When to Opt for In-the-Money Plays

The reason for using an in-the-money option is that the price is mostly comprised of intrinsic value, which is the amount the strike is in-the-money. The corollary is that an out-of-the-money option's price is comprised entirely of time premium and is affected by changes in volatility.

An in-the-money option also offers a higher delta, or greater correlation to the underlying stock price movement. But many people are drawn to the leverage of low-priced options and the potential for large percentage gains, such as something doubling from 40 cents to 80 cents.

For example, assume Acxiom (ACXM Quote) is trading at $19.50. One could buy the $20 call for 50 cents, which would have a break-even point of $20.50, requiring a 5% move. Or one could buy the $17.50 call for $2.40, which has a break-even point of $19.85, or just a 1.7% move. The in-the-money option still provides plenty of leverage. If one bought 100 shares at $19.85 it would require $9,992 in capital, and even assuming buying on 50% margin, $19,850 would be needed to own 100 shares. The $17.50 call costs only $240 to control the same 100 shares.

This brings up another important point: The number of option contracts should be determined by the number of shares you would trade, not the dollar amount you would spend. In the example above, do not spend the $9,992 needed to purchase 100 shares to buy 41 of the $17.50 call options.

Lack of volume is a common problem in many listed options, including some of the most actively traded stocks. Using an in-the-money option makes it easier to price, with the intrinsic value being the main component, and it allows one to determine the fair value of the option more accurately.

A more accurate price allows you to enter an order, even in an illiquid market, with a limit price that should get filled. For an in-the-money option, most market makers only need a dime better than fair value to lock in a small profit. And remember, these guys need to execute trades to make a living, so although you need to have patience, eventually the order will be filled.

On the other hand, out-of-the-money options are more vulnerable to an abusively wide market; when measured on a relative basis, a 15-cent spread on a 50-cent option is like a $1.50 spread on $5.00 option. This can make it very difficult to determine if an option is "expensive" or "cheap" and represents a huge hurdle in realizing a profit. It will take a much larger price move just to move the option's bid price to the offer. Using an in-the-money option allows one to take profits on a much smaller price move.

The probability of a small price move is much greater than a large price move. So unless you are taking a purely speculative flier on takeover rumors or a drug ruling or other outlier events, it makes sense to buy closer-to-the-money options. Your odds of making money are much better.