Today’s Trading Lesson From TradingMarkets

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Why I Buy Deep In-The-Money Options

By Len Yates

Buying deep in-the-money (ITM) options is a
good way of carrying out directional trading in this high-volatility
environment.

Although
volatilities have come down quite a bit in the past four weeks or so, they have
plenty of room to fall further.  As they do, the at-the-monies (ATMs) and
out-of-the-monies (OTMs) are going to be hurt, while the deep ITMs will be
relatively unaffected. This is because deep ITM options have very little time
value.

I’ve been using deep
ITM calls more than usual these past few weeks. One reason I like them is that
as the market trends upward, it naturally experiences one- or two-day setbacks,
and these setbacks affect my deep ITM calls very little on a percentage basis.
Thus I am more comfortable seeing my position through. And because (as
mentioned) the deep ITM option has very little time premium, I am not nervous
about time decay.

On the risk/reward
scale, holding deep ITM options falls in between the higher leverage / higher
risk buying of ATM or OTM options, and the more sedate buying of vertical debit
spreads. I commented on vertical debt spreads last time as being a good way of

neutralizing the effects of falling volatilities.  However, buying a deep
ITM option can be just as good in this regard, and is more straightforward — not
involving as many transactions.

Note that buying

LEAPs accomplishes a similar thing. However, buying deep ITM (usually
nearby) listed options is probably a little higher on the risk/reward scale
because of the fact that deep ITM options move point-for-point with their
underlying. Also note that LEAPs posses a much greater vega risk (exposure to a
fall in volatility).

Some investors might
object that deep ITM options have a wider bid / asked spread, causing the trader
to experience worse slippage. But I have not found this to be a problem in the
issues I trade, especially because I can direct my trades to the best market. If
you cannot direct your trades, placing an order in between bid / ask is often
successful.

Some investors also
object, psychologically, to paying more than a price of about 6 per option,
preferring options priced between 2 and 5. Of course the investor should realize
that this is not rational. (My mother-in-law refused to buy a stock priced above
100 — I tried to explain to her that price itself makes no difference. It’s the
financial ratios that count.)

Holding deep ITM
calls (or puts) is like buying (or shorting) the underlying stock in a sense, as
deep ITM options move point-for-point with their underlying. However, buying
deep ITM options cost less than stock, allowing you to either leverage up or
retain cash for other investments or to just earn interest.

For example, let’s
consider Dell stock and options. At the time of this writing, Dell is trading at
26.5 and seems to be in the baby stages of an uptrend.  To go long, you could
buy 1,000 shares of stock for $26,500.  Or you consider buying calls. The
nearby’s (with three weeks to go) are currently priced as follows:

Strike   
Bid            Asked            Time Premium

30        
3/8               1/2               7/16

27.5      1
1/8            1/1/4            1 3/16

25         2
7/16          2 5/8            1 1/16

22.5      4
3/8            4 5/8              1/2

20         6
1/2            6 3/4              1/8

Note that the deep
ITM calls have a time premium of only 1/8. That means the passing of time and a
possible volatility drop could only take 1/8 away from you in the next three
weeks!  The equivalent of 1,000 shares of stock can be had by buying just 10 of
these for $6,750.  In effect, it’s like buying a cheap, $6 stock and hoping it
goes to $9 — which will happen if Dell simply rises 3 more points.

Contrast that with
the experience of others, who typically buy the ATM or OTM options. First,
getting a 1,000-share equivalent stake would require buying 20 of the ATM
options with their delta of 50 each (as the stock moves one point, the option
would move about half a point).  This position would cost $5,250.  Say the stock
moves up a bit, then pulls back over the next couple of days, returning to its
starting price. Now your option is worth a bit less than what you paid, kind of
making you wish you’d waited until now to buy it. Then the stock advances a
couple of points. Nice, but your options are worth about 3 at this point — up
only slightly because of one week’s time decay. Rather frustrating.

The ITM option
buyer, however, is satisfied to see his option up 2 points at the end, and never
having seen it fall below his purchase price in the meantime.

So next time you’re
looking at going long (or short), consider using deep ITM calls (or puts).