That $0.10 call option might look like a steal… but is it really? While cheap options might seem like they are naturally a low-risk investment, that is not always the case because there is quite a bit going on behind the scenes that makes cheap options a less-than-ideal choice when it comes to trading and investing.
It only makes sense for cheap options to attract new traders—the low cost of entering would make for a higher profit scenario, and they present a great opportunity. That is the way it might seem on the surface, but you’ll quickly find that these types of options are priced low for a reason due to their small likelihood of being profitable and their illiquid nature. Keep reading this article, and we will unpack a ton of interesting topics on cheap options, including hidden risks, misconceptions, and better ways to evaluate opportunity.
Why Cheap Options Are So Tempting
Cheap options offer a wide appeal to traders who are new to the market as well as veteran traders who are looking for the ideal entry point. There are a lot of obvious reasons for hopping on cheap option opportunities, but there are some reasons that aren’t so readily apparent at first glance. Get ready as we run through the main appeal of cheap options to online traders and why they can be tempting to pursue.
- Low Upfront Cost: The obvious appeal of cheap options is the low cost upfront, which makes them seemingly have a low risk factor. The satisfaction that a trader can experience by getting options at a low price can be a big motivator, and this could possibly pose a problem down the road when it comes to long-term cost concerns.
- The Appeal of Massive Percentage Returns: Getting options for a cheaper price presents the advantage of gaining a bigger profit potential, so long as the stock prices move in your favor.
- “Lottery Ticket” Mindset: Social media and meme stock hype culture can reinforce this view of online options trading that sees it as a get-rich-quick scheme that only requires a gamble and some good luck to work out. Some traders see the cheap option prices as a plus, requiring them to only make a small “bet” for the promise of a potentially massive payoff.
A great example of cheap options is cheap weekly calls on volatile stocks, these being weekly options that expire every Friday and have a shorter timespan than a lot of other investments. Because there is less time for the options to become profitable, they come at a lower price, but they offer the promise of favorable movements for traders due to their volatile nature.
The Greeks behind the Curtain
Cheap options have several Option Greeks at work behind the scenes that can offer traders a decent insight into what is occurring in terms of the option’s value. Our hope with this section of the guide is to show you what truly goes on behind the curtain and why pursuing cheap options price-wise might not always be the best investment decision. As we dig into delta, theta, gamma, and vega, we hope you can see the challenges that come up against the goal of making these opportunities profitable.
- Delta: The Delta Greek measures the option’s sensitivity to changes in the underlying asset’s price. It offers insights into how much the price of the option is expected to move for every $1 change that happens in the underlying asset’s price. Low deltas mean a low probability of finishing in the money.
- Theta: This Greek refers to a measurement of how much an option’s premium is expected to lose value every day as the contract gets closer to its expiration date. When it comes to options that come at a cheap price, they tend to bleed value fast, especially weeklies. You might be getting in at a good price, but you have limited time to turn a profit, and the time value of the investment depreciates quickly.
- Gamma: In terms of options trading, this Greek represents the rate of change in the option’s delta for every $1 movement in the price of the underlying asset. At-the-money options have the highest gamma levels, and you typically see a higher gamma showing a more rapid change in delta, especially with small price movements in the underlying stock or asset. Small price changes often don’t help these positions much.
- Vega: This Greek measures an option’s sensitivity to changes in the underlying asset’s implied volatility. A higher rate of vega means the option’s price is more sensitive to volatility changes. When it comes to cheap options, small changes in volatility often don’t help these positions much.
Simply put, these Greeks offer some key insights into the things that cheap options have going against them. Small changes in volatility or price typically don’t have much of an effect on cheap options. In addition, cheap options that can be found with weekly contracts are sensitive to the negative effects of time decay, and they have a low probability of finishing in the money due to their low delta levels.
Implied Volatility and Why It Matters
When you’re looking at the price of an option online, it’s key to consider implied volatility and its role in the situation. There is a clear distinction between the market price of a stock and its implied volatility in trading. Just because the price is low doesn’t mean that IV (or the market’s expectation of the stock’s future price swings) is going to be low as well.
Cheap price doesn’t mean cheap IV. A low IV level can make it come across as cheap because the premium is lower, but it isn’t always a true indicator that the options are undervalued. On the other hand, if a stock’s fundamentals don’t support a higher price point and it is considered “cheap,” it doesn’t necessarily mean that it is undervalued. Many cheap options are overpriced relative to their probability of success.
Example
A $0.05 option with 300% IV is a great example of a trap when it comes to “cheap options.” This trade comes with a high IV level, and this means that large price movements are to be expected, at least according to market expectations. There is an incentive for traders to go after this trade due to the low entry price. However, IV crush comes into play if the underlying stock doesn’t move in your favor following an event that would make the trade profitable. It results in a sharp IV drop, which could cause you to lose your premium if the option’s price falls below your purchase price.
Liquidity Issues and Execution Costs
When you’re dealing with cheap options, they might look good on paper, but you’ll soon find that multiple issues can arise with buying and selling them quickly and efficiently, as well as the logistics of getting the orders filled at the correct execution costs. Keep reading to learn about some significant liquidity issues and execution costs that could cause problems for you while trading cheap options.
- Low Open Interest—While it’s not always a 100% guarantee that cheap options are going to have low open interest, there is a correlation between the two, and this is usually the case with cheap options that are considerably out-of-the-money and have limited potential to turn a profit. Low open interest refers to low liquidity or the ability to buy or sell the options efficiently at a fair price.
- Wide Bid-Ask Spreads—Because they generally have lower liquidity, cheaper options also have wide bid-ask spreads, which is the difference between the highest price a buyer is willing to pay for the assets and the lowest price that a seller is willing to accept. The reason that some options are so low in price is that they are harder to sell or buy quickly, which leads to a decreased demand for them.
- Hidden Cost of Slippage—With cheaper options, slippage can occur when the price at which you order is filled is different from the expected price when you placed the order. Slippage is known to happen with cheap options that already have less-than-ideal liquidity, and this can erode profits for strategies that are centered around using illiquid options.
When you take a look at options valued at $0.05, you can get a good idea of exactly why they are difficult to get filled at the right times and at the right prices. These options can become $0.01 losers fast due to the challenges that they face.
These are the reasons why:
- Wide Bid-Ask—The right price to fill this order can become subjective because you can have a bid that is as low as $0 or an ask price that could be $0.05 or more.
- Low Liquidity—Cheap Options are usually way out-of-the-money, which means that it is difficult to execute trades at the midpoint, and this is mostly due to having fewer buyers and sellers available. What happens is that orders are filled much closer to the bid price or the ask price, and this is where slippage can occur when these orders are being filled.
- Volatility with Pricing: Because you’re dealing with smaller amounts when it comes to price, you have much more significant percentage changes, which can lead to increased slippage with cheap options. Price moves even slightly, and it is a much larger change than it would be if the price for the option were a few dollars instead of a few cents.
- Order Type and Size: Slippage occurs more frequently when traders use market orders that execute at the next available price. You also have to take order size into account in addition to the type. Slippage can be worsened when you attempt to fill a large order that contains a lot of low-priced, illiquid options. The size of these orders can move the price against you if there isn’t enough volume for the desired price level.
Psychological Pitfalls for New Traders
Cheap options can play mind tricks on some traders and investors, so it’s key to be aware of the psychological pitfalls that can ruin a good trading plan. You don’t want to make these mistakes or fall into these ways of thinking because it could cost you in the end—the lure of cheap options might look good on the surface initially, but it could come back to bite.
- Lottery Mindset vs. Probability-Based Trading—This mostly applies to traders who are new to options and don’t completely understand how they work, but some traders view options like playing the lottery or a casino game. They view it as a way of taking a chance and placing a trade to see if luck will smile down on them. Options aren’t supposed to be like that, but instead are done using strategic moves that are probability-based and intended to speculate on future price movements.
- Chasing Cheap Options—If you make it a part of your trading plan to strictly go after cheap options, you can run into all the issues we have already discussed, such as the fact that they rarely end in the money and that changes in implied volatility and price don’t have much of an effect on moving the needle.
- Overtrading—Taking on a large volume of cheap options just for the sake of not wanting to miss out and experience as much “action” as you can is a big mistake and can cause traders to become overleveraged in their investments. The best way to go about trading options is to have a trading plan in place for the allocation of your capital and to choose high-quality trading setups to maximize potential returns while staying disciplined in options trading.
- “Just One Win Will Make Up For It All” Fallacy—The best course of action for traders who are experiencing a string of losses is to simply cut the trades loose to minimize potential bleeding, but some traders fall for the idea of chasing losses or revenge trading as a way to get back the money they originally lost. The problem with this approach is that it can dig you even further into losses, though there is no harm done if the plan works out.
- The False Sense of “Cheap” Meaning Low Risk—Options are cheap for a reason. It is often because they have a short period before they expire, or they are significantly out-of-the-money, which means that they have a small likelihood of being profitable. This makes them high-risk propositions.
Case Study or Hypothetical Breakdown
Let’s take a walk through an example trade to showcase the idea that most “cheap” options setups are doomed from the beginning, though they seem like a great deal when you’re buying them. $0.10 options are considered cheap, and they might seem like a steal because a low cost like that would work wonders for your ultimate profit margin. However, the option is priced at $0.10 for a big reason (or two): the option is likely far out-of-the-money, and there might only be a short time, like a week, where a profit can be realized.
Instead of going with this cheap option, it is important for traders to find quality setups that are low-priced but are unvalued and have potential, avoiding mistakes caused by confirmation bias. These quality setups should have a longer expiration and a better delta. It might be more expensive than the $0.10 option, but it will have a better chance of turning a profit.
A good example of a trade that is low-priced but has a more favorable risk-to-reward ratio would be a stock trading at $40 with a strike price of $38 and a premium of $2.50. It would also have an expiration date that is three weeks long, giving the setup ample time to profit and not fall victim to time decay concerns.
Smarter Alternatives to Cheap Options
As much as you might like to trade cheap options, especially if you’re dealing with a smaller amount of available capital, there are some smarter alternatives where you can experience a much better outcome. While they might not seem as exhilarating as buying cheap options for a “big opportunity,” these strategies are much more sound and can result in traders realizing a profit.
- Buying Options with Higher Delta and Longer Expiration: While the higher delta generally means that there is higher risk associated with the trade, it also means a higher profit potential, which is much better than going with cheap options where there’s little likelihood of turning a profit to begin with. It is also key for traders to choose longer expirations, giving their investments enough time to realize a profit and not be decimated by the horrible impacts of theta decay.
- Using Spreads to Lower Cost and Improve Probability: Traders can consider using trade spreads to lower their margin requirements and to reduce exposure to volatility and other risks, which ultimately lets them keep more of their capital for themselves. On top of these benefits, trading with spreads can also help traders in terms of the probability of the trade swinging in their favor and making a profit.
- Waiting for Setups with Better Reward-to-Risk: You’re selling yourself short by choosing trades based on cheap prices alone. It is often a better choice to simply wait for trade setups where the risk-to-reward ratio is more favorable for realizing a profit. Cheap option prices might seem like a good idea on the surface, but there is so much going against them behind the scenes in terms of becoming profitable.
When Cheap Options Do Make Sense (Rarely)
Believe it or not, there are a few instances where it can make sense to go after cheap options, though we wouldn’t recommend it in more cases. Keep in mind that these instances are far and few between, so this isn’t so much of a green light as it is us wanting to be completely honest about the effectiveness of this strategy. Cheap options might secure a profit around 5-10% of the time—they’re a long shot.
- Lotto Plays Near Known Catalysts: One of the few times when it makes sense to go after cheap options is if there’s a known event coming that will help to push the stock price in the money. A good example would be if you know there is a positive earnings report coming from a company that is offering a low price on its stock options. That event can act as a catalyst for moving the needle of the stock to get it into profitable territory. The trader wants to be sure, though, to secure the profit before the expiration date hits, so it takes some time to get it right.
- Using a Defined Speculative Strategy: Low-priced options can be worked into a speculative trading strategy, but traders need to find options that are cheap due to being undervalued but still possessing growth potential, as opposed to finding cheap options that are priced lower due to the high likelihood that they will expire as worthless. Remember to use correct position sizing and proper risk management techniques in these cases.
- Only With Full Understanding of the Risks: Don’t trade cheap options if you aren’t familiar with the risks that are associated with these kinds of trades. You should only go after this strategy for the reasons stated in the other bullet points, but also only if you’re well aware of the risks that come from trading options that have little time and space to turn a profit.
Price Isn’t the Full Story
We’d recommend that you stop and think before clicking that enticing $0.05 option on your favorite brokerage app. As great as it might seem on the surface, there are too many problems that crop up from these trades that make the likelihood of securing a profit a complete long shot. Instead, we would encourage you to build a smart options strategy by buying options with longer expiration dates and higher deltas or using spread trades to improve probability odds. Sometimes, the best thing you can do when you see an option priced as low as $0.05 is to look around for a better setup with a more favorable risk-to-reward ratio.
Key Points Revisited
- Cheap options often carry more hidden risk than reward.
- Key risks: time decay, low probability, poor execution.
- New traders should look past price and evaluate probability and structure.
- Smart options trading requires more than just finding a “deal.”
