How to Turbocharge Gains With Options
When it comes to trading options, you have a lot more choices than if you were just trading stocks. Options give you plenty of flexibility and versatility to do what you want. But with many choices come many decisions.
One of the key decisions you need to make is what strike price you should pick. Once you decide you want to be bullish or bearish and you pick the option expiration date, you still need to decide if you want to trade an in-the-money (ITM) option or an out-of-the-money (OTM) option.
With a strategy that’s right for you, options can turbocharge your portfolio gains. Let’s take a closer look.
In or Out?
An ITM option means an option that has intrinsic value—it would have value if the buyer exercised it now. A call option is ITM if its strike price is below the current market price, and a put option is ITM if its strike price is above the current market price. The more in the money an option is, the more valuable it is.
Conversely, an OTM option has no intrinsic value—it would make no sense to exercise an OTM option since you can get a better deal on the market. A call option is OTM if its strike price is above the current market price, and a put option is OTM if its strike price is below the current market price.
For example, if Cisco (NSDQ: CSCO) is trading at $46.50, a $45 CSCO call would be ITM and a $45 CSCO put would be OTM.
Keep in mind that an option being ITM is not the same as the trade being profitable. If you paid a $3 premium to buy an option, and the option is $1 ITM at expiration, then you lose $2 (or $200 per contract). On the other hand, if before expiration you can close an OTM option position at a higher premium than you paid, you made a profit.
Which Is Better to Buy?
So should you buy an ITM or OTM option? It depends.
The table shows the quotes for the CSCO January 2020 calls and puts. The column in deep blue shows the strike prices you can choose. The options that are highlighted in light blue are ITM, while those in white are OTM. Notice that the more ITM an option is, the higher the option price is, and the more OTM an option is, the lower the option price is.
Since an OTM option is cheaper to buy, if the stock makes a big move in your favor, you could make a big percentage gain on your OTM option purchase. However, the flip side is you need the stock to make a sizeable move in your favor for the option to be ITM.
An OTM option has only time value, and time decay accelerates as expiration gets closer, so the option’s value could fall very quickly. If you held the option to expiration and the option is still OTM, you will lose 100% of premium you paid.
Thus, OTM options are riskier than ITM options. They offer higher potential for big percentage gains but their risk of expiring worthless are also greater. To use a baseball analogy, an OTM option is for someone who likes to take big swings for the fences and doesn’t mind striking out as long as he hits some home runs.
More Conservative, Less Risky
ITM options have both intrinsic value and time value, so they are less susceptible to time decay. Their value won’t go down with the passage of time as quickly. They also tend to have higher deltas—how much the option’s price moves in response to the stock’s movement.
The value of delta ranges from 0 to 100 for calls, and -100 to 0 for puts. The higher the absolute value of an option’s delta, the more sensitive the option is to the stock’s movement. For example, a put option with a delta of -75 means that a $1 decline in the stock will result in a $0.75 increase in the option price.
An option’s delta changes when the underlying stock price moves. The deeper ITM an option is, the higher its delta. The deeper OTM an option it is, the lower its delta. An option that is very OTM and close to expiration will have a very low delta because even a big move in the stock price may not increase the chances of the option becoming ITM much.
The biggest drawback to buying an ITM option is that it’s more expensive than a comparable OTM option and it’s harder to have a huge percentage return, but you will have a better chance of recouping at least some of your money even if you are wrong about the stock direction.
Options are a proven way to exponentially boost your portfolio returns, but the world of options can be confusing and beginners may want to get expert guidance. That’s where my colleague Jim Fink comes in.
Jim Fink is the chief investment strategist of Options For Income, Velocity Trader, and Jim Fink’s Inner Circle.
Jim is a seasoned options trader and he has developed a proprietary method that consistently crushes the broader markets.
Now, Jim is making this bold promise:
“If I don’t deliver 24 triple-digit winners over the next 12 months…I’ll happily give up $1,950.”
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