Short Term Direction

Good Morning!

This is the Jumping Cholla (CHOY-uh). The newsletter that turns options market insights into a fun, easy-to-read email that helps you reduce your chances of getting pricked while trading!

And even if you don't trade, learning how to think like a trader builds a robust framework for problem solving, taking risks, managing a plan, and just living life.

Quote of the day:

"When it comes to investing, there is a big difference between the price of an option and the value of an option."

When you're buying an option, you gotta know what you're paying for! You are buying time for your trade to become profitable.

And unless you know Doc Brown and Marty McFly, time only goes one way. So in essence, you're buying the worst type of asset...a depreciating one!

Now what if you can buy a cheap option that will turn into an expensive option? Well, that's finding value.

Today, we'll discuss how you can efficiently buy an option that expires today in order to bet on directional movement.

BANG for Your Buck:

Large Option Positioning

• 4065 strike creates positive gamma for dealers and will act as resistance.

• 3900 strike creates large negative gamma for dealers, which will exacerbate movement near there.

Buying a 0DTE Option to Bet on Direction

As we covered last week, 0DTE options offer an interesting proposition when it comes to intraday directional plays.

• Built-in stop loss

• Asymmetric payoff

• Guaranteed no overnight position

Today, we're only going to look at getting long an option because 1) most people can't initiate short in their retail trading accounts 2) it's the most simple to understand and will serve as a foundation for position management.

Let's recall a key concept, time is the most valuable commodity. The graph below shows the value of the 4030 Call at expiration (grey line), as well as the value a few hours before expiration (green curve).

GOAL: Find an option that you believe will end up in-the-money and pay as little as possible for the option's "time value"

The area highlighted in yellow is the extrinsic value (time value of the option).

You will notice that the difference between the green line and the grey line is the largest when the underlying is at the Call's strike price, 4030. (No need to dust those books off, but yes, this is calc 2!)

The time value is less when the market is slightly above OR below the red line. Intuitively, this should make sense. When the option is at its strike price, there's a 50/50 chance it will end up a winner. But the winning side has "unlimited" profit, whereas the losing side has a "fixed" loss. (you only can lose what you paid).

It should also make sense that if the underlying goes down, your call option will lose value. (your call is all "probability" at that point i.e. it has a chance to make money but hasn't yet)

But think about this: even as your option goes into the money (appears to be winning), the time value you paid for will decrease in value!

When you buy an option, you are betting that by the end of the day, the increase in "intrinsic value" (how much your option wins by) is greater than the loss in extrinsic value.

This is the key to using a 0DTE option for a directional play: the market must move enough in your predicted direction so that it offsets the cost of the option!

How Value Increases

1. Extrinsic value can increase if your bet becomes more likely to win (FYI, this is why a 0DTE option is more efficient than a futures contract...if you're right!)

2. Intrinsic value can increase when your bet actually starts winning (the underlying is higher than your strike price)

When Do You Buy the Call?

Firstly, the time doesn't really matter. You are always betting that the market will move in your direction such that the price of the option will increase even after time elapses. E.g. If I pay $2 for an option with 1 minute left in the day, and the market moves $3, I still can win.

The most important aspect is "location": where the underlying is in relation to the strike you want to buy.

Remember, by the end of the day, all that yellow will be gone because the time value of the option will be worth $0.00. You want to spend as little money as possible on the extrinsic value. As seen above, the most expensive extrinsic is located precisely where the underlying is trading ("at-the-money").

Okay, so buy a not at-the-money call. But do you buy the in-the-money (ITM) call or the out-of-the-money (OTM) call? An ITM call costs more even though the extrinsic is roughly the same as the OTM call. It's a higher price, but not a higher value. From a capital efficiency perspective, you should trade the OTM call.

Example: you buy the 4030 call when the underlying is 4010. The 4030 call is 20 handles out-of-the-money when you buy it.

1. The call is cheaper (you can also think of it as "your built-in stop loss is tighter")

2. If the market moves to your strike quickly, the call's extrinsic value changes exponentially, and gives you rapid profit. This is what gives you asymmetry in your favor. The value of the option more than doubles, without any change in intrinsic value!

3. And if the market keeps going in your direction, your loss in extrinsic value is minimal compared to your gain in intrinsic value.

When Would Be a Good Time to Sell?

1. When the underlying is at the strike price (it's extrinsic is highest, relatively speaking)

2. Let it run an expire in-the-money

If your gears are turning, you will be even more interested later this week when we discuss management flexibility e.g., selling an option against it to capture premium and give yourself more upside!

As always, pursue the process NOT the profits! See you tomorrow!