Buying Deep in-the-money Options

By Len Yates – President OptionVue Systems International.

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

Whenever you are in market when high implied volatilities, they will eventually begin to come back down to more normal volatility levels. When this happens, the at-the-money (ATM) and out-of-the-money (OTM) options are going to be hurt, while the deep in-the-money (ITM) options will be relatively unaffected.  This is because deep ITM options have very little time value.

I have often used deep ITM calls in this kind of situation.  One reason I like them is that as the market trends upward, it naturally experiences one or two temporary 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 since the deep ITM options have very little time premium, I'm 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 debit spreads previously 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 possess 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.  I have not found this to be a problem in the issues I trade, especially if you can direct 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 keep trying 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:

30

27.5

25

22.5

20

3/8 

1 1/8

2 7/16 

4 3/8

6 1/2

1/2 

1/1/4

2 5/8

4 5/8

6 3/4

7/16

1 3/16

1 1/16

1/2

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 rises only three 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 two points at the end, and never having seen it fall below his purchase price in the meantime.  So the next time you’re looking at going long (or short), consider using deep ITM calls (or puts).

* Option strategies carry inherent risk of large potential losses. As such, these strategies may not be suited to every investor.