The allure of cheap ATM options

Risk.

An option risks only the price paid for the option...no more.

Comparing the two options from today's purchases:

CMC risks $510 and CVA risks $290. Take it one strike closer to the money and the overall cash risked is less. Buying the CVA ATM option right now puts $140 at risk and CMC ATM at $200 (and it is 50 cents OTM).

That makes these ATM options look enticing, but is it just because they are cheap?

Let's think about this for a moment.

Considering that they have no intrinsic value unless the stock price climbs AND the Extrinsic Value will most likely decline as the stock price comes up (Delta is usually around 0.50 for these so the IV goes up by $1 and the EV goes down by 50 cents).

Given this and assuming that I am willing to risk $300 per trade I have three choices:

1) buy stocks (100 shares) and set the stop $3 down
2) buy ITM options (1 contract) and set the stop roughly where the $3 stock price drop would be
3) buy ATM options (2 contracts) and set no stop

WAIT A MINUTE....SET NO STOP?

OK...Let's take CVA as an example, mainly because the closing price today was at the strike price of $17.50...or very close.

I bought one contract for $290 with an IV of $2.35. If the stock moves aginst me by $2.35 I lose all of the IV and some of the EV...total loss of perhaps $255 and I had to have had a stop in place to catch this. If it moves in my favour by $3 I gain $3 of IV and the EV may not change much as it is low already. So slightly less than a $300 gain for the position. Figuring out where to place the stop is tough as it is a moving target for a variety of reasons.

The current asking price for the ATM option for CVA is $1.40. I could buy 2 contracts for $280, slightly less than my loss allowance and slightly less than my actual ITM purchase. With the near 0.5 delta 2 contracts can produce the same option price move relative to the stock price move as 1 contract deeper ITM with a delta of 0.8 or greater.

If the stock price moves against me I lose no IV as there is none, only EV. As an example the next strike for CVA is $20...or $2.50 away but the option is only down by about $1. So the same $2.35 move against me would lose less than $1 overall per contract. About $200 for the entire 2 contract trade...less than the single ITM contract loss. Worst case is still $280.

Here is the catch. If the price moves in my favour by the $3, and I have the two contracts, the total IV for the position is now $600. The EV will likely drop but it cannot drop any more than the $280 it had in the first place, likely somewhat less...but let's take worst case. Lose all EV and the IV alone is still $600, I paid $280 so the gain is $320. Seeing as the $2.35 ITM option still has an EV of 55 cents it would stand to reason that the new option price would have close to that under similar circumstances...so the real number will be $110 more...that's $420 gain.

When we enter any position we do so with the expectation that the price will move in the direction that we anticipate, otherwise why make the trade. This means that having built in Intrinsic Value, by itself, is not as important as it may seem. Once the price moves in our favour the IV will move along with the price.

So taking a trade with no more risk and slightly better upside and not having to worry about anything other than a profit protection stop loss looks like a better all around trade to make.

The trick is finding those stocks that are ATM or slightly OTM that are poised for the next move and have the options priced accordingly. In hindsight I would have made those two trades today using this option thinking instead of what I did... so back to the charts to see what I can scare up for tomorrow... or with the long weekend this weekend, I may just wait until Tuesday.

Jeff.