ITM Calls as a Stock Substitute

I found this series of questions to be quite valuable. Here we have a relatively new options trader who finds an excellent method for reducing risk, but who gets caught up in a mistake that makes him question his methods.

Mark,

I’ve been using DITM options for swing trades, while utilizing the leverage to potentially increase the return of buying stock outright.

Plus much less downside risk, unless you decide to buy extra options with the cash not used to buy stock. To be clear, I’m hoping that you do not decide to buy 10 calls, paying $8 each, Instead of $100 shares at $80/share. That’s a very bad idea. You must determine your correct position size by the number of shares you would have bought, and buy only one call for each of those 100 shares. Careful position sizing is essential to risk management.

I usually pick the first strike showing a 1.00 delta. My question is whether this is actually a good risk to return strategy based on the changing delta.

You adopted an excellent strategy, but your focus seems to be misguided.

100 delta options are too far in the money – unless it’s expiration week. The major benefit of using this trading method (buying calls instead of stocks) is to gain a large amount of downside protection. As you know, a market tumble can be quite costly for stockholders.

If you chose ‘high delta’ options instead of 100 delta options, you would gain that protection at a very modest cost. I urge you to consider the idea of paying a few dimes over parity for a call option that has a 75-85 delta instead of paying closer to parity for that 100 delta option. This is a personal decision and if you refuse to pay that time premium for protection, so be it.

Example

With the stock trading at $76, don’t buy the 65 calls (price = $11.20). Instead, buy the 70 calls (price $6.50). That extra $30 reduces the potential loss. Consider it to be an insurance policy.

Next, I understand neither your reference to changing delta nor “risk to return strategy”.

1) The risk to return is outstanding. You cut the dollars at risk from a gigantic number (when owning stock) to a much smaller number (by owning a call option). Surely you understand that.

2) Changing delta? If you are unfortunate enough to see the stock decline by enough for the option delta to become < 100, that's GOOD for you. You seem to believe it's costing money. All it means is that you would lose LESS money per point of decline that you would lose if owning stock. I have one question for you: If you are a swing trader, why would be holding a long position in this stock when it declines by so much? That is not how swing traders operate. They are quick to cut losses. Remember, until the stock falls enough to cut delta, you lose $100 per point. 'Changing delta' doesn't mean much in your scenario because 100 delta options don't change delta very quickly.

Say I pay $10 for a call with a 1.00 delta, and based on this, expect about a 10% move in option price for a $1 stock move (give or take some). The stocks drops. At this point the option price and delta will also drop,
which could very easily cause the percentage option loss per dollar to go up based on higher volatility.
.

You are off on several wrong paths here, and that’s the reason for posting this discussion. This is a good learning opportunity for rookie option traders:

a) You should expect the ‘give or take’ to be essentially zero for a 100 delta option

b) You are thinking in percentages, and that is confusing you. As a swing trader, concentrate on what you are doing. You are buying (or selling short) stocks, looking to make a few dollars per share. Using call options changes nothing in your basic plan – except that it reduces risk. Concentrate on dollars and forget those percentages.

c) You do NOT KNOW that the option delta will be less than 100 when the stock declines by one point. You did say these are deep in the money options.

d) If there is a change in implied volatility, you WILL NEVER lose ore than $1 per point in the price of an option when the stock declines. Why? You own the option. You own the vega. You BENEFIT when the implied volatility increases. Thus, any losses would be reduce by that change in volatility. Couple that with your anticipation that the delta becomes less than 100 and you benefit again by losing less than $100 per point decline (in the sock price).

Here’s where you miss the big picture: If the volatility increase is large enough – due to a general market scare – you can MAKE money on the decline when oping calls! Did you know that? Get out your option calculator and see what happens to the value of a call with a 70 strike price when implied volatility goes from 30 to 60 and the stock declines from 75 to 70. Assume options have 30 days before they expire. [Your calls would lose less than $1 in value. If they were longer-term options, they would increase in value]

Should the stock move higher, the volatility may decrease and the delta is maxed out at 1.00. Thus, my option price increases, thereby lowering my percentage gain.

No. Delta may be maxed at 100, but so is the delta of the stock. The long call and the long stock move in tandem. The percentage return is totally unimportant – and in fact, it does snot change. You paid $10, so every one point gain is another 10% return on your investment. Plus, your return is far better than that of the stockholder. I’ll say it again. Forget those percentages.

So I’m wondering if this approach actually causes a disadvantage as the reward potential for say a $2 increase may be lower than the risk potential of a $2 drop because the percentage gain decreases for every dollar going up while increasing for every dollar going down. So I may make 18% on a $2 upside but in exchange for a 30% drop for a $2 drop … again give or take.

No. You illustrated why your idea is good. The bad things you found in the strategy are imaginary. They are contrary to fact. You earn as much on the upside (you may earn a little less if you take my advice to buy options with a small amount of time premium). To compensate, you have an excellent chance to lose less than $1 per one point drop in the stock price.

Sit down. Think about this carefully.

One additional point: These DITM calls don’t do the job for stocks that pay decent dividends because you may have to exercsie for the dividend to prevent losing money.

925

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4 Responses to ITM Calls as a Stock Substitute

  1. Lies 03/14/2011 at 8:14 AM #

    Hallo,

    I have a question about the extrinsic value (time value) of an option. I read an article where the author says that the time value of an ITM option is the same as the time value of an OTM options when the strikes have the same distance to the stock price.

    Example: The stock price is 100 -> the author argues that the call 80 will have the same time value as the 120 call, if we make abstraction of dividends and interest rate.

    But when i recalculate this i don’t see this in my result…

    For example:
    Stock price: 100
    volatility: 50%
    Dividend: 0
    Interest rate: 0.01% (because i get an error when i use 0%)
    Days to expiration: 60

    => The call with strike 80 has an extrinsic value of 1.24.
    => The call with strike 120 has an extrinsic value of 2.23.

    Is the author wrong in his article when he claims that an ITM option and his ‘corresponding’ OTM option (= with the same distance to the stock price) have the same time value?

    • Mark D Wolfinger 03/14/2011 at 12:00 PM #

      Lies,

      This author is incorrect. But it may simply be a matter of definition. The extrinsic value of an option may be called the ‘time value’ because it disappears with time. However, it is composed of ALL FACTORS that affect the price of an option, excluding the intrinsic value. Thus time is important. But more important is the volatility. The higher the IV, the more the OTM option is favored over the ITM option.

      Consider this: The time value of an option depends on the strike price. When we buy options (at least ITM options) we can use the cash not used to buy stock to earn interest. The lower the strike – and the more we pay for the option, the less interest we can earn. Thus, the interest factor is higher (for calls) as the strike price moves higher.

      Also: The extrinsic value of the option is not only time value. It also includes ‘volatility value.’ To do your calculation accurately, you must lower volatility to near zero. as you know, the price of an option depends on the chances of it’s undergoing a significant change in value. The OTM call has a good change to double, triple etc – whereas the ITM call lacks that ability.

      Thus, the volatility component of the ‘time value’ is higher for cheaper, lower delta options.

      Regards

  2. Lies 03/14/2011 at 12:42 PM #

    Thanks for the reply.

    The site where i read this article is this:
    http://community.tradeking.com/members/optionsguy/blogs/48905-buying-calls-time-is-money

    • Mark D Wolfinger 03/14/2011 at 8:16 PM #

      To defend that author, he did say this: “but keep in mind we’re using a theoretically perfect example: stock to equal to the 100 strike and no carry costs.”

      And his example included options that were very close to the money, so the volatility effect was also minimal.

      However, his statement is not strictly accurate.