Larry’s Note: Today, I’m sharing another discussion I had with Chris Lowe this week. As a reminder, Chris heads up The Daily Cut e-letter and the Legacy Inner Circle advisory.

We had a great chat, including digging into several key concepts you’ll want to understand when trading options.

I explained how in-the-money and out-of-the-money options work… when to use either kind… and some of the real benefits options offer to traders.

I hope you enjoy. And if there are any topics that you’d like us to cover in future weeks, let me know at feedback@opportunistictrader.com.

[Editor’s Note: Transcript has been lightly edited for clarity and brevity.]

Chris Lowe: Larry, we’ve been getting some good feedback from subscribers already. A lot of them are really enjoying being able to see how you’re thinking about the markets, but people also enjoy a bit of education on terminology around options and how that works.

Last week, you talked to me about out-of-the-money options and in-the-money options. I’m not an options guy, so I’d love to understand, what does that mean?

Larry Benedict: Sure. Let’s equate it to Apple. Apple’s trading at we’ll say about $178.

If we were going to buy an in-the-money call option, that would be any option strike price that’s below $178.

For an in-the-money put option, the strike price would be above the $178 price the stock is trading at.

Then for out-of-the-money puts, the strike price would have to be lower than the price Apple is trading at. You wouldn’t be able to exercise or take delivery of that short position in Apple.

The same thing goes for out-of-the-money calls. Let’s say Apple’s at $178, and we bought the $180 call. That would be considered an out-of-the-money option because the option strike price is above the $178 stock price.

Chris Lowe: So Larry, if I’m in the money, it means I can exercise that option if I choose to?

Larry Benedict: Yes, when we’re trading individual equities, there is deliverability of the stock. If we had a September call option in Apple at $190 and it happened to go above $190, it would have “intrinsic value.”

But you don’t have to take deliveries. We would sell that option instead. We’re trying to take advantage of the move and then not take delivery, because if we take delivery, we’re going to be in a position where you have to put up a lot of capital.

You can control 1,000 shares of stock with 10 options. So for around $3,000, you can control an Apple position of 1,000 shares of stock at $190. If the stock goes our way, we could really, really do well.

Chris Lowe: Larry, is that what the leverage of options is? Is it controlling that large number of shares with a relatively small dollar amount? Is that why the returns can be so big?

Larry Benedict: Rather than pay $178 for Apple, we’re buying the right to own Apple above $190 at the date of expiration. But again, we want to catch the move, sell our option, and move on to the next trade. That’s the game plan.

Chris Lowe: I have one last question before we end today. Why would you buy an in-the-money option versus an out-of-the-money option?

Larry Benedict: That’s a good question.

So let’s equate it to Apple. Let’s pretend Apple’s trading at $180. We buy the $185 puts, so they’re $5 in the money.

You may pay $8 for that option, but you’re actually short 100 shares with just one option. So the only reason we would do an in-the-money option on either puts or calls is if we’re really convicted on the position and we believe that the stock is going to move significantly.

With an out-of-the-money option, you don’t have to put up as much capital. It’s a lot less. Rather than $8, you put up $1. But to profit, you’re going to potentially need a 10–15% move in the stock to get into the money.

The beauty of options is that you know the most you could lose on each of these trades. I always say to subscribers, don’t risk more money than you’re willing to lose. Go smaller, give yourself more time, and have the ability to stay in these positions a little bit longer.

Let’s say we put a position on a high-flying biotech stock. They’re coming out with a new drug, and you think the drug is going to work.

You buy an out-of-the-money call, and you risk $3,000, $2,000, $1,000 – whatever your number is – and that’s the most you’re ever going to lose.

So let’s say the drug trial fails and the stock goes from $140 down to $50. You know what? You’re only going to lose that $1,000 you paid for the option.

Chris Lowe: Well, Larry, that’s super interesting. I’ve finally understood something new about options. So thanks for your time.