Cheap Versus Expensive Options
Many traders, especially beginners, are often faced
with a simple choice to be made regarding
Options Strike and
Even when a trader has defined a
and decided what expiration to use and whether he/she should buy out of
the money, in the money or near the money options the question still
remains. This question can often be simplified to: Should I buy cheaper
or more expensive options?
To more clearly describe the situation lets assume
that we have a trader willing to invest $10,000 in cheap options and
$10,000 in more expensive options, where $0.05 per options contract is
the cost of the cheap options and $5 per options contract is the price
of the expensive options. In this case our options trader would buy
2,000 contracts of the cheap options and only 20 contracts of the
expensive options. As a rule the $1.5 per options contract is paid as
commission and each trader pays commissions twice - when position is
open (options are bought) and when position is closed (options are
sold). In our example a trader would have to put $6,000 over the top as
a commission for buying and then selling cheap options and only $60
commissions for the expensive options. As you see in the first case with
cheap options, our trader has to expect at least a 60% increase in the
options price to cover only the brokerage expenses without pocketing any
profit. In the case of expensive options only a 0.6% increase in the
options price is required to cover the brokerage commissions.
Of course when a trader faces a decision as to what
options to buy, the gap between the cheap and expensive options is not
as big as in our example. However, this example clearly illustrates the
significance of the problem.
Basically, we have a simple choice
- to buy
cheaper options and pay more commissions
- to buy more expensive options and pay less
It looks like the answer is very clear, especially
with the fact that buying more expensive options is considered less
risky in comparison to buying the cheap options. As a rule the cheaper
options are more out of the money, and there is a higher chance that
they will expire worthless at expiration date and with the more
expensive options the more in the money they are, the fewer the chances
are that they will drop to zero price.
Even if the answer points in favor of the expensive
options, an options trader should always remember such factors as
options liquidity as well as the sensitivity of the options to the price
changes in the underlying stock. The deeper in the money options are the
less sensitive and less liquid, and very expensive options are not very
often the best choice for those who expect to close positions with a
profit in shortest possible period of time.
Our choice is to buy 1-3 strikes in the money options
that are 2-3 months until expiration. As a rule these options are still
very liquid and sensitive to the price changes in the underlying stock,
yet not very cheap (less commission is paid) and time decay does not
dramatically affect them.
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