What could be better than turning a small
investment into a mountain of money in just
a few months? Maybe buying that
out-of-the-money (O TM) call option for $0.20—
that’s a mere $20 investment, not including
commissions. And if its price goes to $10,
that’s a $980 profit. Do that a few times, and
you’ll be driving a golden Bentley around
your private island!
Truth be told, if it were that easy, ev-
eryone would be a bajillionaire. The story
of buying cheap O TM options and selling
them for some large multiple of the pur-
chase price as a means to strike it rich is
naturally too good to be true.
First off, the prices of O TM options don’t
always grow dramatically compared to
earlier prices, if at all. Sure, there are some
O TM options that can be $0.20 one day, and
$2 when the stock moves favorably. If the
stock is $100, that $107 strike call might be
$0.20, for example. And if the stock goes
from $100 to $109—a 9% increase—that 107
call could be worth more than $2. It can
happen, but it’s not likely. For that cheap
OTM option to be a huge winner, two things
need to happen: the stock has to move big,
and it has to move in the right direction.
Take a look at some OTM options on the
SPX on the thinkorswim® platform from
TD Ameritrade (Figure 1). Yes, the 2845
strike call is less than $2 (affordable,
by SPX standards). But with the SPX at
$2,704, there’s a theoretical 4.22% prob-
ability that the call will be in the money
(ITM) at expiration. That suggests a theo-
retical 95% probability it’ll expire worth-
less. Not so great.
Further, the SPX price needs to move be-
fore the option’s expiration. You may be able
to do that one time when you buy a cheap
OTM option. But two times? Three times?
Can you make a trading career out of that?
That’s your decision. But a more sensible
strategy that might also have a small capital
requirement and not require perfect market
conditions to be potentially profitable is a
short O TM vertical—a short put vertical
if you’re bullish, or a short call vertical if
With the stock at $100, a short put ver-
tical might be long the 96 strike put and
short the 97 put. If you took in a $0.35
credit, the capital requirement is $65 (the
difference between the strikes minus the
credit), which is also its max potential loss.
If the stock rises 9%, that short put vertical
could have a max profit of $35 (the credit
received), not including commissions.
That’s not as big a profit as you could get
on that long OTM call. But that short put
vertical can be profitable even if the stock
drops a bit, so long as it stays above $97
through expiration. The long OTM call
doesn’t have that advantage. So, consider
the long OTM option as a potential lottery
ticket (high risk, low potential reward),
and the short vertical as a kind of plain-
Who hasn’t seen ads
promoting a trading strategy
that will magically make
you rich? Or read an online
article about a secret
technique to squeeze money
out of the market? Here
are a couple such “secrets”
you may have heard of.
But we’ll show you how to
turn that too-good-to-
with more realistic
risk and return.