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Trading Back Month In The Money Options!

Posted by Pete Stolcers on July 22, 2006

In my last option trading blog, “Buying In-The-Money Options – A Hidden Benefit” I described the advantages of doing so. I did not write about which month to buy. As with all option trades, your opinion of the underlying move will determine the strategy. If you are looking for a longer term move, a back month option usually makes the most sense.

Let me use the previously referenced PCAR trade I did in April. I felt the stock could move $10 higher from it’s price of $72 over a period of months so I bought the August 65 calls for $9.80. I bought ITM options so that I could realize gains on a small move and “jump off” at any time if I wanted to. I also felt the stock was just above strong support and $9.80 “rug” would not get pulled from under me. A back month option displays the properties I discussed in the last posting, but to a greater degree than a front month option. If my assumption was wrong and PCAR fell, the options would implode with time premium and retain more of their value.

Imagine that PCAR dropped in a day and it traded down to $65. A May option that would expire in a few weeks would retain some value, but not as much as an option that expires in another 3 months. The reason for this is that there is time for the stock to “snap back” and an earnings release was due within that time frame. The uncertainty that caused the supposed sell off would actually help the option retain value and the company would have a quarter to correct the problem. Mind you, the hypothetical event stinks because I’m losing money on the trade.

Back to the original line of thought. The move was going to take place over a few months so I had the latitude to look at back month options. What if I was just looking for a $2 gain to unfold in a week? In that case, given the wide bid/ask spread in the options, I would have traded the stock. If you are looking for a $2 move and there is a $.30 bid/ask spread, you are giving up $.60 out of your $2. Don’t line the Market Maker’s pocket. You are giving up too much edge. For the same reason, you don’t buy front month ITM options and “roll” them each expiration. There is too much slippage. Usually, a back month ITM option won’t cost you that much more ($1-$2) and it has a big benefit.

When you buy back month ITM options – you can sell front month premium against them to generate income and take advantage of accelerated time premium decay. In the case of PCAR, the stock ran up and I was able to sell the June 80 calls for $1.30. There was no margin requirement since I owned a deeper call with more time and it generated free cash flow. The stock was holding up well in a declining market so I did not want to close the trade (sell the august 65 calls). I just wanted to take in some premium and add a little protection. The June options expired and the stock rallied again. I could have sold July options against the position, but I did not like the market action and I decided I needed more protection. I sold the August 80 calls for $3.70. Now I’ve collected $5 in premium and I own a 15 point August 65 – 80 call spread for $4.80. The stock is at $77 so it has been a nice trade. It has spent a lot of time over $80 recently and with a little help from the market it will get there again so that my Level 3 Option Reportsubscribers can “max out”.

One note of importance! If the June 80 calls had finished in-the-money, I would have bought them and sold the August 80 calls.

Remember, if you’ve found a longer-term grinding move of $5 or more on a stock with good support, back-month ITM options. During the PCAR trade, I legged into a diagonal spread. In the next posting, I will use the strategy as an entry position.

Send me your comments. It helps me write better content and it gives me a chance to “fill in the gaps”.

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Option Trading Comments

  • On 07/28, Tom said:

    You talk about slippage and not trading larger spreads.  What about the possibility of bidding inside the spread?  I know it is somewhat difficult to do on illiquid options, however I have had some success with the more active options.  Sometimes the spreads go from .25 to .10 to .20 and are moving all over the place.  Is it the market maker playing games?<br>Another question I have is this:  Say an option trades about 500 to 700 or so contracts in an average day. I often see in the bids/ask quotes offers of 200 or 310 or 412 contracts or there abouts in the que. Since the volume is relatively low, it seems that if some of these trades went through the volume would be in the thousands.  Is this the market maker displaying these bids/offers to keep control of the prices?  Thanks for the information.  Tom

  • On 07/28, Pete Stolcers said:

    Hi Tom,<br><br>On less liquid options I would not leave a live limit order between the bid/ask. The Market Makers know when it is it is "dead meat" and it is there to stay. That gives them the latitude to lean on it until the fill is so good they just have to take you out. If a market was $5.00 x $5.40 and you placed a $5.20 bid, you might get filled and the market coming out could be $4.70 x $5.10. You might have gotten filled, but you did not get a good price. In reality, you did not get filled between the bid/ask spread. I would use a conditional order with a limit. For instance, Buy 1 XYZ August 50 call @$5.20 contingent on the stock $53.80 or higher. That way if the stock starts to fall your bid will get canceled. This will keep the Market Makers honest.<br><br>The option size you see on the bid and ask is the auto-quote. You will see it change with the bid/ask/last/size of the stock. The markets tend to be true and if you are giving up enough edge, you can get that size done. The problem is, no one wants to give up that much edge and orders of that size are shopped "off-floor" by size traders.

  • On 08/01, Tom said:

    Hi Pete.  Thanks very much for the information.  Next time I have the need I will try the conditional/limit type of order.  Tom

  • On 09/13, Dima said:

    Hi Pete,
    I have a slightly similar position as you described and a couple questions.  I’m long a back month OTM put and trying to decide if I should leg in with a front month put, which is deeper OTM.

    Long: 25 Put contracts for QQQ strike price 45.  QQQ price currently is 54.5.

    My goal is to reduce time decay, because I don’t know when QQQ will have a severe downturn, I just bet that it will in the next 12 months.  This is my “black swan” position, but I’m willing to reduce potential profit to decrease my risk (time decay).

    My question is whether such diagonal spread is more vulnerable to increased implied volatility. I’m relatively new to options. Are there any disadvantages to legging in here, except for capping a potential profit?
    The next expiration date is 18 days from now, and if I write a deep OTM Strike40 QQQ put, for 5cents, it will most certainly expire out of the money and I will keep the premium. It seems like a no brainer - am I unaware of some significant risks here?  Again, i’m pretty new.

    Thanks a lot!
    Dima.

  • On 09/13, Dima said:

    UPDATE to my previous post.

    Better yet I could leg in with writing a 44QQQ put for Oct11 expiration date.  I’m very sure it will expire out of the money and I would keep 27c*100 per contract. 27c is the current bid, and there’s high liquidity and narrow spread.  This would cover most of my current loss on this position.

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