A Quick Class on Deep Money Options

A long-time reader wrote us this week questioning one of Hugh’s recent options selections. He wasn’t sure why Hugh, a convinced equity bull, would choose to purchase deep-in-the-money CALLs on the indexes if he was so sure we were headed higher. Specifically, he asked –

Why are you going so far out? Do you not think that the market will go higher in the shorter term? Why are you recommending deep in the money calls? Why not recommend at the money or out of the money for greater leverage?

Because Hugh’s such a bookworm and barely gets his nose out of his research long enough to take a breath of the planet’s crisp fresh winds, we thought we’d take the liberty to respond to the theoretical side of our good reader’s question.

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It goes like this.

The value of an in-the-money option is composed of two items – what’s called ‘intrinsic value’ and ‘time value’. The stock is at 100, the 80 CALL sells for $25, and we say that the option has $20 worth of ‘intrinsic value’ and $5 worth of ‘time value’. The ‘intrinsic value’, of course, is the actual worth of the option were it to expire today ($20 in-the-money). The remaining $5 is based on a number of inputs, the greatest of which is the amount of time remaining before expiry. A year’s worth of time will generally carry greater value than a month’s, all other factors being equal.

So far so good?

On the other hand…

The value of an out-of-the-money option is comprised entirely of ‘time value’. The stock is at 100, the 120 CALL option sells for $1.00, and we say that the $1.00 value affixed to the option consists of ‘time value’ alone. Why? Because were the option to expire today, it would be worthless, sitting as it does 20 points out-of-the-money. It has no intrinsic value. What you’re paying for with such an option is the possibility that with enough time the option’s value will increase.

And this is key.

Because what most beginning options traders forget is that an option is a wasting asset. Time is the enemy of the options buyer (and friend of the seller), as nearly all options carry some measure of time value that by definition erodes to nil as expiry approaches.

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The only exception to this rule – as Hugh well knows – is the deep-in-the-money CALL or PUT option. Why? Because in many cases the deep ITM option carries only intrinsic value and either no, or negligible time value.

That Means No Additional Cost

The advantage of purchasing such a product is clear. Whereas stock ABC sells for $100, and each additional dollar of growth offers the investor an additional one percent profit on his investment, with the purchase of a deep-in-the-money CALL investors can magnify their gains considerably.

Using the same example, say we purchase a deep-in-the-money ABC 60 CALL for $41. That’s $4100 spent instead of $10,000 to control the same number of shares – one board lot. $4000 is the intrinsic value of the option and $100 is its time value.

In this case, each additional dollar of growth to the stock will also add an additional dollar of intrinsic value to our option. That is, a move from $100 to $101 gives us a 1% gain on the stock. But a move from $41 to $42 is a 2.44% gain on the option.

I, therefore, have put up less money to control the same action and am rewarded with almost 2.5x the gain should I be in sync with the stock’s direction.

A Two Way Street

Of course the same leverage carries me lower if I’m incorrect.

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Let’s look now at that same trade, except as our friend suggested, using an out-of-the-money or deep-out-of-the-money CALL option.

The stock is at 100, the CALLs we buy are the 120s and we pay $1.00 each.

If the stock drifts sideways and never reaches our 120 strike before expiration, the time value of our option will erode and eventually the thing will expire worthless. If the stock falls, our option’s value also plummets and very likely is more expensive to sell than to leave be to rot (dwindle to nothing).

So why would anyone buy an out-of-the-money option?

And the answer is precisely as our friend suggests in his letter – we do so when we expect a quick move that ratchets our OTM option higher in a jiff. Should ABC jump, say, 10%, to $110, in a short time frame, it’s very likely our option’s value will double or triple in value over that same period.

In essence, the trade-off is all about time.

• OTM options will produce much greater leverage if you’re right, quickly.

• Deep ITM options will produce well-leveraged returns if you’re right quickly or slowly, because they are not time dependent whatsoever – they literally possess no time value.

• OTM options will dissolve into nothing if you’re wrong on market direction.

• Deep ITM options provide a fat cushion and a guarantee that you get out with a good portion of your capital if the trade moves against you.

The Effects of Volatility

And one more thing… as stock’s rise, the implied volatility of their options generally falls. And because implied volatility is a key component in options pricing, it’s very possible (and we can attest to this from experience) to purchase a deep out-of-the-money option, be right on the direction, and see absolutely no gain on the trade. Why? Because volatility decreased so dramatically that the price never advanced.

This happens regularly to those who purchase OTM CALLs at market bottoms.

Hugh’s choice to go deep-in-the-money on his last trade is options prudence at its best. Yes, you pay more. Yes, you may make less. But your risks are far smaller than what’s essentially a speculative all-or-nothing bet using OTMs.

Many happy returns,

Matt McAbby

P.S. And it’s never too late to hitch a ride on Hugh’s last call.

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