When to Opt for In-the-Money Plays

When looking at options, investors too often confuse cheap with good.
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How or why do we want to buy a call that is already well in the money, where the option has no trading volume or any open interest? Regards,
Henry

One of the more difficult parts of option investing is trying to figure out which option is the best choice among the literally hundreds of options listed for any particular stock. There is nothing more frustrating than making a correct prediction on a stock's movement, only to fail to reap the appropriate profit because the option strategy employed didn't produce the expected results.

The experience of an option not "working" probably discourages more people from trading options than any lack of understanding about options concepts. Having a basic knowledge of how different options and strategies perform under various scenarios and applying a few basic rules of thumb can help aid the decision-making process, but the wisest course is employing the most straightforward and simplest strategy.

And because the most common type of trade is based on an expectation of the direction of the price of a particular stock or even the overall market, the simple purchase of puts (a bearish bet) or calls (a bullish bet) is the most effective approach. Unfortunately, individual investors have a tendency to buy short-term out-of-the-money options.

"The most common mistake among retail investors is turning a fundamentally, or technically, sound prediction into a purely speculative proposition because they choose to buy low-cost options," says Adam Nevin, head of derivative trading at NVR Capital. Nevin explains that many investors mistakenly confuse an option's cost in absolute dollar basis with whether it is "cheap" or "expensive" on a relative basis.

An out-of-the-money call, even with a low cost of 20 cents, can actually be quite expensive when implied volatility and time remaining are included in calculating the probability of the option increasing in value.

The general rule of thumb when buying options is to make a directional bet either at-the-money or one strike in-the-money, and have at least 60 days remaining until expiration. The two primary reasons for using a longer-dated option are that it allows a reasonable time for the investment thesis to play out and it minimizes the initial impact of time decay eroding the option's value.

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)

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.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback;

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