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How to trade a
Deep-in-the-Money Option
Using ETFs

 
     
 

On this page I give the nitty gritty details of how to execute deep-in-the-money option trades. I have relatively recently added this strategy to my option trading portfolio, and I have to say that I am doing pretty well out of it!

 

 
     
 
 
     
 

     
 
 
     
 
 
     
 

A deep-in-the-money option strategy is perfect for use on stocks or funds that have relatively low volatility and steady, predictable trends. I have recently added this to my list of option trading strategies, and it is very useful. Trading DITM calls and puts using the method that I will be explaining here is relatively simple, and falls right into my philosophy of swing trading options: short term trades, with the right amount and type of technical analysis (i.e. not too much!), and taking smaller, regular bites out of the cheese rather than trying to swallow the whole block at once!

This strategy works really well on etfs (exchange traded funds) such as the QQQQ, SPY, DIA and IWM. The reason is that these funds represent very broad swathes of the market, and so are a little more steady and predictable in their movements than individual stocks. The advantage of this is that it is fairly easy to identify a trend and trade off it.

How to trade a Deep-in-the-Money Option:

1. Trend analysis - using one of the etfs that I mentioned, do a trend analysis. If you are not sure how to do that, follow the link to my page on Trend Analysis, and follow the steps there. If you can identify that the fund in is in a reasonably strong trend (ADX >25), then you are ready to trade (almost). One final step - look at how long the trend has been going, and look at any potential resistance levels (for an upwards trend) or support levels (for a downwards trend). If the trend is approaching one of these, trade with caution.

2. Entry - set up an entry order. If the trend is upward, then buy calls, and if it is downwards, buy puts. Here is how to set up the order:

  • find a deep-in-the-money option that has a Delta of between 70 and 90%, and costs less than $5.00. If it is lower than 70, you will not be getting good enough advantage of a movement in the stock price. Higher than 90, and your option is too expensive.
  • set your order a few cents lower than the market price. It is better to take advantage of one of the lower swings during the day, so look at the trading range for the day, and set your order near the lower end of the range (not right at the bottom, or you may miss an entry). Review the concept of Swing trading, and finding the "trader's action zone", so that you have a clear idea about finding good entries.
  • it is also good to take a longer term look at the trend, and make sure that you are buying during a 1-2 day pull-back.
  • buy an option that is a least two months out from expiration, so that time decay does not eat your value too quickly. So, if you are trading in early June, then the earliest expiration month you would look at is July.

3. Exit and stop-loss

  • as soon as your trade is filled, place a stop loss order of 50%. This important - your aim with options trading is to control your losses!
  • I usually set an exit order immediately. The conservative way I do this is to set a profit potential of 10%, and then add my broker commissions to that. For example, if I bought a call for $300, the commission for buying is $2.95, and the same for selling. My 10% profit is $30. So, I place an exit order for ($300 + $2.95 + $2.95 + $30), which is $335.90. If the trend is quite strong, and I got a good entry, I will sometimes place the profit potential for 15%. However, I like the smaller bite - very often, my exit trade is executed within a day.
  • Monitor the trade over two days. If there is very little movement, then sell to cover your broker commissions. It is really not worth sticking with one of these trades for even as long as five days - a stalled market costs you money in time decay.

4. Do it again! I often find that I can get between five and eight trades like this a month. Just like selling credit spreads, it is a relatively safe way of making lots of small, quick, profitable trades that quickly add up to make a nice profit.

Cautions

  • be careful of over-analysis, which will keep you from trading. Keep it simple - do the trend analysis, only trade with strong trends, and watch out for support and resistance.
  • make sure that you set your stop loss! Only very stupid, irresponsible and soon-to-be-broke traders don't set stop losses.
  • if your trade is going south, get out. Do not add to it in the hope that it will recover - that is not trading, it is gambling.

Real Trade example
Here is one that I traded recently, where I could see that profit taking was about to set in with a nice long upwards trend:

  • 21 Sep 2010. Bought QQQQ 51 Put for $2.87. Delta was 74%. As soon as the order was filled, I set the profit sell order.
  • 22 Sep 2010. Sold QQQQ 51 Put for $3.16

I started this deep-in-the-money option strategy with less than $1000, buying one call or put at a time. My fund has now grown to a point where I am buying 10 contracts at a time, and I will soon be able to increase that! Trading DITM calls and puts is a powerful, steady profit, limited risk strategy that will help any trader do well.

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