A long time reader wrote in asking if you get more bang for the buck buying an out of the money option, or a deep in the money option on a stock that makes a big move. Interestingly the answer isn't perfectly cut and dry. Let's look. If you buy an in the money option, that option will indeed "track" the movement of the underlying stock more closely than an at the money option. The "Delta" or measure of value is much higher, so when the stock moves, the option tends to move also. If you buy an out of the money option, the stock can actually rise a bit, and yet your option could actually fall. How? When an option is out of the money, the entire value of the option is simply based on "time". For instance, lets say the XYZ company is trading at 50 bucks a share. The September 60 dollar call options are 75 cents. That 75 cents is all "time value" considering the fact that XYZ is still ten dollars shy of the strike price. So, it's quite likely that XYZ could move up to 52 dollars a share, which is a two dollar move, and yet the September call option falls to 50 cents. Why? We have come closer to the expiration day, and some of the time value has eroded. In a deep in the money option, a 2 dollar stock move could be as high as a 1.95 move in the option. So, looking at it like that, standard theory says that deep in the money options will move more on a big stock move and for the "most part" you can consider that to be true. But there is always the exception, and if you look at percent returns, that's where things really get screwy. Let's say you bought September 25 dollar calls on XYZ. You paid 29.00 for them, considering that XYZ is 50.00 a share, you are already 25 bucks in the money and they are charging a 4 dollar premium over that for time. Now, XYZ announces that it's cured cancer and runs to 90 dollars a share. Your call option is going to soar. At very minimum it's going to be worth 65 dollars, and more likely over 70. So, you're return is quite nice right? Right. In fact you've made somewhere north of 124%. But, lets say you had those XYZ out of the money 60 dollar calls for just 75 cents. If XYZ ran to 90 those calls would be worth a minimum of 30 bucks, if not 35 ( depending on how much time was left) Now look at the percent return. It's 3,900 percent. So, here's the deal. For the most part, deep in the money options will reward you more frequently and with more gains than at the money or out of the money options. But, in those rare events where a home run gets hit, an out of the money options bought for pennies will far outperform any in the money options. You're better off buying deep in the money and using smart trading strategies. But occasionally it's a lot of fun to be able to say "I made 2000 percent on my latest trade!" Think about it. |
