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In The Money Or Out Of The Money?

Posted by Pete Stolcers on May 2, 2009

Option Trading Question

Susan R. asks, “I struggle with which option to buy once I find a trade. The In The Money (ITM) options are expensive but they move well. They are risky because they have so much premium. The Out Of The Money (OTM) options don’t cost much but it takes forever to see them go up. How should I decide which ones to buy?”

Option Trading Answer

Susan addresses a daily dilemma faced by option traders. This is a tough question to answer in one article - but I’ll try. First I need to set the table. 

Every option I trade is determined by my opinion of the stock and my level of confidence in the trade. My opinion of the stock will result from technical analysis. I look at how the stock has traded recently. If it has a history of nice grinding moves, I will approach it differently than if it is volatile. If it is approaching a breakout on heavy volume, I will treat it differently than if it has been marching higher in small increments for months. My confidence is a function of how well I have traded recently, my ability to get a good “read” on the market and how good I feel about this piece of research.

I dissect my opinion into statements about direction, magnitude and duration. If I feel the stock will breakout and move 6 points higher in 6 weeks with a high degree of confidence, I may opt to buy out of the money calls with two months of “life”. This is my selection because these calls will provide the most leverage and the highest percentage rate of return. They also have the chance of going ITM. In that case, I will have a fairly large leveraged stock position to trade out of. My confidence has to be high and I can’t miss on any element or the trade will fail. These trades tend to have a higher failure rate but they produce incredible returns when they “hit”.

Let’s use another example where the stock has been in a strong sector and it is leading the market higher in a nice orderly fashion. It has moved sideways and rested for a week and now it looks ready to grind higher. Let’s say the market is shaky and this stock tends to drift lower in a weak market and lead any rally. Let’s also assume that I feel in a flat market the stock will grind 3 points higher over the course of 2 weeks. In this situation, I like the stock but my confidence is not very strong. I will trade fewer contracts and select an in the money front month option as long as it has 2 weeks of “life”. It must have a delta of .9 (or higher) and not carry more than a $.50 premium over parity. If I can buy the next month’s options for an extra $.30 I will probably make that choice. This selection allows me to participate in a move in the stock and I can take profits along the way. An out of the money option will not move enough for me to do so. Since the stock holds up relatively well in a weak market, I will probably have time to get out of the position without losing much if the market turns sour. In this situation I have more room to be “off” than I did in the OTM example. If the stock stays flat, I can scratch the trade and not lose any premium decay. If the stock only goes up $1 instead of three, I can still make money.

In this example I have assumed that the options are moderately priced. If the implied volatility is high, selling strategies would probably be more effective.

The take away is this, my opinion and confidence determine the selection. The more explosive the move and the higher my confidence, the more I lean towards out of the money options. The more grinding the move and the lower the level of confidence, the more inclined I am to trade In the Money options.

Option Trading Comments

  • On 04/05, Arkadiy said:

    I think I agree with the autor, it doesn’t really deliver on its promises

  • On 04/05, Arkadiy said:

    Great post. Thanks for all the practical insight for a “young” writer.

  • On 04/14, John H said:

    Money management with low balances.  I read a lot about managing accounts by limiting the percentage of your balance you risk on any individual trade.  However, if a person wants to get into trading, but has a limited amount of capital they are willing to risk, say $2000 - $4000, it seems that one has to risk a substantial percentage to make any gains when all the fees are added in.  If you were to only risk 20% or less on any one trade, you would have to almost double your money a large percentage of your trades and trade short term OTM options.  It seems that risking a larger percentage on a longer term deep ITM trades on quality companies would be safer.  How would you approach trading if your account balance was less that $5000?

  • On 05/12, Online Options Trading said:

    For biotech stocks, which one is better ITM or OTM ?

  • On 05/12, Pete Stolcers said:

    It is impossible to generalize with options. Each stock and market condition is different.

    If the market, the biotech sector and the stock were all in an up trend, an OTM call would be the way to go. If the market is choppy and the stock is grinding higher, selling an OTM put spread might be the way to go, that way you are giving yourself breathing room if the market breaks down.

    Your opinion of the market and the stock determine the right strategy. You must quantify the magnitude and duration of the expected move.

  • On 08/17, Money said:

    I’ve always wondered about options trading.  Thanks for the article, you definitely have some very good examples.

  • On 04/02, Alex Lawson said:

    in a covered call how deep in-the-money should you go?Three strikes below stock priceas a maximum?

  • On 04/06, Pete Stolcers said:

    There in lies the key. It is a function of the market and your opinion of the underlying stock. I have designed an entire course around this subject.

    In short, the more conservative you are, the deeper in the money and farther out in time you go. The more aggressive you are the closer to expiration and the farther oput of the money you go.

    Trends, momentum, earnings and macro conditions all come into play.

  • On 05/02, David O. said:

    Sort of off-topic, but I to would love to hear how you would approach trading options with a low account balance (4000-5000).  From what I can tell the only way to get any serious reward would be to speculate and treat an option like a stock.  Selling options would require lots of margin to cover the requirements, and a safe return (OTM spreads) would be to small for all the trouble required.  My broker (IB) charges very little for options trades (.75 per contract) so jumping in and out on a daily basis wouldn’t be that expensive.  Am I overlooking something?

  • On 05/06, Pete Stolcers said:

    Starting with a small option account is difficult because you are alway fighting minimum commission charges. Many brokerage firms have done away with minimum charges and first of all, find one that has deep discount rates.

    The key is to spread your money out over many trades so that no one position can take you down. Premium buying is a much more volatile strategy, but to your point, it does not require as much capital and the rewards are much bigger.

    Most novice option traders blow their account out because they allocate too much capital to one trade and they don’t cut their losses.

    For that reason, I suggest OTM credit spreads. With a $5k account, you should only do about 2 or 3 spreads per trade. Distance yourself from the action and let time decay work for you. As I write this, the VIX is at 38. That is historically high and it favors selling strategies.

    This is the slow but steady path to success. Build your account over time and as your skill improves, gradually introduce buying strategies.

  • On 05/06, David O. said:

    Thanks for the response.  I have always looked at OTM credit spreads but to do it safely (buy a lower/higher strike for protection) it always seems to end up making very little money.  My minimum commission on an options trade is $1, so I can afford to get in and out of trades without losing much.  Also with spreads you need margin, with accounts under $25K you get hit with day-trader rules.  This vastly limits what you can/can’t do on a daily basis.  I guess I’m going to stick to being a buyer until I’ve built my account up enough to start introducing other strategies and overcome the $25K rule.  I was a buyer through the sept-dec time period and made quite a bit of money(by my standards) with straddles on the banks.  I am just looking to branch out and learn other ways to make money in the options market.  Thanks for your response and I look forward to your market analysis on a daily basis.

  • On 01/14, Buyer Jobs said:

    I’m afraid I completetely agree with Pete - who gives some great examples in the article.

    In response to ‘David O’ I’d suggest you’re doing the right things - keep building up until you’re ready to branch out - Good Luck!

  • On 10/13, Chris said:

    What happens if I own options that are deep in the money and I’ve acquired a significant profit through the option price appreciation, but I don’t allow them to exercise at expiration because I don’t want to own the stock.  Do I retain the value of the option even after it expires in the money and I don’t exercise?

  • On 10/13, Pete Stolcers said:

    You must sell the options in the open market before the closing bell on expiration Friday or the brokerage firm will auto-exercise the options. You will come in long stock on Monday and you will have to get out of the stock position or face a big margin call.

    Get out Friday and aviod the hassle/risk.

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