Buying options, either bullish Calls or bearish Puts, is a limited risk tactic that can be used as a stock substitution strategy for directional trading.
No matter what happens to the underlying stock, the maximum dollar exposure is the premium paid for purchased options.
Less capital is required than outright stock purchases and the leverage of options can significantly increase returns.
Years ago a trading software company I worked with created a simple acronym to help traders purchase the right options to increase their probability of success.
DEPOT Method
- D – DELTA is the percentage that the option moves in comparison to the underlying stock or ETF. Choose a DELTA of 70% or higher to get an option that closely reflects the stock action.
- E – Expiration is important to have the time to be right. Ideally, you will purchase 2 to 3 months until expiration to minimize time decay.
- P – Premium is the cost of the purchased option AND the maximum risk for the position. This premium is typically less than 15% of the total outlay for buying 100 shares.
- O – Open Interest is the number of contracts already outstanding. This relates to position entry and exit ease with OI building over time. Option bid/ask spreads have dramatically tightened over the last years to lower actual execution costs.
- T – Time value versus intrinsic value is an important factor to consider – with a $1.50 or less a breakeven ideal. The deep in-the-money options have very little time value and will directly reflect directional moves in the stock or ETF.
The lesson to be learned is to buy better options…increase your probability with deep in-the-money calls or puts that are mathematically superior to long shot out-of-the-money plays.
The DEPOT method puts odds in your favor to profit from only modest market moves.
This disciplined approach to purchasing options is designed to increase the probability of success and buy enough time to be right.
