How to Buy Out-Of-The-Money Stock Options
- “I was taught never to buy OTM stock options, they are too risky”
- “People who buy OTM stock options always lose money”
- “I only sell options- that way I ‘win’ most of the time”
- If a large group is afraid to make a certain trade that creates opportunity for others who know how to value these instruments.
- If the selling of options is commonly seen as the ‘safe,’ ‘reliable,’ or ‘easy’ trade than it will naturally depress the price of the options (the crowd prefers to sell rather than buy).
I completely understand this thinking and up until 2011, I was not a consistent buyer of out-of-the-money options either, but then `something happened that had a drastic effect on my approach.
In 2011, I started working as a market-maker trading stock options on the Chicago Board Options Exchange (CBOE.) As a market-maker, you’re required to make prices on a minimum number of stocks. For me, I would make markets on over 100 names and on every strike within those 100 names.
Some quick ‘back of the napkin math’- 100 stocks, 10 strikes for each stock option, calls and puts, and at least 3 expirations…that’s 6,000 active markets all day, every day.
I think you can see- valuing options to the $.01 is a key element for survival as a professional market-maker.
The opportunity to be a market maker was special at the time and making money was somewhat ‘easy.’ I do not want you to misunderstand– when I say ‘easy’, I mean in relation to other trades or markets.
A market-maker’s job is to ensure that all strikes have a market so customers of the exchange can trade freely. When an option contract is particularly illiquid, the market-makers can price themselves in an extremely wide spread. By wide, I mean they’re only willing to buy and sell at extremely advantageous levels.
In 2011, if the last trade in a given strike were a $1.00, the market-makers would be $.60 bid @ $1.40. At the time, market makers had an implicit understanding (not formal) that we would keep the markets somewhat wide (in this example $.60 @ $1.40). We knew that if markets were tighter we could lose our edge and thereby cannibalize our business. It was in everyone’s best interest to protect the wide spreads.
The table below shows how the bid/ask spreads narrowed over the years. In the column to the far right you can see who benefits and how the ‘edge’ has shifted from the professional market maker to the retail customer.
|YEAR||BID||LAST TRADE||OFFER||WHO BENEFITS?|
Here’s another example: If the last trade in a stock option is $1.00, and I’m the best bid for $.60 – another market maker could easily be $.65 bid. If I wanted to be the ‘best bid’ I could go $.70 bid and we could ‘do this dance’ until the markets are $.99 bid at $1.01. The result of market-makers competing against one another would be destroying the business.
Then something drastic happened – the robots came and they wouldn’t play fair!
Who are the robots?
The robots are automated market-makers that use algorithms to make markets more efficiently than humans. The effect is an increase in volume for the exchange and better markets for the retail traders. The ‘machines’ were content trading for a small ‘EDGE’ in each transaction whereas the humans need wider markets to compensate them for the risk. All this change is good because the markets were evolving and creating opportunity for those who can properly value stock options.
So now, what’s a professional option trader do?
Independent market-making was no longer a viable option because the ‘robots’ were backed by the deep pockets in the industry. It was time for a change, and if the market-makers were losing edge someone had to be capturing edge. Do you know who was grabbing that new found edge?
You, The Retail Trader!
And now Me, the retail trader.
In trading, I always follow the edge because if you stick with a bad trade long enough, it’s just a matter of time before Mr. Market wins. In this business, when trades fundamentally change, you have two choices: either change and adapt, or, find another market to trade (because those who hang around are doomed to failure).
As retail gained the edge, I headed in that direction- and here is the reason – as the bid/asks tightened in the options market, names that had wide (untradeable) markets in the past were now TRADEABLE. Names that used to be $.80 wide on every strike, now had bid/ask spreads that were down to $.20 and sometimes $.10. And that’s great for the retail trader…and now it’s great for me too!
Here’s an example: $PACB, Pacific Biosciences of Ca. Inc. As you can see, $PACB is an extremely volatile biotech stock. I’ll speak from personal experience because I would NEVER make a market that’s $.20 wide on a name this volatile. Never. Ever. Ever.
Thanks to automated market-making, we can now pick our side on high flying stocks like $PACB. Let’s look at the 12.5 strike: $.50 @ $.60. That’s a great market for the retail community. It is fair and it is tradable (we can transact if we choose). The 7.5 Puts look good too. Notice how the markets get wider further from strike ($15 strike: $.15 @ $.40) – this makes sense to me because even automated market makers have no interest in selling little out-of-the-money options on an extremely volatile Biotech stock. Maybe in a few years (if we’re lucky) those will also be $.10 wide …
Over the last couple of years, I have become laser focused on finding out-of-the-money options that the market has priced inefficiently. By inefficiently I mean the option prices are too low for how much movement there is- or the options are priced in a way that is too disconnected with how the stock historically behaves.
I no longer have an obligation to make markets on 100’s of stocks. I now have my ‘pick of the litter’ and can trade any stock option I choose. Here’s what I like to do: I sift through 100’s of stocks, 1000’s of strikes using the skill-set I learned as a market-maker and apply that to finding out-of-the-money stock options on speculative stocks. This is where the automated market makers are making poor markets and this is the area I try to exploit.
Let me walk you through an example using $ABC stock option:
What do we know about $ABC stock from its chart?
- $ABC is trading at its highest level of the year.
- $ABC’s range of the last 3 months: High Trade $45, and a low trade of $18 – so the range in the first 3 months of the year is $27.
- This stock is extremely volatile based on the 3 months of data in the chart. $ABC actually doubled in price in the last 14 days of trading.
Let’s look at $ABC again but this time instead of looking at the last 2 months of data, let’s dig deeper and answer these important questions.
- How much does $ABC move per month?
- How much does $ABC move every 10 days?
- How much does $ABC move per day?
The above chart breaks $ABC into different time-frames. It is the same as the previous chart but it provides more data. From this data we know the range (the difference between each month’s high and each month’s low):
|Month||High||Low||Month Range||Avg Move Per Day|
Let’s analyze further, what’s the movement if we look at $ABC in 10 day increments?
|10 Day Period||High||Low||10 Day Range||Avg Move Per Day|
|01/01 - 01/10||$30||$20||$10||$1.00|
|01/11 - 01/20||$29||$18||$11||$1.10|
|01/21 – 01/31||$32||$19||$13||$1.30|
|02/01 – 02/10||$32||$22||$10||$1.00|
|02/11 – 02/20||$37||$23||$14||$1.40|
|02/21 – 03/01||$45||$36||$9||$.90|
We have an idea of how $ABC has behaved over the last 60 days and we’re going dig further but we need to cover straddles because that’s going to be the key to how we value $ABC’s options.
STRADDLESThe first thing when looking at a new options chain is to value the straddle.
Definition: Purchase or Sale of an equal number of puts and calls with the same terms at the same time. A straddle buyer would buy at-the-money calls and at-the-money puts on the same stock. If the underlying stock significantly increases or decreases and the new value of the call or put is more than the cost to purchase the original two positions- you profit. The opposite of the buyer is the straddle seller. The seller shorts the at-the-money call and the at-the-money put.
Why does someone buy straddles? Here are a few reasons:
- In anticipation of an implied volatility increase.
- Betting that either the call or the put goes far enough in the money to make it intrinsically worth more than the call and the puts originally cost.
- You can never lose more than the cost of your straddle and your upside is unlimited.
- Time (theta) hurts the trader that’s long the straddle. They need movement and they need it NOW!
- When the underlying moves, long straddle holders get long stock on the rally and short stock on the break.
Example: $ADT stock is trading $10. The closest month expiration is 5 days away and the $ADT at-the-money straddle is trading $1.00 (the 10 strike calls are trading for $.50, and the 10 strike puts are trading at $.50).
In this example, the market is telling us that $ADT is priced to move $1.00 in the next 5 days. If we buy the straddle for $1.00, we are betting that $ADT moves more than $1.01, either up or down before these options expire in 5 days. The seller of the stock option straddle is betting on no movement.
Here is a trick I use when looking at a new options chain and it’s actually the first thing I do. Figure out the value of the straddle and use that information as a 50/50 bet of the underlying’s expected movement until expiration. Let’s look at the example below.
Above is the option chain for Facebook stock – last trade in $FB is $101.00
What can we learn?
- Options expire in 338 days: Jan 20, 2017
- The expected movement within 338 days is roughly $29.50 –
- $100 straddle: $16.00 for $100 calls and $13.50 for $100 puts.
- Buyers of the straddle need $FB to move $29.50 higher or $29.50 lower.
- Time passing hurts (theta)
- Stock movement helps (volatility)
- Sellers of the straddle need $FB to stay within the straddles range: $70.50 - $129.50.
- Time passing helps (theta)
- Stock movement hurts (volatility)
Here’s a trick for delta – it can be used as the percentage chance the option has to expire in-the-money. For the $110 calls, these options have a 49% likelihood of landing in-the-money and the $85 puts have a 25% chance to expire ITM.
Now that we have an understanding of straddles, let’s go back to our example of $ABC stock.
Earlier we established the 10-day range for the last 60 days was:
$10, $11, $13, $10, $14 and 9: The average for these periods = $11.17.
Next, using those 10 day increments we broke the movement down into average daily movement of $ABC. And here’s the average daily movement numbers: $1.00, $1.10, $1.30, $1.00, $1.40 and $.90: The average daily move using this data = $1.12.
So our findings show us this:
Using the last 60 days of data from the $ABC chart, the average 10-day range: $11.17
Using the last 60 days, the average daily range was: $1.12
Now for the fun part… Let us look at $ABC’s straddle (last trade $45) …
|Calls||Exp in 10 Days||Puts|
Straddle = $6.00
$3.00 for the 45 calls + $3.00 for the 45 puts
Straddle seller needs $ABC between $39 and $51
Straddle buyer needs $ABC higher than $51 or lower than $31
Do we think $ABC will trade over $51 or under $39 in the next 10 days?
We know this:
- Over the last 60 days $ABC’s average daily range = $1.12
- The Average move for each 10-day period for the past 60 days is $11.17
If $ABC moves up $.50 every day for 10 days…that’s a $5.00 move.
So, moving $6.00 in 10 days when the stock only moves $1.12 a day does not seem very likely. It doesn’t seem like its 50% likely either, which is what the straddle is suggesting.
This information tells me $ABC’s straddle is excessively expensive. Stocks gyrate back and forth even when making big moves. If $ABC moves $1.00 a day, then a $3.00 straddle would be a much more appropriate value for the straddle.
If presented with this trade: I would aggressively sell straddles in ABC.
By Jonathan Rose