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.