Options trading: which month, which strike price?

Question

Looking for direction to something published on the subject, or general advice.

When purchasing a simple Stock Option, what method should be used to select which month and which strike price?

Sometimes I feel like it's a guess, having no real knowledge on the subject. Typically follow these self-made rules:
-Stay away from the current month unless it's the 1st week (e.g. I would not buy a Jan Option today with only 1 week to expiration).
-Calculate the premium: For Put contract take Strike less the Ask; for Call take the Strike and Add the Ask -the difference to the current stock price is the premium. $1-$2 premium to control an Option for 2 months seems within reason.

Answer 1

There are good tutorials and teaching materials at the Options Clearing Corporation website:

http://www.888options.com

An excellent short book is available at the Montreal Exchange website:

http://www.m-x.ca

This takes the reader, in less than 50 pages, from introductory material for beginners through simple combination stategies to more advanced concepts such as implied volatility and "the greeks." At this website, click publications, click guides & strategies, scroll down, click equity option strategies.

There are many books. Perhaps the most respected is Lawrence Macmillan, Options as a Strategic Investment. There's also Mark Wolfenden, The Short Book on Options. You might try borrowing these or others from your library first, to see how you like them.

Your idea of how to calculate the premium is not quite right, but it's appealing because it shows you are thinking logically and appropriately about the problem.

The premium is what you pay to buy the option.

The premium gets further divided into intrinsic value and time value. Intrinsic value is only present in ITM (in-the-money) options, and is the difference between the strike and the market price of the stock.

The rest of the premium represents time value. This is present in all, or almost all, options, whether ITM, ATM or OTM. For ATM and OTM options, all of the premium is time value as there is no intrinsic value.

Time value varies according to factors such as stk price and stk beta, time to maturity of option, implied volatility of option, calculation of the delta, theta, gamma of the option, calculation of even rarer "greeks." Time value decays towards expiration date, and decays most rapidly in the short period immediately preceding expiration. You've noticed that, because you already know not to buy an option during the current month.

Your "self-made rules" show that you've understood that time value exists. Now just to learn what the generally-accepted rules are !

Hint: it's the option buyers who generally lose money, because they are buying a wasting asset.

Hint: it's the option sellers who generally stand to make money, because they are repeatedly selling time value.

Answer 2

If you buy the July contract with strike 170, which is 18.7% out of the money, you place a bet that the GS spot price will increase from currently 143.21 (closing price on 9 July) to 170, by the expiry date of the option, which is on 18 July. This would mean an increase of the stock price by 18.7% in just 7 days. This is not very likely, and that's why the option is so cheap: last traded price was 10 cents at a volume of only 475 contracts. However, if you plan to sell the option before expiry, let's say on 13 July, you might break even at a stock price of 150 due to the convexity of the option value. All this without counting the transaction costs, of course.

Answer 3

The strike price should be very close to the current stock price and the expiration month should be at least 3-months out.

Answer 4

With no knowledge of options it sure is just a guess. Might as well be blindfolded and throw a dart. My advice is to not invest in anything you don't have a decent knowledge base in. Those self made rules tell me you are clueless.

Options can multiply your gains AND they can multiply your losses just as fast. There are advantages to them but they are far more complicated than simply buying a stock.