Why should I buy DITM options?
Who would turn down the opportunity to buy shares at half price? Especially when the profit potential is exactly the same and the loss potential is cut in half. This is exactly the benefit of trading DITM (Deep-in-the-Money) options. By buying an option as a proxy for a stock, but at about half the price, you can take advantage of the full range of a market move. Because your initial investment is less, your risk is reduced. However, because you are earning the same return as if you had bought the stock, the return on your investment doubles.
Many traders stay away from options trading, because it is often perceived as a game. A trader will buy a cheap OTM (out-of-the-money) option, hoping that a market move will turn the option into an incredibly profitable trade. It is true that options trading is often driven by greed rather than good strategy, and that due to the leverage involved in options trading, it is much riskier. However, if options trading is based on a well-planned strategy, it need not be risky or a gamble.
DITM options trading is a whole different ball game – it cannot be classified at the same level of risk as other types of options trading. In fact, it has a lower risk profile than trading common stocks. The reason for this is the powerful weapon of DELTA, which is one of the so-called “Greeks”. Delta is a term that describes the degree to which an option’s price will increase relative to the price of the underlying stock. For example, suppose the Delta of a call option on XYZ stock is 50%. If XYZ increases in value by $1.00, the option price will increase by about $0.50. That is, 50% of the market movement is captured. DITM options typically have a Delta of 90% or more, which means that more than 90% of a market move can be captured. The trick is that the cost of the option is usually about half the price of the share.
This means that if a trader wants to buy 100 units of XYZ shares at $20 each, his total investment is $2,000. If the stock rises to $22, he can sell for a profit of $200, which is a 10% ROI. However, in this example, our trader might buy a call option (representing 100 units of shares). The cost would be around $1,000, if the Delta is close to 100%. If the stock were to go to $22, it would capture the exact same move of $200. Because your initial investment is half that of a stock trade, your ROI is now 20%, exactly double.
There are only three disadvantages to DITM options trading. The first is that dividends are only paid on the shares actually owned, not on the option to buy the shares. The second is that options always have an expiration date, so if the market movement has not been captured before expiration, the option must be sold or it will expire worthless. The third is that options broker fees are slightly higher than those for outright stock purchases.
Trading DITM options is a very effective strategy that is equivalent to swing trading, day trading or momentum trading. It is not suitable for long-term traders, but it is an extremely useful way of trading stocks in the short term with half the risk and double the potential reward.