An option available at a low premium only is never a cheap option to buy. You should know about the intrinsic value and time value of an option to find a cheap option to buy.
Options make a low risk trading tool in futures & options segment. They carry significantly lower risk as compared to futures trading. Options are popular among retail traders because trading with options does not require big capital. Moreover, buying options enables you to make unlimited profits with limited risk.
You can trade options by investing a small amount, known as option premium. Options allows us to take exposure to a large trading position. This is because of the cash leverage, the options provide us. Allured by this property of options, beginners or inexperienced traders take big trading positions. They think that options are cheap to buy and they can make big profits with small investments. Most of the times, they have to face the losses in options trading.
Though it looks like options are cheap to trade but are they really? We will find out next and how to find a cheap option to make your trading profitable.
I assume that you know well what are options. In options trading, you buy options at lower price and sell them later at a higher price. The difference between your selling and buying price of options is your profit. Here your reward or profit potential is theoretically unlimited. Your risk is limited maximum to the premium paid to buy an option. You do not lose more than the option premium, you paid to buy an option.
While selling or writing options, it is the other way around. You sell an option at higher price and expect the price to fall to make money. You get the option premium as your profits. The net difference between selling and buying back is your profit earned. In option selling, your risk is unlimited and profits are limited.
Popularity of options among the market traders is because of requirement of less capital to take a trading position in the market and the lower risk. Although, most of the traders are aware of the benefits of options trading and are regular options traders, even then it is a fact that they are not as much familiar with option pricing as they should be.
Option pricing depends upon several factors which you must know in detail before you opt for options trading. These are market price of the underlying asset, time value (duration left), volatility, interest rates and very important options greeks. We are not going into much details of that here. You can learn about these factors here.
While talking about the option pricing, the aim of a trader is to buy an option at a cheap price and sell it at a higher price. So, let us move on to finding cheap options to buy in options trading!
Which Is The Cheap Option?
The question before us is now which option is cheap to buy. Here we are talking about available different strike options for any specific stock or an underlying security. Let’s take an example ;
The above image shows the option chain for stock of State Bank of India (SBIN), taken from the National Stock Exchange (NSE) website. The stock was trading at ₹ 2441.65 on August 1, 2014.
Suppose we expect the stock to move to ₹ 2500 in next few days and we need to buy a call option. So which option is cheap to buy among the different strikes available, from 2400 to 2550?
Possibly most of us shall be thinking of 2540 or 2550 because the premium needed to buy the 2550 call option is 125 (Lot Size) x 55 (Current Call Price) = ₹ 6875.
This is quite less compared to lower strikes such as 2400 where it can be 125 x 124 = ₹15500. For 2450 call option it is 125 x 96.75 = ₹12093.75. If you are thinking that 2400 strike call is cheaper to buy in comparison to 2450 or 2550, you are going great.
How Is It A Cheap Option?
To understand the reason behind it, you should be knowing that the option price includes two components –
Intrinsic Value of Option
The intrinsic value of an option is the inherent value of an option. This is the price which is valid even after the expiry of the derivatives contract. This is credited back to the option buyer after contract expiry. All options become zero on the end of expiry day.
‘Out of money’ (OTM)options become zero while all ‘In the money’ (ITM)options retain their intrinsic value and the corresponding amount is paid back to the ‘in the money’ Option holder.
All ‘in the money’ options have intrinsic value which is the difference between the stock price and the strike price. For SBIN stock trading at 2441, the 2400 strike call has an intrinsic value of 41
Intrinsic Value :- 2441-2400 = 41.
If the stock expires at 2441 on contract expiry, the option buyer will get back ₹125 x 41 = ₹5125 out of ₹15500 paid while the rest of the premium will be washed out.
‘Out of the money’ options have zero intrinsic value.
For all call options, the call strikes seen lower than the current stock price have intrinsic value. Similarly, for all put options, the put strikes above the current price of a stock are ‘in the money’ options. In the above figure all put strikes of 2450 and above are ‘in the money’ put options.
To make it easy to differentiate, the NSE has shown it in different colors. The yellow portion on the left side in the figure shows ‘in the money’ call options while the white portion shows ‘out of the money’ call options. On the right side, the yellow portion shows ‘in the money’ put options and the white portions shows ‘out of the money’ put options.
The premium reflects only the time value. The ‘out of the money’ options near the current stock price have high premium compared to farther strike prices. This is because the probability of stock price reaching the near strike options is quite high.
Now that we have understood the option pricing, we come back to our above example of 2400 and 2450 call option for which we calculated the premium as ₹15500 and ₹12093.75 respectively and we wanted to find the cheap option.
For 2400 Call Option-
Intrinsic Value :- 2441- 2400 = 41
Premium :- Option Price – Intrinsic Value = 124 – 41 = 83
For 2450 Call Option –
Intrinsic Value :- Zero (Out of the Money Option)
Premium :- Option Price – Intrinsic Value = 96.75 – 0 = 96.75
Thus we see that for 2450 call option, we are paying additional ₹13.75 as premium and it is only the time value of the option and it will go on decreasing as the contract expiry approaches near.
Before buying options, it imperative that we choose the right option by analyzing the option price. Don’t keep accumulating out of the money options with low prices just thinking that they are too cheap to buy. In fact, they are not cheap but costly.
The probability of the underlying security going there is low and the price of those options is only because of time value which goes on decreasing with each passing day and you may end up losing all the premium you paid to buy those options. Out of the money options make very good strategy to sell the options rather.