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This is a level 1 question.
Could you please explain the advantages and disadvantages of trading deep-in-the-money, front-month options?
Let's begin by defining some of the terms mentioned in your question. An option is in the money when it has intrinsic value, which is the difference between an in-the-money option strike price and the current market price of the underlying security. A call is in the money when the market price of the underlying stock is greater than the option's exercise price. It is the opposite for puts, as these options are in the money when the market price of the underlying stock is lower than the option's exercise price.
That brings us to deep-in-the-money options. These are options that are so far in the money that they are unlikely to move out of the money prior to their expiration. This is one of the advantages of deep-in-the-money options.
A major advantage of deep-in-the-money, front-month options is that the deeper in the money they move, the delta for a call position moves closer to 100 percent. Delta is the percentage of the price movement in the underlying stock that is translated into an option's price movement. Because of this high delta, these options behave more like the underlying equity by moving nearly point for point with the stock. This is a major advantage since the capital required for these options is less than that for the stock. Thus, given a point-for-point move, the options will provide greater leverage because the profit potential is larger.
Another advantage of deep-in-the-money, front-month options is that they lessen the impact of time erosion (the loss of an option's value over time when all other factors are constant). This is because most of an option's premium is linked to its intrinsic value. Let's compare a near-the-money option with a deep-in-the-money option.
IBM is currently trading at 105.70, and the August 105 call is offered at 4.20, while the August 85 call is offered at 21.10. The price for the August 85 call consists of 20.70 points of intrinsic value (market price of the underlying stock less the strike price) and 0.40 point of time premium. As such, only two percent of the option price consists of time premium. The August 105 call has only 0.70 point of intrinsic value, with time premium making up the remaining 3.50 points. In other words, time premium accounts for 83 percent of the value of the August 105 call. If the stock closes at 105.70 at expiration, both buyers keep the intrinsic value, but they lose the time value of their respective positions. Thus, the in-the-money buyer loses only two percent, while the buyer of the August 105 call loses 83 percent.
There are some disadvantages to front-month options that are deep in the money. One is simply that they are front-month options, so the buyer will lose some value if the underlying stock doesn't move quickly in the right direction. What's more, the position may not have time to recover if the underlying stock makes an immediate large move in the wrong direction. It is important to remember that front-month, deep-in-the-money options can end up with a 100-percent loss. However, the odds of this occurring are considerably lower than using at-the-money or out-of-the-money options.
Another disadvantage of deep-in-the-money, front-month options is their cost. Since they carry so much intrinsic value, they are usually more costly than near-the-money options, which may keep smaller investors out of the market. This also lowers the leverage of the position. Using the above example, if IBM increases to 115 (an 8.8-percent gain) at August expiration, the 85 call would be worth 30 (a 42-percent increase) and the 105 call would be worth 10, a 138-percent increase. Clearly, the at-the-money option enjoys a leverage advantage over the deep-in-the-money option.
We appreciate your question and wish you the best of luck in your trading.
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Question Level Key
Level One--Basic Jargon, Definitions, Basic Mechanics of Trading.
Level Two--Introductory Points, Practical Points and Simple Strategies
Level Three--More Advanced Strategies and Repairs
Level Four--Risk Management, Psychology, and How Best to Evaluate Things.
Level Five--High end questions concerning Portfolio Analysis, Managing a Portfolio
of Options, Option Pricing Models, and Nuances of Trading. Included could be a variety of
other topics.
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