When to Buy Options

Sometimes options make a lot of sense.

They are a way to limit your dollar risk and achieve a higher percentage return on your investment.

But they are not suited for every trade. In fact, sometimes they are a terrible idea.

Let’s look at two trades…

Berkshire Hills Bancorp

Four weeks ago, I issued a Buy Alert for Berkshire Hills Bancorp (BHLB) to my Insider Edge subscribers after seeing heavy buying from company insiders.

The stock is up 14.27% in less than a month.

But I also recommended an option – the September $30 call for $0.95 – as another way to play it.

They are now worth $1.50 – a gain of 57.8%.

In this situation, you could have made 4X the return using a call option.

But this is not always the case.

Cyclerion Therapeutics

On the same day in May, I also recommended a stock called Cyclerion Therapeutics (CYCN).

CYCN is already up 50.19%.

I included an option pick on this one as well.

But the option is only up 100%.

A 100% return in just under a month is good, but it should have been more.

The BHLB options generated 4X the stock return.

But the CYCN options only produced 2X.

The reason?

Implied volatility – or IV for short.

Every optionable stock has an implied volatility figure for each expiration date.

It represents the volatility of the underlying stock.

If market makers expect the stock to make a big move, that IV number will be very high.

Conversely, stocks anticipating less severe moves will have a lower IV.

The BHLB options had implied volatility of 51.5%.

The IV for CYCN, on the other hand, was a whopping 228.3%.

The higher the IV, the more you are going to pay for the option.

And that goes for calls and puts.

You don’t have to master the option Greeks to have success as an option trader.

But you do want to know when trades have a low probability of success.

CYCN paid out because the stock made a monster move.

Had it failed to climb significantly, the value of those call options would have likely gone down.

If the IV is too high, you can lose money even if the stock goes in your direction.

My advice would be to avoid stock options with implied volatility above 50%.

Can you still make money with a high IV?

Sure.

We just doubled our money on one.

But in these situations, the risk/reward ratio will generally be better if you just buy the stock.

Of course, some stocks don’t even have options.

They’re too small.

Deswell Industries

Tuesday, I took a position in Deswell Industries (DSWL).

The stock had been setting up since March, and I entered on the initial breakout at 4.10.

The next morning, the long-awaited surge materialized.

Shares were up 17% in the first hour.

I sold half my position for a 13.9% gain and raised my stop to break-even on the rest.

Hopefully it continues higher.

Either way, I know I’ve got a profitable trade.

And I don’t have to worry about time decay or when my options expire.

P.S. I added GNK to my watchlist on Monday. The stock surged 8.06% Wednesday morning. Hopefully you got a piece of the action.