The Case for In-the-Money Options

05/03/2010 11:03 am EST

Focus: OPTIONS

Most people have the idea that owning stock is a sound and prudent thing to do, yet many consider options to be speculative or even outright gambling. But I'd like to show you how, if you pick the right options, it is not so very different from buying stocks. This is what is meant when you hear people discussing a stock replacement strategy.

Now, I don't like the idea of owning options as an investment, and never suggest that anyone invest that way. The rationale behind my stance is that the vast majority of option buyers pay far too much in time premium, in effect placing a wager that the specific stock will move sharply higher soon, or before the option expires. That is gambling and not investing.

A stockholder can afford to wait for his/her reason for buying the stock to be recognized by the market. The individual investor who buys options cannot afford to wait because time erodes the value of the options.

For the small minority who has proven skills as market timers, owning at-the-money (ATM) or out-of-the-money (OTM) options may prove profitable. But buying those options is a trap for the average individual investor.

But if a trader buys call options that are already in the money (ITM), the picture is entirely different. These options have a high delta (75-85) and increase in value at a pace that almost matches that of the stock.

True, owning ITM options is less profitable than ATM or OTM options when the hoped-for move occurs. However, the profit from that rally is "good enough" when you consider that there is a big benefit that comes with owning ITM calls.

In return for paying time premium, your loss is limited to the price of the option. In a market downturn, instead of being exposed to a large loss (e.g., a $42 stock declining to $25), the owner of the call option with a $35 strike price can lose no more than the option premium. That amount varies depending on the stock's volatility and the remaining lifetime in the option, but it's likely to be in the $1 to $2 range, plus intrinsic value.

It's a tradeoff that is not suitable for every investor. But if you are willing to sacrifice a little upside potential in return for additional protection in a down market, these calls are suitable investments.

Buying ITM calls is identical to a strategy referred to as buying "protective puts." Buying one put per 100 shares of stock is a method that is equivalent to owning the call option with the same strike and expiration date. But when you consider trading costs, it's more efficient to buy calls than to buy stock and puts.

I am not trying to convince investors with long-term investment objectives to switch from stock to options. My purpose is to compare stocks with options and be certain that you recognize what you get when buying stock.

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Let's consider that $42 stock mentioned above. The table below indicates the value of a six-month call option, assuming the options trade with an implied volatility of 35.

In-the-Money Options

Buyers of the six-month 35 call option pay $148 per contract in time premium.

Investors who hate paying anything for time premium may prefer the six-month 25 call, which carries a time premium of only $29. By buying this call with a lower strike price, you accept an additional downside risk of $1,000 per option.

For investors who insist on paying zero extra premium, and who are willing to take even more downside risk (it's a small risk, as there is little likelihood that this stock can move below $25, but it is possible) there's the call option with a strike price equal to zero.

Such options don't trade on any of the option exchanges, but they do trade on the New Your Stock Exchange. And these options with a strike price of zero come with a bonus: They never expire. They are called stock.

The point of this exercise is to illustrate that buying ITM options is not so different from buying stock. I've seen new investors buy low-priced stocks for the simple reason that they cannot afford to buy higher-priced stocks. That's a big mistake. It's much better to buy a few shares of a stock you truly want to own than choose from the universe of low-priced stocks. Or you can put up less money and buy ITM options.

A recent discussion with a reader prompted this post. He is willing to invest cash in a stock position, but considers his option purchases to be speculative and uses far less cash when buying options. It's clear that this trader buys low-priced ATM or OTM options. The thought of owning deep ITM options instead of stock was not considered. This post is dedicated to him and other stock-owning investors who think options are too risky.

By Mark Wolfinger of Options for Rookies

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