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When a trader thinks that a stock will go up they can:
1. Buy the stock, or
2. Buy its Call Option, or
3. Buy its future. Or
4. Sell its Put Option
Similarly, when a trader thinks that a stock will go down they can:
1. Short the stock (shorting the stock is possible intraday only), or
2. Buy its Put Option, or
3. Sell its future. Or
4. Sell its Call Option
In this article, I will discuss when you should buy a call or a put option. I have explained in my blog that buying an option means you are racing against time. It doesn’t matter if you are buying a call or a put option. Once you buy an option, you are racing against time.
Read below to know when you should buy a call option.
The expiry should be at least 30 days away.
This is very important. If the expiry is very near, then the option’s premiums will start decreasing very fast. The premium decay will be so fast that you will not be able to exit the trade quickly or exit the trade with a profit unless, during that last period, the stock moves rapidly up. Usually, it will not happen because during the last couple of days before expiry all the buyers and sellers create liquidity. The liquidity is so much that the demand and supply remain the same, leading the stock to move down or remain in the same position.
When the expiry is 30 days away, at least for the next 10 days, the time premium value, a.k.a. theta, does not erode too much. So try to exit at least 20 days before expiry if you bought an option.
If the INDIA VIX is below 15 the option premium will be less than average, if it is between 15-20 then the option premiums will be average and if the INDIA VIX is above 20 then the option premiums will be above average and will keep increasing with the increase of INDIA VIX. So decide accordingly.
The benefit of a low VIX is that you will get options at a low cost so the risk will be less, but if the VIX is high you have to pay a high premium to buy an option on the other hand, it will lower the risk as a high VIX will indicate huge movement which may lead to a profit.
However, in most cases, you will know why INDIA VIX has increased. It will be mainly due to an upcoming political event like elections an economic event like budget or geo-political events like a likely war or an attack by another country.
Once the event is over there will be a sudden drop of the INDIA VIX within 2-3 working days. You must exit the bought options before the event ends, or else you may suffer a huge loss as the option premium will erode quickly. In such cases even if you are right in direction the premium erosion will eventually negate the delta increase so you may not get the desired profit or suffer a loss.
Do not buy ITM options, ATM options or Very Far OTM options:
In The Money (ITM) options are very costly. They behave like Futures. If right in direction they will make a good profit for you, but if wrong in direction the loss will be huge.
At The Money (ATM) Options have the most time value and therefore face the fastest premium decay.
Very Far Out of The Money options are cheap but most of them expire worthless as the stock never reaches there. In ten times you will make a profit one time. They are very tempting to buy for their low price – but rarely do they give profit. So better avoid them.
Therefore buy slightly Out Of The Money (OTM) options – 2-3% far. They are not costly and they give good profits when right in direction, and less loss when wrong in direction.
Find intrinsic value to know if the option is overpriced or underpriced – then do this:
Earlier it was difficult to find the intrinsic value of an option as a lot of calculations are involved in the Black & Scholes model formula to know its intrinsic value, but nowadays your broker will display an option’s intrinsic value.
If the price of the option is above the intrinsic value then it is overpriced and needs to be sold. If the price is below the intrinsic value it is underpriced and needs to be bought. This is an important factor when deciding whether to buy or sell options.
However, depending on just the intrinsic value is not an ideal way to buy or sell options.
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