Are deep in the money options better than not-so-deep options? Better than just buying (selling) the stock?
Out of The Deep
Courtesy of Adam Warner at Daily Options Report
Options and ETF’s, they go together like the Yankees and overpriced empty seats. So what’s the right way to play options on ETF’s? ETF Trends highlights some thoughts on the subject.
Trading options on ETFs could potentially allow traders to use the leverage of derivative markets to increase gains from ETF trades, writes David Penn for Yahoo! Finance. It should be noted that not all ETFs have liquid options, which means most investors should stick with more widely-traded index ETFs and liquid country ETFs.
……Penn says the basic options strategy for ETF traders is buying deep in the money calls with long signals in ETFs, or buying deep in the money puts to fulfill short ETF signals. Let’s translate that.
“Deep in the money” refers to calls that have a strike price that is 2 or 3 strike prices below the current price of an ETF. As an example, if an ETF were priced at $44 and a long signal on the close was received, a deep in the money call would be a call with a strike price of $40 or even $35.
With short ETF signals, traders may use puts if prices are thought to head lower and increase in value as the markets abate. Buying puts deep in the money is a way to use puts on overbought ETFs.
Why would an investor want deep in the money options? Deep in the money options are more likely to closely track an underlying asset whereas out of the money options could be subject to major impacts as a result of adverse price movements in the underlying asset. If the underlying recuperates or closes profitably, a deep out of the money option may not recover as much.
Deep call, hmmmmm, didn’t someone we knew used to recommend those?
But I digress.
Deep Calls are fine, but the better comparison is to look at them vs. long stock as opposed to long ATM or OTM calls. That’s because Deep Calls basically are stock with an embedded put thrown in.
By embedded put, I mean that you can only lose what you pay for the call, so it effectively provides you put protection at the strike price of the call. Now you pay for that put protection via the premium in the call above the stock.
You can also use Calls instead of stock in order to tie up less capital. Of course that then becomes a leveraged trade, which is fine so long as you allocate capital accordingly.
Now are Deeps the best way to play ETF’s? I really don’t see it. I mean absolutely nothing wrong with Deeps, there’s just no particular reason they fit ETF’s any better than regular stocks. It’s like off Amazon (the site, not the stock). "If you like playing with Deep calls in AAPL, you’ll love playing with deep calls on QQQQ"
