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The Most Important Lesson for Options Traders

10:09 AM

I am not joking when I say that gaining an understanding of delta changed my trading life forever. And I promise that this four-part series will be one of the most important and influential investing lessons you've ever had.

Even if you don't trade options, you should still read this, because it can significantly reduce your risk in this market. You can learn how to replace your overpriced stock with call options -- but you MUST know which options to buy, or else you might actually increase your risk instead.

Learning about delta and using it to make better trades is not really complex, so don't be intimidated. Just remember the two most important things:

1) If you sell your stock and buy call options to replace it, then buy "in-the-money" call options.

2) Only buy one call option for every 100 shares of stock that you own (or would want to own).

In other words, if you have 100 shares of Capital One Financial (COF), and want to close the position at $21.60, you will have $2,160. To establish an option position, you should buy only one call option contract (which represents 100 shares). If you buy the COF Jan 15 Call and pay $8 per contract (an $800 investment), then you should put the remaining $1,360 in a safe, interest-bearing security, such as a money-market fund or Treasuries.

This four-part series will help you understand why it's important to buy in-the-money call options in place of stock (as opposed to at-the-money or out-of-the-money options).

What is Delta?

The "delta" of an option measures how much the option changes in price when the underlying security moves one point.

For example:

Let's say that ExxonMobil (XOM) is trading at $65 per share, and the XOM Jan 65 Call is selling for $5. (NOTE: Because XOM's stock price is the same as this option's strike price, this option is trading at-the-money.)

When XOM rises one point (from $65 to $66), the Jan 65 Call should then sell for $5.50. Thus, the option only increases by 50 cents when the stock rises by one full point. This at-the-money option is said to have a delta of 0.50.

by Chris Rowe

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