Deep-in-the-Money Investing: Missed the Market’s Run? Here’s a Second Chance…
by Karim Rahemtulla, Options Expert
Tuesday, December 1, 2009: Issue #1148
Take a quick glance at the share prices of certain companies today and you’d think the savage 2008 was a distant memory. But 2009 has confounded the “experts” who called for more of the same this year, with stocks rallying sharply, giving investors a chance to recoup some of their losses – and even turn a profit.
However, not everyone jumped aboard. And during the greatest destruction of wealth in our generation, few could blame them. So if you feel like you’ve missed the boat on some of Wall Street’s resurgence this year, I have some great news. Companies like Apple (Nasdaq: APPL), Google (Nasdaq: GOOG), Cisco (Nasdaq: CSCO), Dow Chemical (NYSE: DOW), and Freeport McMoran (NYSE: FCX) are all trading at multiples of their March lows.
Having embarked on such a run, you might think that the shares are now out of reach. But that’s not the case if you think they’ll go even higher over the next year or two. Actually, in some cases, you can still buy them at discounts of up to 50% or more from their current prices.
Just one thing before we start, though: You must not want to “own” these shares for more than a year or two. We’re more focused on nimble trading. So lace up your sneakers because the strategy that accomplishes what I’m talking about is referred to as deep-in-the-money (DITM) investing.
Deep-in-the-Money Investing with High Deltas
Buying options that are deep-in-the-money means they have strike prices (the price at which you can buy the shares) that are well below the current price of the stock.
This is also known as high delta investing.
Don’t be confused… it’s pretty much the same thing. Delta is an options term that simply refers to change in share price versus the change in option price. The higher the delta number, the more correlation there is between the movement in the price of the underlying shares and option.
The highest delta you can get is 100. This means the price of the option will move in lockstep with the movement of the shares. If the shares rise by $2, the options will climb by $2, too. If the shares fall by $3, the option will also drop by $3.
So, why use deep-in-the-money options, or those with high deltas?
Pay Less Money in Premiums with Deep-in-the-Money Options
Simply put, by picking deep-in-the-money options, you’ll pay less money in premiums. The option itself will be more expensive than an out-of-the-money option, only because deep-in-the-money options have more intrinsic value (the difference between the price of the underlying stock and the strike price of the call option).
Let’s say you missed the run on Microsoft (Nasdaq: MSFT), but you think Windows 7 will prove to be a resounding success and the shares may move to $40 per share in a year or so.
Ordinary investors could buy MSFT at $30 and pay $30,000 for 1,000 shares. If the stock does what you think and hits $40, you’ll make $10,000 ($40 minus $30 multiplied by 1,000 shares = $10,000). But that’s a lot of money to spend – and a lot of money at risk.
Here’s a better choice – an example of a deep-in-the-money or a high delta options trade…
Go Deep-in-the-Money with LEAP Options
Instead of shelling out all that money to buy MSFT shares outright, you do this…
- Buy the Microsoft January 2012 $20 call LEAP (WMF-AD). This means you’ll have the right to buy MSFT for $20 a share prior to expiration. The option is currently trading for about $10.70 per contract and has a delta of 100.
- Of that $10.70 price, $10 is intrinsic value ($30 current price minus $20 strike); the other $0.70 is premium for time and risk.
Here’s the difference between going deep-in-the-money and at-the-money (where the option’s strike price is at the current price of the underlying stock)…
- If you bought an at-the-money call option on MSFT (meaning a $30 strike price option), it would cost you $4.50 per contract. Thing is, though, all the $4.50 would be comprised of time and risk with zero intrinsic value.
This is important because if MSFT closes at $30 at expiration, the holder of the at-the-money $30 strike option would lose $4.50, while the holder of the $20 strike would lose just $0.70.
Let’s take it one step further and use a $40 close for MSFT…
- The holder of the $20 option would have an option worth $20 ($40 share price minus $20 strike) for a profit of $9,300 (or 46.5%). We arrive at that figure this way: $40 (stock price) minus $20 (strike price) minus the cost of the option ($10.70) multiplied by 10 contracts (1,000 shares) = $9,300.
- The holder of the $30 strike option would make $5,500 ($40 minus $30 minus $4.50 option cost) – a profit of 122%. Of course, this investor risked less money upfront, so his percentage return is higher. But so too is the risk of him losing all or most of his premium if the shares drop.
Alternatively, if MSFT moves down, the holder of the deep-in-the-money option would experience almost a penny-for-penny move down because the delta is 100. And because of stop-losses, he’d be able to control the loss, just like the shareholder.
Here’s the kicker though: The option holder can only lose what he has invested – $10.70 per contract, versus $30 per share for the MSFT stockholder.
Plus, if MSFT hits $40, the return for the deep-in-the-money guy would be about 87% ($9,300 divided by $10,700 invested = 87%). And while the regular shareholder would make $10,000, he’d have $30,000 at risk for a return of just 33%.
In sum, deep-in-the-money or high delta options are the way to go if your time horizon is known and you want to have less money at risk while not risking any upside at all.
Good investing,
Karim Rahemtulla
Related Investment U Articles:
- Potentially Grab Portfolio Gains Without Buying Shares or Risky Options
- How to Recover When Your Option Trades Turn Against You
- How to Sell Put Options and Snag the Market’s Daily Deals
- The Legged Spread Trade: Take 10 Cents and I’ll Show You How to Make It $2.50
- The Covered Call Strategy: Generating Income From Stocks in Any Portfolio
14 Responses to “Deep-in-the-Money Investing: Missed the Market’s Run? Here’s a Second Chance…”
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Dubbed a "market maven" by CNBC, Karim Rahemtulla is one of the country's foremost specialists in options trading. As founder and editor of The Smart Cap Alert, he focuses his efforts on all aspects of options trading – LEAPS, put selling/covered calls and spreads. 
Re: Buying DITM calls
Another competitive option (the other kind) would be to buy the stock on margin, margin interest being comparable to option premium. One consideration would be dividends, tho not in MSFT’s case. Another would be the ability to sell an option against the stock, collecting premiums against the margin interest.
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I thought I’d read a previous piece you had done that argued the buyers of options loose $$ and the sellers make $$. Is there a way to do this sort of strategy by selling puts rather than buying calls?
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Good article. You need to present it to Alex and Louis so they can consider less risk options in their trading services or at least give both a high risk and medium risk choice.
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Thank you Mr. Rahemtulla for yet another great IU options education article (12/1/09, High Delta Investing). Two questions if I may. Where can one find the delta metric for specific options under consideration? Also, in one of your previous options articles, published sometime in the last 60 days I believe, you provided a link or web address for options price modeling. I’m not able to find that article and am hoping someone can provide the web address.
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Dave,
One of the best websites to use for option information is: http://www.ivolatility.com/. Also, the article that you were referring to was on the CBOE Volatility Index that had this link for options price modeling:
Use this link to find out the implied volatility for a particular stock.
Here’s where you can find an options pricing calculator.
Good investing,
Investment U
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Sorry for asking a stupid question, but how do I invoke the use of this investment tool if I’m using an online broker like Etrade?
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Ryan,
Unlike ScottTrade, Etrade does allow users to buy and sell options and futures. If you already have an account with them, go to https://us.etrade.com/e/t/investingandtrading/optionstrading and log in for more information.
Good investing,
Investment U
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Insidefull. But how do I find/calculate the delta for specific options?
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Jac,
You can go to Yahoo! Finance at http://www.yahoofinance.com to see what if any options are available on a particular stock, but if you want a more central database, check out http://www.ivolatility.com/.
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The annual Investment U conference in March. I will not be able to attend. Will there be an audio available for viewing the seminar?
Keith
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This sounds like thr opposite of Lee lowell tading system?
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Gregory,
This is Karim Rahemtulla’s specialty, not Lee Lowell’s. And yes, you are right that there are differences in their styles. Deep-in-the money strategies can be more risky but also more rewarding.
Thank you,
Investment U
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In order to evaluate a trade, I always try to understand the other side of the trade. Given that interest rates are so low, what is the benefit to the person selling me the deep in the money option?
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In addition to http://www.ivolatility.com, you should also try http://www.livevol.com for option information.
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