While these steps can be applied to any market and time frame, they are not intended to be used by themselves, but can help you avoid buying really cheap far-out-of-the-money options that have an extremely limited possibility of producing a return, writes the staff at Investopedia.com.
When it comes to buying options, most traders focus on the premium paid rather than the potential returns. While this is important information in terms of making a calculated trade, many options traders tend to lose sight of the probability of the market reaching and exceeding its position's strike. The average monthly range of the market number provides perspective on two important elements of an options trade: whether volatility is expanding or contracting and whether the market has a chance of reaching and exceeding the breakeven point of the position. Read on to learn more.
1. What is the Probability?
It is commonly said that the majority of options expire worthless. If that is a true statement and you are trading a position that is long premium (i.e. buying a call or a put), you need the market to have a chance of reaching a price that will make your option position profitable. When considering an option position, it is important to consider if it is probable that the market will reach that point. Just because the premium paid is cheap or underpriced does not make the trade a good one, especially if the market has little or no probability of reaching that goal.
2. Calculate the Average Monthly Range
To calculate the average monthly range, all you need is access to reliable historical prices. For any stock, you can get historical open, high, low and closing prices for a given date range. This will give you all the key numbers that will be used in the calculation-the high and the low for each trading day. To calculate this average for a given period of time, subtract the low from the high for each month to get that month's range. For the time frame, add up each month's range and divide by the number of months.
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|pagebreak|3. Select a Time Period
Generally, it pays to look at a time frame of twice the length of the option position you are considering, and then break this up into two separate blocks of time. For example, if the option you are considering has three months of time to expiration, look at the average monthly range of the last three months, the three months prior to that and the last six months.
4. Apply the Strategy
Using the Nasdaq 100 Trust (QQQ) as an example, we find that as of June 2007, the previous three months had an average range of $2.55, the three months prior had an average monthly range of $2.46, and the six months combined had an average range of $2.51. Therefore, we should look for options that will perform within the confines of a $2.50 move in a month. So, for a three-month time frame, you should look for something no more than $7.50 out-of-the-money. If the QQQ is trading at 46.50 in June and the August 48 calls are trading at 1.00, the top of the average monthly range takes us to 54. QQQ would need to trade to 49.00 for us to break even on buying the 48 calls for 1.00.
5. Words of Caution
In certain markets and at certain times, by using the average monthly range to choose options strikes, we may find that the implied volatility has pushed the option premiums to unreasonable levels. This causes smaller traders to buy strikes that are too far out-of-the-money, simply because they want to be in a given market and have limited capital.
In these cases, the use of the average monthly range should be telling you to either avoid that market, or to use a strategy that can get you closer to the current market price, such as a debit spread (bull call spread or bear put spread).
6. The Debit Spread
In certain market conditions, the debit spread gives the investor a limited risk position and gets closer to the current market than buying an option outright. In exchange, the investor sacrifices unlimited gains for a limited, but defined, maximum gain. This is often a favorable tradeoff, and will keep the investor grounded in the reality of what the market is more likely to do. The advantage of unlimited gains is normally only effective if the market were to make a rare historic move.
By the staff at Investopedia.com
