We often hear about traders selling options. But why (or when) might a trader buy options?
Understand when it might make more sense to buy options
Know how much impact a change in the underlying stock price could have on the options price
Sometimes trying different strategies can open up new perspectives. We asked Brent Moors, education coach at TD Ameritrade, to shed some light.
It’s true that selling options has many benefits, but there are times when it may make sense to buy options.
Traders might use long calls and puts to make more efficient use of a portfolio’s capital (versus buying stock outright) to attempt to take advantage of a directional move in the underlying. If the stock makes a strong move in the direction you’re hoping for, its underlying options are likely to make a significantly larger percentage move.
For example, a 5% rise in a stock may mean a 50% increase in the price of a call option. A 5% drop in the underlying may mean a 50% increase in a put option. The lower cost of the options versus buying an equivalent amount of the underlying can translate to capital efficiency. For example, this could be a benefit when long puts are used to help protect a stock or an entire portfolio against a down move in the underlying stock.
Long options can also benefit from spikes in implied volatility (IV). Long options are vega positive. This may be advantageous in the case of long puts, because when there’s a strong drop in the underlying, IV will likely rise. The long put trader can benefit from favorable delta and vega effects. Bottom line: The sensitivity to volatility changes might mean you can use long options when you anticipate large volatility moves.
But these benefits also have another side to them: IV can drop and make it even harder to make money.
Then there’s theta lingering in the background that can work against you. But you may be able to minimize theta damage. Theta is generally higher closer to the expiration date and when it’s closer to being at the money. So you could buy options that are further out until expiration, shorten the holding period of the contract, and buy contracts that are further in the money (ITM).
Is there a way to figure out how much impact a change in the underlying stock price may have on the options price?
The Theo Price tool on the thinkorswim platform could help. You can find it in the Option Chainunder the Trade tab. Select Theo Price, Mark from the Layout menu, then select Theo Price. This opens a menu where you can make theoretical adjustments to the stock price. In the Option Chain you can see what the theoretical price of the option might be.
By changing strike prices and expiration dates, you can help control how much risk to take when buying options. Generally, the more ITM a contract is and the further out until expiration, the more expensive it’ll likely be.
Options buying can be an important part of your tool chest. In general, these tips can help you navigate the world of long options:
While options trading involves unique risks and is definitely not suitable for everyone, if you believe options trading fits with your risk tolerance and overall investing strategy, TD Ameritrade can help you pursue your options trading strategies with powerful trading platforms, idea generation resources, and the support you need.
Learn more about the potential benefits and risks of trading options.
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