A Brief Commentary on Buying Out-of-the-money calls

A practical breakdown of why directional accuracy isn't always enough when trading out-of-the-money calls.

We rarely buy out-of-the-money calls, because when you do, there is a chance that you could be right about the direction of the underlying stock (up), but still lose money. Normally, we prefer a slightly in-the- money call with a delta of 0.6 or higher, so that it will move more in line with a rising stock. In that case, if I’m right about the direction of the stock, I have a strong chance of making money with my call – even though it may suffer some time decay.

To illustrate this point, I’m going to cite the recent purchase we made of SPY out-of-the-money calls in the May 16th issue. At the time SPY was trading at 589.34, and since cumulative volume breadth (CVB) had made a new all-time high, we expected $SPX and SPY to do so as well. The all-time high for SPY was 613.23.