Best options for speculation - OTM, ATM or ITM?

Discussion in 'Options' started by silent_tunes, Sep 29, 2010.

  1. Please help me out with this learning exercise. I have thought about this problem intuitively and would like input from other experts on this forum:

    IF one were to speculate on a stock/ETF (say I am bullish on SPY), which options/strike prices/expirations make the most sense for speculating in this scenario?

    I will start the discussion with a few things I could think of:

    1. If I am buying options, deeply ITM options would cost more; therefore, for a given total amount at risk, the number of contracts would be less; therefore, lower commissions.

    Considering commissions, ITM better than ATM better than OTM.

    2. For a favorable move in the underlying, % change in the value of options would be highest for OTM options. Similarly for an adverse price change in the underlying, OTM options would lose the most.

    Therefore, on a risk/reward basis:
    ITM (less risk/less reward)
    ATM (medium risk/medium reward)
    OTM (high risk/high reward)

    3. The open interest/liquidity etc. of ATM options is likely to be highest. Therefore, the bid/ask spread can be expected to be the smallest for ATM options and comparatively higher for ITM and OTM options.

    Therefore, on a trade execution/best fill basis:
    ATM better than both ITM and OTM

    Can others share their opinions/comments and build on this list? Please remember that this is simple option buying strategy; complex strategies that require higher option trading level approvals are not available to everyone and therefore, will not be helpful here.

  2. MTE


    There is no one size fits all answer here. The answer really depends on the time frame, size of the expected move and volatility view.
  3. Agreed

    But I would say OTM offer highest risk/reward. If you are in a liquid name and get a strong move in the stock, OTM options can make a substantial gain for a much lower cost. I feel ATM/ITM are less risky and offer a cushion where OTM are the most lucrative.
  4. MTE


    Agreed. :)

    If I'm trying to catch a short term move then I would generally go for the shortest expiration possible and slightly OTM.
  5. Just be ready to handle the 4 pennies a day loss on the near term slight otm.
  6. 1) If you're at a deep discount broker, commissions should be a secondary consideration (or less). They're part of the cost of doing business and usually a fraction of the cost of the premium at risk. Worry about the underlying and the premium.

    2) Risk isn't one dimensional. OTM options are riskier in terms of total loss of premium but ITM options cost more so tiotal risk is larger.

    3. While ITM's are likely to have a larger B/A spread, the ITM is likely to make a small profit on a modest move while the OTM's lose it all.

    No matter how many pros and cons you come up with, the short answer is what MTE said: "The answer really depends on the time frame, size of the expected move and volatility view."