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Option Trading Tip - Buy Deep In-The-Money Options

Aug 17, 2007
In times of high volatility, Buying deep in-the-money (ITM) options is a good way of implementing directional option trading strategies.

This is because high implied volatilities, will eventually begin to come back down to more 'normal volatility' levels and when this happens, the at-the-money (ATM) and out-of-the-money (OTM) options are going to suffer.

Deep in-the-money (ITM) options, however will remain largely unaffected. Why you might ask? Well this is because deep ITM options have very little time value and it is the time value or 'extrinsic' value of an option that is effected by rising or falling implied volatility.

In volatile markets, using deep in-the-money options can be more forgiving if you are right about direction, but your timing is slightly off. For example if you have a stock with a strong underlying uptrend that has experienced a healthy correction and you enter a little too early by buying Calls before the stock starts trending up again.

Because deep ITM options have very little time premium, they offer somewhat of a 'buffer' should the stock move against you slightly or move sideways for a period before it starts trending again.

At-the-money and out-of-the-money options are ALL time value and therefore your timing in regards to the direction of the underlying needs to be spot on. In times of high implied volatility, any period of sideways movement, or a 'slowing' to how much a stock is rising or falling, can result in considerable erosion in the time value premium for both at-the-money (ATM) and out-of-the-money (OTM) option holders.

This is due to both a fall in implied volatility and also time decay.

When it comes to 'neutralizing' the effects of volatility, buying a deep in-the-money (ITM) option can be very effective in this regard.

Many traders argue however, that there are definite disadvantages to buying deep-in-the-money (ITM) options saying that they are 'expensive' and are prone to greater slippage due to a wider spread.

To that I rebut by saying that the word 'expensive' does not apply to deep in-the-money (ITM) options. The fact that they demand a higher premium is due to their 'real' intrinsic value. In regards to the wider spread, this is in most cases due to market makers not advertising their 'true' buy/sell price.

In my experience, placing an order that splits the bid/ask in half, usually results in a quick fill and a successful entry or exit.

Ultimately, I like to think of deep in-the-money options as a surrogate for the underlying stock itself.

In fact, if you go deep enough in the money, where the delta is 1 for calls and -1 puts, these options will move point for point with the underlying stock.

For 'short-term' directional traders (and LEAP traders - though LEAPS have greater volatility risk due to their higher vega), this provides an opportunity to effectively trade the options 'as if' you were trading the underlying stock itself, but for a fraction of the capital outlay.

That in my book is a smart way to use the leverage that options provide and 'trading smart, not hard' is fundamental to achieving consistent trading profits.
About the Author
James Thomas is a successful private option trader and creator of http://www.option-trading-tips.blogspot.com - an informative resource full of useful option trading tips, including free video tutorials.
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