How to evaluate LEAPS and Deep OTM options?

[TheLEAPSguy]

How do you evaluate OTM call options? Everything I have read only teaches about ITM

Is there some resource out there that will teach me how to buy OTM calls?

I’m getting really frustrated. All the books I’ve bought and in everything I’m reading to learn no one teaches this.

They all teach how to evaluate and buy ITM options.

I’m a value investor (with a GARP/growth at a reasonable price focus).

Most of the really high volume, popular, and high flying stocks that people trade options on don’t fit what I’m looking for.

I want to buy OTM call options and LEAPS 7 to 8 months (or more) out on undervalued stocks and hold them for two to three Quarters/earnings calls.

On the stocks I’m looking at the volume and open interest is low. The spreads are wide (more like huge) and the delta and gamma on most is low.

So far the stocks I want to buy options on the delta is no more than 25 or 30. The Gamma for most is 3 to 5.

How can I evaluate an OTM call to see if it’s worth buying? What numbers/metrics should I focus on?

 

[stepandfetchit]

IMHO: The most difficult issue is posing the correct question (not for us, but for yourself)! Solving problems is the easy part. Adequately identifying what you know (your edge) is very illusive. Your statements seem to imply you are observing proper criteria, such as Open Interest unpleasantries and large B/A spreads. My advice is to NOT throw in the towel too soon, but with each obstacle, take a step back and ponder a bit. IE insure you verify the B/A spreads during market hours (and not just after hours). If the IV of your target security is elevated, you may want to also consider other ways to participate in a move of the underlying, such as Spreads or butterflys (can help to negate some excess IV).
I have begun looking into directional trading with options and developed a tool to aid in my selections. If you have some very focused targets and underlyings, you can PM me & I'll see if my tool can be of any help. (Underlying, #days, +/- % price change, +/- % IV change expected).

PS: I like using Return on Reg-T Risk as a metric for such things as a primary metric.

 

[guru]

How do you evaluate OTM call options? Everything I have read only teaches about ITM

Is there some resource out there that will teach me how to buy OTM calls?

I’m getting really frustrated. All the books I’ve bought and in everything I’m reading to learn no one teaches this.

They all teach how to evaluate and buy ITM options.

I’m a value investor (with a GARP/growth at a reasonable price focus).

Most of the really high volume, popular, and high flying stocks that people trade options on don’t fit what I’m looking for.

I want to buy OTM call options and LEAPS 7 to 8 months (or more) out on undervalued stocks and hold them for two to three Quarters/earnings calls.

On the stocks I’m looking at the volume and open interest is low. The spreads are wide (more like huge) and the delta and gamma on most is low.

So far the stocks I want to buy options on the delta is no more than 25 or 30. The Gamma for most is 3 to 5.

How can I evaluate an OTM call to see if it’s worth buying? What numbers/metrics should I focus on?

Not easy to evaluate those because the ROI or reward-to-risk, and actually all metrics can be very different each time you make similar LEAP trades, even on the same stock, and especially on various unrelated popular stocks. Basically there is no single formula.

But, you can help yourself by buying call spreads instead, because then at minimum you'll be able to calculate your exact max/potential ROI. For example if a $10-wide OTM call spread (like $100/$110) costs $4 then your max ROI will be 150%. That's because $10 wide spread will be worth max $10 when the stock price lands above both your OTM strikes at expiration, while you've spent $4, so you'd make $6 profit on the $4 investment.

The bid/ask spreads generally aren't a problem, as it is often possible to get filled near the mid with some slippage, but not too bad if you're patient. But you may be misguided and "cheated" by the mid-price being unrelated to fair value, so simply try to get your spread order filled at quarter of the mid-price, then slowly (like every few minutes) increase your bid/limit price until it gets filled. And don't buy all the spreads (full qty) all at once, again, to make sure that you don't get screwed on bad pricing. Basically if you're careful then you'll get a fair price. You'll get a bad price only if you rush, as market making computers will be happy to take any amount you'd pay. Otherwise if you don't give them an edge then they'll slowly evaluate your pricing and will decide to take it or not, though they'll fill you only if they can make a few extra cents as well.

 

[newwurldmn]

How do you evaluate OTM call options? Everything I have read only teaches about ITM

Is there some resource out there that will teach me how to buy OTM calls?

I’m getting really frustrated. All the books I’ve bought and in everything I’m reading to learn no one teaches this.

They all teach how to evaluate and buy ITM options.

I’m a value investor (with a GARP/growth at a reasonable price focus).

Most of the really high volume, popular, and high flying stocks that people trade options on don’t fit what I’m looking for.

I want to buy OTM call options and LEAPS 7 to 8 months (or more) out on undervalued stocks and hold them for two to three Quarters/earnings calls.

On the stocks I’m looking at the volume and open interest is low. The spreads are wide (more like huge) and the delta and gamma on most is low.

So far the stocks I want to buy options on the delta is no more than 25 or 30. The Gamma for most is 3 to 5.

How can I evaluate an OTM call to see if it’s worth buying? What numbers/metrics should I focus on?

Real easy. Don’t worry about gamma or delta. Only think about what you think the stock is worth, what your pnl will be if you get there at expiry, and what your margin of safety will be.

There’s a reason most value guys don’t buy options: they might know what the stock is worth, but have no idea when it will get there.

 

[ironchef]

Real easy. Don’t worry about gamma or delta. Only think about what you think the stock is worth, what your pnl will be if you get there at expiry, and what your margin of safety will be.

There’s a reason most value guys don’t buy options: they might know what the stock is worth, but have no idea when it will get there.

You are gambling if you don't know when it will get there yet you bought?

Another question for you sir: Most options are fairly priced based on the situation at hand, so where is your margin of safety?

Thank you.

 

[ironchef]

How do you evaluate OTM call options? Everything I have read only teaches about ITM

Is there some resource out there that will teach me how to buy OTM calls?

I’m getting really frustrated. All the books I’ve bought and in everything I’m reading to learn no one teaches this.

They all teach how to evaluate and buy ITM options.

I’m a value investor (with a GARP/growth at a reasonable price focus).

Most of the really high volume, popular, and high flying stocks that people trade options on don’t fit what I’m looking for.

I want to buy OTM call options and LEAPS 7 to 8 months (or more) out on undervalued stocks and hold them for two to three Quarters/earnings calls.

On the stocks I’m looking at the volume and open interest is low. The spreads are wide (more like huge) and the delta and gamma on most is low.

So far the stocks I want to buy options on the delta is no more than 25 or 30. The Gamma for most is 3 to 5.

How can I evaluate an OTM call to see if it’s worth buying? What numbers/metrics should I focus on?

N(d2) ( and N(d1)) gives you the rough probability of touch at expiration, so your delta of 25 has a less than 25% probability the underlying will be there at expiration. If that is your strategy, you should expect a win rate of ~25% overall if you hold them to expiry.

As @newwurldmn said, do you think that represent the strategy of a value investor?

 

[newwurldmn]

You are gambling if you don't know when it will get there yet you bought?

Another question for you sir: Most options are fairly priced based on the situation at hand, so where is your margin of safety?

Thank you.

My view on this:

If you think BA will be worth 300 at the end of the year, and the Jan 225 call is $20, then your margin of safety would be 300-245. It’s how right you dont have to be And still make money .

 

[ironchef]

My view on this:

If you think BA will be worth 300 at the end of the year, and the Jan 225 call is $20, then your margin of safety would be 300-245. It’s how right you dont have to be And still make money .

To make money I have to be more right than the market makers and the general market.

 

[newwurldmn]

To make money I have to be more right than the market makers and the general market.

To a value investor, they just have to be more right than “Mr. Market”

 

[guru]

My view on this:

If you think BA will be worth 300 at the end of the year, and the Jan 225 call is $20, then your margin of safety would be 300-245. It’s how right you dont have to be And still make money .

So you’d break-event at $245 and get 275% ROI at $300.
While if you buy $215/$225 call spread for $3 then you’ll break-even at $218 and get 230% ROI at and above $225.
Both are valid bets and calls may actually work better during temporary swings.
I guess the OP just wants to be able to come up with some metrics to plan and estimate his bet.