A Simple Step to Vastly Reduce Your Risk

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Last week, we grabbed our first handholds on the “learning wall” of options trading. 

This wall is steep… and perilous for the unprepared. If you start climbing without understanding what you’re getting into, it will humble you.

But that doesn’t stop plenty of traders from trying well before they’re ready.

See, a lot of times, traders try to climb the wall like Alex Honnold – the freak-of-nature free solo climber that scales sheer cliffs with nothing but his bare hands and a superhuman lack of fear response. 

Problem is, almost no trader going this route will survive the climb. 

You’re better off with a belay… a solid rope… and some carabineers to make sure one mistake doesn’t put you out of the game permanently.

That’s why this week we’re going to talk about your first piece of “climbing equipment” for the options market: an understanding of moneyness.

Before you can trade options for income… or use them to mitigate risk during a market downturn… or trade options spreads, which help you trade a bit of profit for a lot of safety… this is essential to grasp before you can “climb” any further.

So, commit these concepts from today’s TradeSmith Daily to memory. They’re a big part of your lifeline if you happen to lose your grip.

“We’re in the Money…”

So, what is this funny-sounding word, “moneyness?”

Moneyness is simply the relationship between an option’s strike price and its underlying security’s market price. 

We can think of it as the effectiveness of any given option, since it has a huge impact on the “premium” (or value) of an options contract. 

Options exist in one of three states:  “in the money,” “at the money,” or “out of the money.” 

If an option you hold is in the money, that means you could exercise it for a favorable result.

Last week we showed you what that favorable result is as a call option holder. If you own a $15 call option on stock ABC and that stock is trading at $20, you could exercise the option to buy the stock at $15 – a $5-per-share discount to its market value. 

That option is considered “in the money” because of your ability to do this. It’s specifically $5 in the money, which is also the intrinsic value of the option contract.

On the flip side, an out-of-the-money option has zero intrinsic value. That would be the case for your $15 call option if the stock were trading at $10, because if you exercised it, you would have to buy the stock at a price higher than the market value. (In almost all cases, you wouldn’t want to do this. But it’s important to understand you always have that right as an option holder.)

And when an option is at the money, it simply means the strike price is the same as the market price. So here, too, there is no intrinsic value.

What Moneyness Means for Your Trade

The game of options trading is all about determining the statistical probability of an option having or lacking moneyness, and how much, by the time it expires. 

When buying call or put options, the more moneyness you wind up with at the end of the trade, the better. And the further out of the money you go when buying the option, the more you stand to make if the stock does make it through your strike price, which would push your option into the money.

Imagine you bought that same $15 call option while the stock was trading for just $5, and it wound up at $20 by expiration. That option gained $15 worth of intrinsic value, which on its own implies a return of 300%. (The exact outcome also depends on the volatility of the stock and the timing of when this happens in relation to your expiration date.)

But, of course, there’s a trade-off: While your potential returns are higher, the probability of a far out-of-the-money option going into the money is much lower.

As for put options, it’s important to understand that moneyness works in reverse for those trades. Where with call options you want a strike price lower than the current market price, representing your ability to buy stock at a discount… with put options you want a strike price higher than the market price, representing your ability to sell the underlying stock at a premium.

It’s also important to understand that moneyness is not a universal good. If you are selling (shorting) an option instead of buying, for instance, you would actually want that option to have no moneyness at all at expiration (and to have a very low chance of attaining it). But we’ll get to those strategies in future issues.

For now, though, you can see how option moneyness lets you do more than simply make blind guesses as to which option to buy. You can create a trade plan first, find a price target, and plan your trade around that.

And that, naturally, is where TradeSmith helps you shine.

Mastering Options with the Probability of Profit 

At TradeSmith, we’ve developed a proprietary algorithm that determines the likelihood of any trade idea being profitable. We call it the Probability of Profit (POP) algorithm.

It factors in an asset’s volatility, its dividend yield,  interest rates, and more to create a simple percentage likelihood of this trade working out in your favor, depending on the strategy you’ve chosen. 

Calculating this on your own for each trade gets tedious. And turning those numbers into a 0%-100% odds figure is even harder. 

Lucky for you, our easy-to-use POP Calculator does all that for you on any asset in our system. 

Let’s continue using Apple (AAPL) as an example, like we did last week.

• Maybe we think AAPL is going to rise to $240 per share by next Friday, Sept. 13: about a 10% gain. Seems a little bold to me… but let’s go for it. 
• We’re also pretty confident it’s not going to fall too much: no lower than $215 per share, let’s say.

Let’s plug those numbers in the POP Calculator and see what we get:

As it turns out, AAPL has very low odds of hitting the highest target price of $240 by next Friday – less than 3%. And it actually has much higher odds of hitting the lower price target of $215 during this period – 58.14%, better than a coin flip.

On the second window, we get some probabilities that are useful for options trading. With these readouts, we can see the likelihood of each outcome so we can decide which options strategies are the best for us to deploy here.

Based on these readouts, it seems that buying put options in expectation of AAPL falling through $215 and those puts being in the money on Sept. 13 (29.07% odds; still not great) is a better bet than buying call options in hopes that it’ll have risen through $240 and those will be in the money (1.31% odds).

Matter of fact, the best trade here is to create a strategy which will benefit if AAPL is trading between those two prices next Friday: an outcome with 69.62% odds, according to our proprietary POP Calculator. That scenario is, in fact, possible to position for with options by using spreads… but also a topic for another day.  

That’ll wrap this week’s continuation of our options education series. We’ll be back with you soon on our next installment, which will cover my personal favorite way to use options – not as a buyer, but as a seller.

Have you ever ventured into the options market before? If so, how did it go, and what did you learn from the experience? I’d love to hear from you at [email protected]. While we can’t respond to every email, we do read them all, and we’d love to follow up on your emails on this topic in a future TradeSmith Daily.

All the best,

Keith Kaplan
CEO, TradeSmith