Directional OTM Option Trading

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Directional OTM Option Trading?!?
In one of my previous newsletters, I addressed the issue of the intrinsic value of option premium as well as the extrinsic (Time) component of it. However, no matter how obvious and self-evident those concepts appear to me, to my students, they seem to be extremely confusing.

During my most recent class in Northridge, California, I encountered a student who needed an in-depth explanation as to why I discourage directional trading using OTM (out of the money) options on the high flyers such as Google.

In this example, which is intended for educational purposes only, I will go through my usual procedure of evaluating a possible trade which involves several steps such as doing Fundamental and Technical Analysis and then moving on to the examination of Implied Volatility.

I will just briefly run through all three of them. Fundamentally, GOOG is not having a stock split in the near future, for this particular stock is well-known for its unwillingness to even consider stock splitting. Technically speaking, I have found GOOG, at the time of the writing of this article, to be in a formation known as an Ascending Triangle.

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The chart below shows the strong zone around 427 to 428. I marked it on the chart with a solid blue line, and it is apparent that that zone has acted multiple times as both resistance and support. The price, at the time of writing, was at 409.60 and I have marked with a black line a diagonal uptrend that was in play.

I personally did not see any trade set up based on what the chart was telling me. However, for educational purposes only, the students and I continued our scrutiny of whether it would even make sense to trade GOOG directionally with OTM options.


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Step Three
The third step I take after Fundamental and Technical Analysis is the (I.V.) Implied Volatility check. With my students, we pulled up the website of the Option Industry Council which showed us that the current volatility on GOOG was 40.38%, while its extremes were: High of 94.12% and Low of 27.18%. When the I.V. is compared to itself, the current I.V. is at its lower range. High volatility is associated with the overpriced premium, while lower volatility tends to have somewhat less expensive premiums.

Next, I have moved on to the option chain evaluation. Figure 2 below shows the option chain on my TradeStation platform. I have customized the set up in such a way that it presents the information which is relevant for this newsletter. Reading the tabs from the left to right for the calls in the month of August include: Volume for individual strike prices, Open Interest (or outstanding contracts) on the individual strike prices, Time Value (or extrinsic value of the option premium), Intrinsic Value, Bid, Delta, and Ask.

Notice that I have colored several columns in different colors. The Intrinsic Value is colored in green, Time Value in red, as well as Delta in blue. (In this discussion, I will skip discussing the Delta).


CLICK HERE FOR THE FULL-SIZED CHART

CONTINUED IN PART TWO...
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