I recently opened an e-mail from a member of The Trend Rider who had asked me what I think about an energy company that I have touted in the past.

He owns call options. 

He wanted to know if we shared the same logic in believing that the stock would ultimately trade higher.

While I agreed with this trader's logic on the company itself, I did not share the same views on which option would be the best one to trade. 

Below you will find most of the actual reply that I sent to this member. 

I thought that this is a very common issue that anyone who has traded options should have a full understanding of. 

Here it is: 

Dear -------, 

I know that you spoke with an associate of mine who told me that you spoke about cheaper options, as opposed to more expensive options that are deep "in the money."

I, personally, always prefer to buy calls that are deep "in the money" because the calls that are deep in the money have much less time value (on a percentage basis) than options that are "at the money" or "out of the money."

One advantage of buying options that are "deep in the money" is that if your stock were to trade flat until expiration, you would have minimal loss. If you own at the money, or out of the money options, and your stock trades flat, the options would trade to zero.

So while the options that are deep in the money may be a bit more expensive, you are essentially trading a portion of the stock (plus maybe 10%-15% extra time value.) If you own at the money or out of the money options, you are really gambling your money trading an instrument that is 100% time value.

I usually figure out where I believe that the stock will trade, and then I calculate how much the option will be "in the money" if the stock were to hit that target price. 

To calculate what this number will be, I take that target price and subtract the strike price of the option. I assume that THAT dollar amount is all that I will get out of the option. For instance: If XYZ stock is at $50, I may buy the 40 call which is already 10 points "in the money" ($50 - 40 strike price =10).

Those calls may trade at $12, which means that they have 2 points (or 20% extra) in time value. Let's say I think the stock trades to $65. That would cause the 40 calls that I bought at $12, to trade up to $25 per contract ($65 p/share target price of stock - $40 strike price of the option = $25.) Now there may be a little extra value in the option. 

For example, it may trade up to $26, or maybe $25.80, but I typically will still assume that it only gets to $25. The main reason that I assume that there will be zero time value, is because there will actually be very little time value, at best.

If we are close to expiration, there will probably be zero time value. But even if we are far away from the expiration date, when we sell our call option when the stock hits $65, there will be very little time value left in our option. (Maybe about 3%-5% time value.)

Options that are deep in the money lose a significant amount of time value. The more "in the money" an option becomes, the less "time value" it will have. This is true whether we opened our position with options that are deep in the money, at the money, or out of the money.

Take the above example - Remember: our XYZ stock which trades at $50, decides to trade 15 points higher to $65. But let's say that this time, we decided to buy the $55 calls (which are 5 points "out of the money") before the stock made it's move. 

Assume that we bought the 55 call option at $3.80 p/contract. (This $3.80 option is 100% time value because it is "out of the money.") Even if on that SAME DAY, the stock traded to $65 p/share, that 55 call option may only trade to $11.00 or so. The stock traded 15 points higher, but the option only traded $7.20 higher.

Notice that even though virtually zero time has passed (maybe a few hours,) your 55 call option has lost $2.80 in time value (your option started out having $3.80 time value and now only has $1.00 in time value because it is 10 points "in the money" and only trades at $11.00.) 

If you follow the first "deep in the money" example, you put up $12, and make $13 profit. If you follow the second "out of the money" example, you put up $3.80 and make $7.20 profit. Sure, if everything goes perfectly, you made a larger percentage gain in the second example.

But the problem is that you are taking a MUCH larger risk and will succeed less often with the second example. As we all know, things don't always go as we hope they will. 

That is why the second example is very aggressive. The first is the smarter way to live to fight another day if things go wrong. Also, when traders lean towards the second example, it is usually because they feel that they can buy more, since the option trades at a lower price.

But the reality is that the trader is also risking much more in the second example. If the stock traded flat in the first example, you only lose 20%. If the stock traded flat in the second example, you lose 100%. If the stock traded 3 points higher in the second (more aggressive) example, you may make a profit, but you also may lose money depending on how much time it took the stock to trade 3 points higher. 

What a bummer! I know; I used to do the same thing. I got greedy in 1997 and made a killing for myself and my clients. I was on cloud nine. I multiplied accounts by 500% in less that a year. I mean I couldn't lose... 

Yeah, okay. The market turned sour in April 1998, and there was another killing. Only I hadn't made it. I suffered it.  Again, I hope that this helps.

The point is that I believe that it is better to be less aggressive. When playing options it is easy to cross the fine line that exists between using options to reduce risk, and using them in a way that significantly increases risk.