a $100 investment.

These three items are what you need to know as you compare

options in order to select the best one to buy:

1. The fair price of an option

2. The probability of profit

3. The delta

How do you use this information? Try to buy options where

the option is under the fair price. Know that the higher the probability

of profit and the higher the delta, the better the play.

But, what is the delta? The delta tells you how the option

will move if the stock or futures increases 1 point. For example, if

the delta is .30 and if the stock increases 1 point, the option will

increase 30% of a point or .30.

There are many computer programs that will provide this

output, including Option Master®, which also works on a Palm

system.

If these three items do not look good, look for another option

or create a strategy that has a good risk-reward picture, (to

be covered in a future chapter). If I can’t find a good play on the

underlying stock or futures, I pass the position or just play the

underlying stock or futures without using options.