Buying In-the-Money Stock Options

Buying in-the-money options can achieve large profits with controlled risks relative to out-of-the-money options. In particular, deep in-the-money, front-month options offer a relatively conservative approach to options investing by giving a stock options trader more control over the time value and intrinsic value components of the option.

An important component of deep in-the-money options is their substantial intrinsic value, which is equal to the stock price less the strike price for a call or the strike price minus the stock price for a put. As options move deeper into the money, the delta (the amount by which an option’s price will change for a one-point move in the price of the underlying stock) approaches 100 percent for call options. The option thus behaves like the underlying stock by giving a point-for-point move with the price change in the underlying equity. Thus, these options are like playing the stock but with the advantages that options provide, including a much lower capital outlay, limited risk, leverage, and much better profit potential.

A significant advantage of front-month, deep in-the-money options is the significantly lower influence of time erosion on your position. Even though the option is front-month, the effects of time decay on your position will be small because most of the option premium is linked to the intrinsic value. On a percentage basis, the time premium for a front-month, deep in-the-money option is far less than for an out-of-the-money (or slightly in-the-money) option. For example, assume that a stock’s price is at 51, the 45-strike and 50-strike calls are priced at 6-1/2 and 2, respectively, and the options expire in 30 days. The deep in-the-money buyer is paying six points of intrinsic premium and 1/2 point, or 7.7 percent of the total premium, in time value. The slightly in-the-money player, however, is paying 1 point, or 50 percent, in time premium. If the stock closes at 51 at expiration, both buyers keep the intrinsic value but lose the time value of their positions. Thus, the deep in-the-money buyer loses only 7.7 percent while the slightly in-the-money buyer suffers a 50-percent loss.

Finally, the concept of leverage is key to understanding the advantage of deep in-the-money options compared to the underlying stock. For example, a 55-strike call option on a $60 stock with a premium of $7 will double in price if the stock rises to $69 by expiration (the intrinsic value would be $14). Compare this 100-percent gain with the 15-percent appreciation if you had purchased the stock ($69 from $60), a leverage ratio of 6.6 to 1. Thus, quick moves in the stock can result in a substantially greater percentage return with an in-the-money option play.