The Potential of Low-Priced Options

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The Potential of Low-Priced Options

When contemplating low-cost trading options, it is critical to grasp the distinction between “cheap options” and “low-priced options.” Essentially, inexpensive options have very little probable potential and are priced appropriately, while low-cost options are deemed undervalued and are therefore priced lower than their true potential may merit.

Learning how to identify legitimately low-priced options, as opposed to cheap options, is the foundation for any successful trading in the realm of options requiring less than the customary initial outlay.

One benefit of trading low-priced options is that they generate a better percentage return than most higher-priced options.

Key Takeaways

  • Cheap options have minimal potential and are correctly priced, but low-cost options are seen as cheap and may have growth potential.
  • A smart trader should be able to distinguish between the two and understand how to access and profit from trading low-priced options.
  • Volatility may be used by traders to identify and benefit from low-priced options, such as purchasing an option when its price fails to climb in tandem with its increasing volatility.
  • Low-cost options may be used for speculating, or wagering on the market’s future direction, as well as hedging, or safeguarding an investment.

Strategies for Profiting From Low-priced Options

Profiting from trading low-priced options requires options methods that take advantage of market volatility. In general, more volatility equals higher option prices, and if a trader can recognize a circumstance where an option price has not grown in line with its increasing volatility, they may have discovered an undervalued option affording the opportunity for a bigger profit with a modest outlay.

Options trading is based on two fundamental concepts: speculation and hedging, and low-priced options may be used in any of these scenarios. While speculation, or betting on the future direction of the market, is often regarded as a dubious practice, it could be argued that hedging, or using options to protect an investment, is still a form of speculation, because if the movement being hedged against does not occur, the money invested in creating the protection is lost. Using low-cost options as a form of hedging may at least guarantee that the amount of money spent to safeguard an investment is not too large to risk, regardless of the strategy’s result.

Areas to Understand When Trading Low-Priced Options

1. Leverage as Applied to Options

In option trading, leverage is the process of making the same amount of capital work more efficiently and financially. See the definition of trading leverage.

While the actual cash amount earned as a return on an option transaction is less, the percentage rise is often far more than the percentage increase in the return on a comparable stock investment. The option transaction also includes the danger of just losing a portion of the amount that may be lost on the stock.

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This simply implies that the same amount of cash might be employed over the same time period in a much broader variety of assets with a much larger potential return and a much lower risk per investment, which is a very worthwhile use of leverage.

2. Future Volatility

It is critical to understand how expected future volatility, or implied volatility, is used to determine how comparably high- or low-priced an option’s premium is in options trading, particularly when trading low-priced options.

3. Odds and Probabilities

A comparison of an option’s implied volatility to its historical volatility might help a trader predict the probability of a future stock movement. This odds and probabilities analysis assists the trader in determining if a low-priced option is really a good bargain and how to effectively make a transaction with a realistic expectation of a given result.

4. Technical Analysis

Technical analysis techniques, such as chart and candlestick patterns, as well as volume, sentiment, and volatility indicators, give a reasonable and tangible foundation for making options trading choices.

Using technical analysis tools will give the information required to build a profitable trading strategy, using criteria such as:

In the instance that the implied volatility is low compared with the historical price movement of the stock, this can be taken as an indication that a worthwhile potential trade could be made on this option. If the stock continues to move at the rate of its historical volatility, rather than slowing to the current implied volatility, a return could be expected that is in keeping with the higher price that the higher volatility would have commanded, meaning the lower price paid could be considered a bargain – providing that the market behaves accordingly with this strategy.

5. Market Optimism and External Influences

A large news event may cause a sudden shift in stock prices, which is frequently accompanied by a significant rise in implied volatility. The stock will normally settle to some extent in the months after this drama, as more news developments are expected. In most cases, a narrower trading range leads in a decrease in implied volatility. If a trader feels that a price breakout is coming, he or she may acquire options at the present lower cost, and if their forecast is true, the transaction might be called a steal. If the price fails to break out of the limited trading range within the trader’s time period, a loss may be made.

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6. Using the Black-Scholes Model

The Black-Scholes Model—a mathematical options pricing model—can also be used to determine the real value of an option in comparison to its price in order to determine if the option is truly low-priced or merely inexpensive.

Strategies to Undertake

1. Focus on Smaller Stocks That Offer the Potential of Greater Profits

While it’s easy to get caught up in the hype surrounding high-profile companies, big-name, big-money stocks don’t usually offer great percentage returns. In reality, the contrary is frequently true, with low-priced equities having a higher possibility of earning large percentage gains than high-priced options.

2. Avoid Short-term, Out-of-the-money Options

Although these options are less expensive than longer-term, in-the-money options, they are frequently “cheap” rather than “low-priced.” It is always tempting to trade the lowest options available, particularly for rookie options traders. They justify that they are lowering their risk. However, although trading inexpensive options does decrease the amount of capital outlay, the chance of a 100% loss is considerably raised since these cheap options have a very high possibility of expiring worthless.

3. Buy Higher-delta Options

Simply put, a higher-delta option is one that is more likely to expire in the money. An option that is already in the money has a large delta, and if this sort of option can be acquired at a cheap cost, this is the optimum situation for a potentially profitable and desirable transaction. Another benefit of higher-delta options is that they act more similarly to the underlying stock, which means that when the price moves, the options gain value quickly.

4. Buy Options With anAappropriate Time-frame Before Expiry

Options with a shorter period to expiration are less expensive since they have a smaller window of opportunity to make a profit. Although the investment may seem enticing due to the lack of a substantial initial expenditure, the low possibility of the close-to-expiry option yielding a profit implies that this sort of trader is playing against the odds. When trading low-priced options, buying options with a decent length of time before expiry is part of a successful trading strategy.

5. Consider Sentiment Analysis

When deciding which stocks to purchase low-priced options on, sentiment analysis may be used to determine the possibility of a present trend continuing. When price increases are accompanied by negative or bearish behavior, such as increased trading of put options, increasing short interest, and less-than-optimistic analyst ratings, it is frequently a good opportunity to purchase. As the stock price rises, the skeptics typically turn into prospective purchasers, ultimately jumping on board after discarding their pessimism. Alternatively, broad excitement for an upwards trending stock may signal that the majority of participants have already joined the trend and that it is nearing its apex.

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6. Implement Underlying Stock Analysis

When trading low-priced options, the use of technical analysis may give a solid foundation for picking and timing a transaction to profit on market movement and circumstances. A good understanding of the underlying stock is usually advantageous to the trader looking to make a profitable deal.

7. Avoid Complacency and Greed

Low implied volatility indicates lower option pricing, which is often the outcome of market greed or complacency. To properly locate and trade low-cost options, a trader must avoid falling into the same traps of complacency or greed. Don’t grow comfortable and believe that since the implied volatility is low and the option price is cheap, it must be a good bargain. Make certain that you are investing in a true low-cost alternative rather than a cheap one. Greed may be a trader’s deadliest enemy in all sorts of trading, therefore making sensible, reasonable, and consistent judgments rather than fantasizing about large gains is the path to success.

8. Use Mean-Reversion Trades

According to the notion of mean reversion, stock prices will return to their mean, or average, after a significant move. Because trading on the basis of mean-reversion is not a foolproof approach, it makes sense to join the possible snap-back price action of a stock that has reached its “snapping point” using low-priced options rather than the underlying equities.

The Bottom Line

Understanding the difference between an option that is inexpensive merely because it has a poor probability of being profitable and an option that is really low-priced due to undervaluation or volatility disparities is the key to effectively trading options with lower-than-average premium prices. A trader may become competent at generating regular winning trades and successfully leveraging their investment money by trading carefully picked low-priced options by properly following the tactics mentioned in this article and developing a solid knowledge of the ideas stated above.

Investopedia does not provide tax, investment, or financial advice. The material is offered without regard for any individual investor’s investing goals, risk tolerance, or financial circumstances, and may not be appropriate for all investors. Investing entails risk, including the possibility of losing money.

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