Currently the Implied Volatility of options is high, making them expensive to buy. The challenge facing option buyers during times like this is how to overcome some of the inflated option pricing. One method to avoid paying too much for volatility and time value is to buy In-The-Money (ITM) options. The further that options are ITM, the less you pay for the volatility and time component of that option and the more you pay for the real or intrinsic value.
With oil appearing to find support around US$60 a barrel and Santos (STO), being a large producer, I’ll look at a way of going long on the company using ITM options to benefit from a rise in the price of oil. Due to the current volatile market, this will be a short term trade as I don’t want to buy a lot of time value in case the share gaps down significantly.
For example, with STO currently trading at $13.50, the $12 December 08, Call option costs $2.35, which means that it has $1.50 of real value and 85 cents of volatility and time value. Whereas the $14 December 08, Call option at $1.30, is all volatility and time value. Simply, this means that if STO is trading at $14.00 at expiration then the $12 Call option will still be worth $2 but the $14 Call option will be worthless.
Using options has two main benefits. One is that they will limit my maximum risk to $2.35 per share. Not that I intend to lose that much, but should the share gap down then the potential for maximum loss is always there. However, due to the way that options work, should the share gap down to say $10, the option will still retain some time value. The second benefit is that I don’t have to come up with the full $13.50 per share. This allows me to preserve capital or be in other trades at the same time.
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Whilst the STO chart does show a large drop in price for the first half of October the share has recovered strongly in the last two weeks. In ProfitSource, a short term Elliott Wave setting is showing the start of an ABC pattern. The Oscillator has also made a strong recovery. See above.
The Actual trade is to buy 1, December 08, $12 Call contract for $2350 (1000 shares x $2.35). My intention is to only keep these options until the 28/11/08 unless I’m stopped out or have made my profit target beforehand. My stop loss is if STO trades at or below $11.95 and my profit target is STO at $15.
As you can see I now have a very simple trading plan in place, with a time stop as well, this is extremely important when trading options.
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Figure 2 shows an OptionGear risk graph of the trade, demonstrating that even if the share drops to less than $12 in the short term, the Call option will still have value. The red curved line represents the current value of the trade as the share price rises or falls.
Remember, you always have options,