Deep in the Money Play

Discussion in 'Options' started by switze22, Jan 20, 2008.

  1. Ok, so I am new to Options, but I like the idea of Deep in the Money plays.

    Seems like a good way to make return with less risk than owning the stock itself.

    So, 2 questions.

    1. Say I think stock ABC is going up. The stock price is at $100, and I buy an option with a Strike price of $10 with a premium of 91.50.

    So, I would pay 91.50 x 100, and have my option.

    Then, assuming delta is 1, for every $1 the stock goes up, the option will go up $1 as well.

    So, before the expiration date, I can sell the option for a profit. But, if the option expires below what I paid, then I would only lose the extrinsic value of the option?

    Should I be worried about low volume if im only buying 1 contract?


    Ok, #2.

    I think apple is going to go up on earnings on Tuesday.

    I currently own like 39 shares equal to around $6,300.

    Would it make more sense for me to sell the shares and buy a Deep in the Money option before Tuesday? Which expiration month should I pick?

    Seems like I could make more money with less risk.


    Ok, thanks everybody. Sorry about my ignorance, but I am trying really hard to learn options.


    Thanks,

    David
     
  2. MTE

    MTE

    If the stock expires below 101.50 then you would have a loss on the option equal to (stock price - 10) - 91.50. So, if the stock expires at 90, for example, then your loss is 90 - 10 - 91.50 = -11.50.

    Deep itm, low volume = wide bid/ask spread = significant slippage.

    I wouldn't recommend doing this until you actually have a good understading of options, at which point you should know the answer to this question yourself.
     
  3. So that would be a -$1,150 loss?
     
  4. MTE

    MTE

    Yup!
     
  5. contango2

    contango2

    Each deep in the money options contract (delta close to 1)behaves similarly to owning (or shorting) 100 shares of the underlying.

    Time value is not much of a factor if you are DEEP in the money. So in your example the extra 1.50 in time value you say you are paying is more likely to be next to nill.

    Liquidity won't be a problem if you stick with higher volume underlyings.

    To the untrained eye the Bid/Ask spreads may look big.... but for trading purposes you should calculate the spread as a percentage of the option premium.

    Take the current AAPL March CALL contracts as an example:

    Look at the March 125 Call (at the money)
    Bid/Ask = 8.55/8.70

    .15/8.55 = 1.75% spread

    but the deep in the money March 90 Call Bid/Ask = 36.30/36.50

    .20/36.30 = .55% spread

    Percentage wise it's actually better than the at the money spread.
     
  6. Buying a $10 call for 91,50 on a $100 stock makes no sense because you're not reducing your risk. You make (or lose) $1 for each $ the stock rises (or falls) and you have purchased something with a much larger spread. Consider something much less ITM.

    If the underlying drops, you will lose the time premium that you paid (the extrinsic) plus the amount that the stock drops drops (intrinsic).

    Your primary concern should be getting the direction right. In addition to the large spread, you might even find that the option trades below parity (the bid) and in order to avoid losing that add'l amount, you'll have to exercise and short the shares.


    It only makes sense if AAPL goes up a lot.
     
  7. Speaking of ditm plays....anyone know what happened to Lenny Dykstra? He was suppose to continue updating his trades and "not leave his readers out to dry". He popped off the radar about the same time the market started to tank and never posted any updates like he promised.

    I would be very careful with ditm contracts, unless you are really good at predicting stock movement and also timing. Most of my option trade losses are from ditm calls, back then when i didnt know any better. As a rule for myself, i never pay more than 50 cent for any naked contracts anymore, most of these are otm speculative trades - ie many small losses a few big wins.

    Mostly just write otm spreads now, once i determine a stock will move in a direction.
     
  8. contango2

    contango2

    I think you have missed the point...

    What is being discussed here is the use of DITM options as a PROXY for outright buying of stock.

    Let's say I wish to buy 100 shares of Microsoft. At $ 28.96 per share that costs $ 2896.

    Instead I can buy an April 15 Call for $1395 that has a current Delta of 1.00. It has virtually no time value to lose.

    If by April expiration MSFT goes up by $5 in either case I make $ 500. If it goes down $5 I lose $ 500.

    I am obviously using leverage with DITM options as opposed to buying the stock and leverage must be used wisely.

    On the other hand I don't have the Theta issues associated with ATM or OTM options and I don't have the Gamma issues to contend with if the stock takes a dive.
     
  9. contango2

    contango2

    "If the underlying drops, you will lose the time premium that you paid (the extrinsic) plus the amount that the stock drops drops (intrinsic)."

    ....wrong ...Deep in the money options have very little or even no time value. ATM options have much more time value to risk losing.

    "Your primary concern should be getting the direction right. In addition to the large spread, you might even find that the option trades below parity (the bid) and in order to avoid losing that add'l amount, you'll have to exercise and short the shares."

    ....huh...I'm just an average retail investor with a PC and I can get immediate execution of AAPL deep in the noney options at the mid Bid/Ask spread no problem.
     
  10. I think that the original poster is just recognizing the tremendous leverage of options.

    If his option contract is setup to increase $1 in value for every $1 that the underlying stock rises, then he is gaining 100:1 leverage.

    He's paying a premium for this leverage, and just like any leverage it can go up or down, but beyond that I think his principle concept is to use the option as leverage.

    With the right conviction on price direction for the underlying stock, I don't think this is a terrible proposal. I've never done a DITM or a ATM option though, i'm always 2 or 3 strikes OTM
     
    #10     Feb 14, 2008