Buying Deep ITM Options
Buying deep in-the-money (ITM) options is a good way of carrying out directional trading in high volatility market environments. When implied volatility (IV) levels fall, it is the purchasers of at-the-money (ATM’s) and out-of-the-money (OTM’s) options that are hurt the worst, while the deep ITM options are relatively unaffected. This is because deep ITM options have very little time value.
One reason I like buying deep ITM calls is that as the market trends upward, it naturally experiences one or two days of setbacks. These setbacks affect my deep ITM calls very little on a percentage basis, so I am more comfortable seeing my position through. And because 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 have 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 process with fewer transactions.
Note that buying LEAPs can accomplish a similar thing, but 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. LEAPs also 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. 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 the higher price per option, preferring lower priced options. The experienced investor realizes that this is not rational. (My mother-in-law refused to buy a stock simply because it was 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 the stock, allowing you to either leverage up or retain cash for other investments (or to just earn interest).
For example, bank stocks have been moving up recently, and Bank of America (Symbol: BAC) seems to be in the baby stages of an uptrend. Let’s consider the prices of its stock and options. The stock price is currently $53.62 so you could buy 1,000 shares of stock for $53,620.
Or you consider buying calls. The nearby’s (with 19 days to go) are priced as follows:
Note that the deep ITM calls have a time premium of only 13 cents. That means the passing of time and a possible volatility drop could only take 13 cents away from you in the next 19 days! The equivalent of 1,000 shares of stock can be had by buying just 10 of these call options for $6,250. In effect, it’s like buying a cheap, $6 stock and hoping it goes to $8 – which will happen if Bank of America rises only two 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 52.5 ATM options with their delta of around 50 each (as the stock moves one point, the option would move about half a point). This position would cost $3,100. 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 1.75 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).