Buying DITM (Deep-in-the-Money) options takes full advantage of the DELTA of an option, so that swings in the stock are matched dollar for dollar with the changes in the value of the option.
This a great strategy for those who are still a bit scared of buying options (as you should be!), but love the challenge of swing trading stocks, and want to gain some leverage on a trade as well as reducing overall risk and cost of investment.
Options that are ATM (At-the-Money), or trading very close to the price of the stock, usually have a Delta of between 30 and 70, and for most stocks, hover around 50. This means that when a stock moves, only 50% of that move is captured by the change in the price of the option. So, if the stock price increases by $1, an option with a delta of 50 will change in price by 50 cents. ATM options (or near-the-money options) are cheap, but their price movement is much smaller than that of the underlying stock.
Your choice of DITM options is based on the fact that you will find options (calls or puts) that have a delta of 100, or as close to 100 as you can find. This means that every dollar that the stock increases or decreases in price will be matched by the option.
VERY OFTEN these DITM options cost about half the price of the underlying stock price, or less. This means that you can buy either:
100 shares of XYZ at $25 = $2,500
OR
1 Option Call for XYZ at $12 = $1,200.
In other words, you have effectively bought the stock for half price. You miss out on dividends, but that is your only downside. In any case, if you use swing trading as the basis for your trade, you are not going to hold the stock long enough to benefit from dividends.
Now, if your DELTA is 100, or close to 100, you will get the full benefit of the swing. Percentage wise, it is even better! For example, if you are aiming for a 7% profit swing in your stock, the effect will be a 14% swing in your option price. Much better odds!
So, how do you buy DITM calls and puts?
First, select your stock based on trend analysis and swing trading principles. In other words, a stock that is at a pivot point and is about to swing up to some juicy profits.
Second, pull up an options table which shows the DELTA of the option. Your broker software should have this feature. Either that or use the Options Calculator, for which you will need to know the volatility of the options. Pick an option that has a DELTA that is at or close to 100, and buy it.
Third, set your stop loss immediately. If you normally set a stop loss of 4% for your stock, then set a stop loss of about 8-10% for your option.
Finally, set a profit target based on the swing of the underlying stock. Either simply add the dollar value of your anticipated profit to the option price, or use the Option Calculator to work it out. Or use a trailing stop. Sell the option as soon as you hit your profit target - don't wait until expiration, other wise you will lose 100% of your investment!
Advantages:
- You invest less money to capture the movement of a stock;
- You have less downside risk (about half of that needed to buy the stock);
- You gain about 100% of the price movement;
- You get a higher return on investment (ROI) i.e. you have higher leverage.
NOTE:
Base your trade on a movement in the STOCK that you anticipate because of your skill in Swing Trading. Do not buy options that have too much time incorporated - DITM options are also affected by Time Decay!
Return from DITM Options to the Home Page
Or: Review how options are valued, and refresh your memeory on the use of DELTA
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