Should I buy options that are in the money or out of the money?
Best Answer
163 points
Carsten answered one year ago …
Other than the delta mentioned above, you should also consider the implied volatility before considering any options, but especially OTM options.
If you expect that volatility to increase substantially over its current level, then OTM's can be a good choice.
This will only give you a good risk/return ratio if the implied volatility is low (<15-25%, AND given enough time of course, 3-6mo).
A big increase in the implied volatility can affect the value more than the change in the intrinsic value.
If the underlying moves in your favor,both effects are cumulatively beneficial, but if it moves against you, then the loss in intrinsic value is covered (at least in part, sometimes more so) by the increase in extrinsic value due to the vola spiking up.
Because this happens in a short time frame (a few days at most), there is no great loss to the time component, allowing you to close the OTM position in a decent fashion (before vola drops).
OTM's are definitely not advisable with high implied volatility, because the loss in time value is then compounded by the decline in implied volatility (much more likely than a rise to even higher impl. vola).
Finally, you should always look at that volatility for any option, because options other than deep ITM ones will suffer from a decline in implied volatility. Buying with impl. volas >65-70% is definitely risky.
Ex: Apple.
When the stock left its upward trend in January, the deep OTM puts (115-130 strikes) had implied volatility of around 40-50%. After the Apple's quick spike down to the low 120's, the implied volatility on these went to 80%-110%, and they all gained 60-100% in a few days.
Yet the ITM calls lost less than the corresponding amount, as their implied volatitliy also went up sharply.
[this last ex. is from options warrants for Apple, but also applies to options]
Answers
1130 points
sundarkambam answered one year ago …
1. In the money Option :
a. Cost = More Expensive to buy the option.
b. Risk = Less risk in losing your premium money
c. Returns = People don't expect it to move very widely
d. Who invests in them = People having more capital than "Out of Money" guys
2. Out of Money Option
a. Cost = Less cost to buy the option
b. Risk = More Risk in losing your Premium money
c. Return = People have more expectation that there will be big percentage Positive move.
d. Who invests in them = People having less Capital than "in the money" guys
116 points
CollegeKid answered one year ago …
In the money options are usually the way to go. This goes for puts and calls. The reason for this is that if you buy an in the money option, the option won't lose as much values when the stock goes down as an out of the money option. Also in the money options don't have as much extrinsic value, so as it gets closer to expiration your option will still retain its value because it correlates closer with the stock price itself.
College Kid
952 points
rvilmur answered one year ago …
With 80-90 % of options expiring worthless, OTM options are the losers. Buyers are gambling on a large increase in stock price to get up to their cheap options strike price. In addition many buyers will buy more OTM options than ITM options because they are cheap; not so, if they expire worthless.
So, the answer is to find a stock that you have an expectation of rising and buy an ITM option with a delta of 0.8 or greater. Also you need to have a time expectaion over which you expect the stock to rise; so buy enough time (3-6 months) to where the time decay is slow. If the stock goes against your expectations, you will have time to exit the position with part of your capital. Don't use an actual stop loss as the market makers can pick you off and then raise the option prices. A mental stop that you adhere to is best.
If your stock does rise significantly you can roll the position to a higher strike to take profits off of the table and reduce your risk. For example, roll a Jul 30 strike to a Jul 35 or 40 strike to bring your delta back to around 0.8.
With ITM strikes, many other things can be done such as selling short term OTM options against your ITM position to lower your cost basis.
If all of the above is Greek to you (delta is a greek) then you need to get more education on options before investing your capital.
265 points
MaverickInvestor answered one year ago …
It depends what you want to achieve.
If you're selling covered calls, then ITM options offer the greatest downside protection, and work well providing there's enough implied volatility to give you a decent chunk of time value.
OTMs are fine, but you get less of a downside cushion. And you can always make up for this by using a protective, long-dated OTM put.
427 points
larryat36 answered one year ago …
To have your option mirror your stock try to get a delta of 80 to 85. this will give you a great risk reward. bBe sure to buy enough time for your expectations to play out. Payying for more delta than that is really increasing the cost more than the benefit you would get.
Read more from larryat36 flag as abuse great answer163 points
Carsten answered one year ago …
Other than the delta mentioned above, you should also consider the implied volatility before considering any options, but especially OTM options.
If you expect that volatility to increase substantially over its current level, then OTM's can be a good choice.
This will only give you a good risk/return ratio if the implied volatility is low (<15-25%, AND given enough time of course, 3-6mo).
A big increase in the implied volatility can affect the value more than the change in the intrinsic value.
If the underlying moves in your favor,both effects are cumulatively beneficial, but if it moves against you, then the loss in intrinsic value is covered (at least in part, sometimes more so) by the increase in extrinsic value due to the vola spiking up.
Because this happens in a short time frame (a few days at most), there is no great loss to the time component, allowing you to close the OTM position in a decent fashion (before vola drops).
OTM's are definitely not advisable with high implied volatility, because the loss in time value is then compounded by the decline in implied volatility (much more likely than a rise to even higher impl. vola).
Finally, you should always look at that volatility for any option, because options other than deep ITM ones will suffer from a decline in implied volatility. Buying with impl. volas >65-70% is definitely risky.
Ex: Apple.
When the stock left its upward trend in January, the deep OTM puts (115-130 strikes) had implied volatility of around 40-50%. After the Apple's quick spike down to the low 120's, the implied volatility on these went to 80%-110%, and they all gained 60-100% in a few days.
Yet the ITM calls lost less than the corresponding amount, as their implied volatitliy also went up sharply.
[this last ex. is from options warrants for Apple, but also applies to options]
2172 points
ChaosNantuko answered one year ago …
It depends on how far out the option your trading is.
When i look at options, i look at the delta:cost ratio (DC), and the theta:cost ratio (TC).
The higher the delta:cost ratio (DC), the faster you make money when the stock goes up.
The lower the theta:cost ratio (TC), the slower you lose money when the stock doesn't do anything.
So then delta:cost (DC) is strongly related to your profit potential, while theta:cost (TC) is strongly related to your risk.
The best DC:TC (similar to reward:risk) ratio can be found with the ITM options if your looking at the current month.
However, if your looking at long term options, the ITM options can actually have a worse DC:TC ratio compared to the short term options with the same strike, while the long term OTM options have a better DC:TC ratio then their short term counter parts.
Based on this information, i concluded that if your trading short term options, its better to use the deep in the money options for the trade, and if your trading long term options, ATM, or even slightly OTM options are preferable.
Of course, if your selling options, the situation is reversed. (sell short term ATM or slightly OTM options, sell long term slightly ITM options)
