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Buying In-the-Money Options - A Hidden Benefit.

Posted by Pete Stolcers on October 13, 2008

In today’s option trading blog I will discuss why I often like to trade in-the-money options. When I find a stock that looks like it will move higher/lower for a few weeks or more, it’s a preferred alternative to taking a position in the stock. Let me explain by using a bullish example.

In April I felt that PCAR was an attractive stock that could move higher over the course of the next few months. It had formed a solid base at the $70 level and it had been as high as $75 in 2005. The earnings were very consistent and the P/E was very reasonable. If the stock could get through $75, I felt like it could steadily move higher. I did the trade in the Level 3 Option Report.

The options were fairly expensive from an implied volatility (IV) standpoint and I did not want to “buy” a lot of time premium. After a looking at the options, I decided to purchase the August 65 calls for $9.80. They were $7.80 in the money and I was paying $2.00 over intrinsic value. Here is why I like selected that those options.

If the stock moved a bit higher, the deltas were fairly high (.80) and I would be in a position to take profits if I wanted to. If I purchased an out-of-the-money option, the low deltas would require a big move for me to overcome the bid/ask spread and the commissions. The ITM call options would act like a surrogate stock position on the upside and at some point they would move in tandem with the stock. Most traders are drawn to the leverage and limited risk features of options and I’m no different. However, here’s one thing that most retail traders don’t consider. If I was wrong (really wrong) and the stock dropped, the options would reach a point where they would start picking up implied volatility. They would lose money at a slower rate than the stock.

If the stock fell to $65 and the options were at-the-money, they would still be trading for around $4. I had every intention of stopping the trade out if the stock dropped below $70, but stocks do gap on news. If this scenario had unfolded, there may have been a “kicker”. The options might actually be trading for more than $4 because the quick drop in the stock price spikes the option IV’s.

Here’s the take-away. With ITM options trading near their intrinsic value, you can gain point-for-point with the stock on the upside and not lose point-for-point on the downside. You also get the benefit of leverage and limited risk. Wide bid/ask spreads are an obstacle and it can cost you $.20 on each side of the trade. These positions are not intended for day trading.

In the next article, I’ll tell you the benefit of buying an August option instead of May option in this instance.

It you trade ITM options, share your experience with us and I’ll comment.

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Option Trading Comments

  • On 07/20, Tom said:

    Excellent point.  Basically you can accomplish the same trades you would make with stocks by using options that are deeper in the money. You can even buy some insurance if desired and still your comparable capital outlay is about 2/3rds less. The "left over" capital can be safely tucked away for whatever purpose. And your overall account risk has been drastically reduced.<br>P S....you are right about the pattern changing over time (previous post). Thanks for the advice.  Tom

  • On 07/21, Bill said:

    I’m fairly new to options trading, but have had some experience in stock trading (mostly momentum or swing trades). I’m investing in options more regularly because of the increased leverage and limited risk. The increased bid/ask spreads and the rather delayed, jerky price changes in options are, however, hard to get used to.<br>Nevertheless, on the basis of my own experience, I came to exactly the same conclusion about buying ITM options (calls/puts). I try to keep an eye on how much extrinsic value there is an any position, but I’m finding that ITM options eventually catch up, sometimes spectacularly, with the underlying stock’s trend. I’m just glad to have my own thinking confirmed!!

  • On 07/21, Dwight said:

    I was considering ITM options but read that they are often exercised because of their in the money value.  Is this true?

  • On 07/22, Pete Stolcers said:

    Hi Dwight,<br><br>When you buy an option you are always in control of the exercise. You will hold that option until you decide to exercise it or sell it. If it is ITM on expiration Friday and you don’t want to own the stock (in the case of a long call position), you "roll" the position by selling the option and by buying the next month out.

  • On 07/22, Pete Stolcers said:

    Hi Bill,<br><br>There will be times when trading the stock is better. If the options are ill liquid and the bid/ask spread is wide, trade the stock. If the trades is very short-term in nature (1-2 days), trade the stock. Due to slippage, when you decide to trade options , you have to be willing to hold the position for at least a few days.

  • On 08/17, Nigel said:

    I am new at options, and just place my firtst two trades (disaster). I observe you set your stop loss at a price point, but do you consider time to expiration e.g. you purchase an option 5 months out and it violates your stop in two days, you still have 4 months before timedecay accelarates do you wait a while for the position to improve.

  • On 08/18, Pete Stolcers said:

    Hi Nigel,<br><br>Whenever I trade options I’m willing to give the trade a lot more room to move than if I’m trading the stock. The bid/ask slippage is so great that you have to be willing to take some heat on the position. If the stock breaks a long term trendline or horizontal support/resistance, you have to rtespect that. If it violates a short term level, you might still give it room. Read through as many of my blog archives as you can. On May 21st in "Past Q&A" I wrote an article on Protective Stops. There are many pointers that will help you. Since you are new to options, try scaling in… no matter how much your commissions are. Consider the extra commissions an added tuition while you get started. You’ll see, it is a small price to pay compared to a big position loss. Also consider trading 1 lots. I know it’s not very exciting, but it is better than losing money.

  • On 02/02, Phil said:

    First time reader on your blog and I must give my compliments on such a terrific site. I’ll definitely be spending a lot of time on this site and will spread the word.  Excellent and thanks for all the knowledge!

  • On 07/24, kathy said:

    Hi
    Could you explain why someone would buy a leap in the money call option?
    Thanks

  • On 10/31, Georgios said:

    Hi,
    first time in your blog and new on options trading. Want to learn more and would like know how I can pay -if possible a service- so I can get some recommendations on option trades. Or trade along side with you. Is this possible?
    Thank you and greetings from this part of the world!

  • On 11/03, Pete Stolcers said:

    I offer stock and option research at www.oneoption.com. In each report, I give detailed analysis. You’ll to know exactly why the trade makes sense.

  • On 04/04, Matt said:

    I see that ITM options have a higher delta, and are better choices. But don’t they also have higher volatility, which means more unpredictability in regards to the option price changing radically?

  • On 04/05, Pete Stolcers said:

    It is typically better to buy ITM options on a stable stock that is predictably grinding higher. They you cam make point for point on the option as the stock moves upward. When stocks are volatile and they have the possibility for surprises, you might consider buying an OTM option, or selling a credit spread to distance yourself from the action.

    Your strategy is the result of your opinion on the underlying stock. Quantify the direction, magnitude, duration of the move and the probability of it (your confidence). There is not a single BEST strategy. Every trade and every day is unique.

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