I have started using options more. I am buying deeper into the money than you usually suggest. That way my premium is much less. It also appears that the option moves more directly with the stock. Obviously my leverage is not as good. Any thoughts? When you use options, do you base your "Stop" on the cost of the option, or the cost of the stock? (November 20, 2001)
You are right about paying less for the nonintrinsic or that portion of the option that is not in the money also known as intrinsic value. As we discuss in the seminars, the deeper you go into the money, you are buying intrinsic value, i.e., value that is equivalent to to real dollars because if the option expired that day it would be worth the amount of dollars it was in the money. The deeper you go into the money, the more intrinsic value you buy for relatively small increases in option price. Thus the volatility and time components make up less of the price you pay. If the stock goes nowhere you can get most of your money back on expiration because you can get $1 in value for the option for each $1 it is in the money.
You have to pay more for an option $15 in the money versus one at the money. But, it is NOT a dollar for dollar increase. Thus you could go another $10 in the money and not see a $10 increase in your option price over an option that was at the money or $5 in the money. You are buying more value at expiration if the stock goes nowhere, but you are paying less for that dollar.
Because you pay more, your leverage is decreased. But as shown above, that is not necessarily a bad thing with a wasting asset such as an option. In addition, you also correctly state that deep in the money options tend to move almost dollar for dollar with the stock's movement. That can give you quick moves, netting you a good gain dollar-wise. It may not be as big a percentage gain, but it is like a high percentage pass in football: you get the completion and accomplish your objective with lower risk.
These are less volatile than at the money options. Thus even though you get a higher delta, at the money options can jump when the stock jumps, giving you a big percentage move. You have to see the jump in those options AND it has to be timely. If it does not occur until expiration, your option will be pretty much worthless without a massive move that puts it deep in the money just to get your money back, money that was spent on time and volatility (for the at the money option). That is why we say at the money or out of the money near term options are for speculators hoping to hit the home run by timing things just right while deeper in the money options, the options we prefer, are for investors.
When looking at upside targets or downside sell points we look at the stock because the option's value is derived from the stocks' value. Thus, if a stock hits targeted resistance and starts to fall, we would sell our option if our plan was to play to the resistance. The option did not hit resistance, the stock did. On the downside we look at the stock price as a key to what we would do with the option. If it is a breakout and it fails, odds are the stock will fall further, and thus the option will as well. If it is a clear break of support or other failure by the stock, we use that.
As a rule of thumb, we don't like to lose more than 25% on any option position; if it hits 25% and the stock looks bad, we will exit. If it hits 25% down but the stock still looks as if it can move higher, we are flexible and will let it ride as long as we have enough time to make money. Remember, options start to lose value 60 days out from the expiration. Thirty days out they really start to lose value rapidly. If we don't feel the stock can recover quickly, we would rather sell and preserve what we have than hope for that gian. We have lost money doing this; I recall an episode with the SOX off the bottom where it was rallying, fell, and then rallied back. I took some additional positions on the rally back; adding to a position. About three weeks from expiration, and the next session it started to sell again. I bailed on the near term options I had bought first. Well, the index sold down intraday a bit the next session and then started a massive run. The options I sold would have delivered about a $40 gain. The ones I kept helped get me over my grief.
I did two things on those trades: made a decision to protect what I had in my short term options that were closing in on expiration; if the index had sold anymore, they would have been worthless with so little time left. I also added to a position with different options when I saw an opportunity the day before. That allowed me to stay with what I thought was a winner even though I had to close out a position that was underwater. The move was coming, I just did not want to gamble on losing any more on that position if it waited a week to move.
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