Everyone seems to have a strong opinion: “I never buy out of the money (OTM) options; they are a waste of money” or “I never buy in the money (ITM) options; they are too expensive and work against the leverage that options provide”. Your choice of options can be the difference between trading success and failure; the difference between getting paid when you’re right and making less than an adequate return. Let’s explore the pros and cons of each and take a stance!
Advantages and Disadvantages of in the Money Options
ITM options are options that have some intrinsic value. A call option is ITM when the stock’s current market price is above the strike price. The difference between the current market price and the strike price is the call option’s extrinsic value. A put option is ITM when the stock’s current price is below the strike price. The difference between the strike price and the current market price is the put option’s extrinsic value. The main advantages of buying ITM money options relative to OTM are:
- Less stock movement is needed for the option to be profitable
- There is a greater probability of making some money
- It is a more conservative trade
- The passage to time has less impact on the value of the option
There are several disadvantages:
- The options are more expensive resulting in a great investment
- Losses can be larger
- Lower return on capital when the stock price moves quickly in the direction of the trade or implied volatility increases
Advantages and Disadvantages of Out of the Money (OTM) Options
OTM options don’t have any intrinsic value. For a call, the strike price is above the current stock price. For a put, the strike price is below the current stock price. There are several advantages relative to ITM options:
- The options cost less so a lower investment is required to purchase the same number of options (or more options can be purchased)
- Leverage – the opportunity for a significantly higher return on capital for fast or large moves in the direction of the trade or a large increase in implied volatility
There are several disadvantages:
- The probability of profit is lower
- The passage of time will have a bigger impact on the option’s value
- The option will lose value quickly if the stock price moves against the trade
Buy ITM or OTM Options?
At Masters In Trading, we strongly suggest buying OTM options. Using the Masters In Trading tools significantly increases the probability of a significant move in the underlying stock price realizing the leverage that OTM options provide – invest a little to make a lot. Let’s take a look at a real example. $CALM was identified as trade opportunity on a recent Masters In Trading Week Ahead Trade Sheet. With $CALM closing at $58.70, the suggested trade was to buy a May $55 strike put for $1.55. Let’s take a look at what the Masters In Trading tools were indicating that gave us confidence that a big price move and increase in implied volatility was coming.
The High Value Target (HVT) tool is a must-have for options traders because answers the basic question, is it a good time to enter or exit?
Being able to discern if a stock is ‘expensive’ or ‘inexpensive’ at any given time gives options traders the edge they need to trade successfully. By utilizing the BUY and SELL signals given through this tool, options traders can get an idea of how far a stock is from its 21-day simple moving average of price.
The chart below on the stock $CALM informs options traders when the underlying price has shifted beyond three and four standard deviations away from its 21-day moving average. This provides a useful means of identifying opportunities in options trading as a stock or security that has strayed too far from its range is typically predicted to fall back within it. By tracking the 3 year history of $CALM, options traders can identify this anomaly with greater accuracy and make informed decisions about their next trades.
Finally, notice how $CALM is extended beyond the expected move for the monthly expiration using Masters In Trading Volatility Visualizer:
Again, these tools provide “The Edge” for a trader to identify potential bigger moves in price and implied volatility to offset some of the challenges with OTM options resulting in higher profits and return on capital.
Let’s compare the profitability and return on capital of the suggested OTM option trade with an ITM option trade. By the end of the following week, $CALM had moved from $58.70 to $55.73. The May $55 OTM put purchased for $1.55 was worth $2.63; a profit of $1.08 or 70% return on capital (in a week!). A May $62.5 strike ITM put purchased at the same time for $5.40 was worth $7.85: a profit of $2.45 and a lower return on capital of 45%. Let’s take this one step further. We could have purchased 3 OTM options for less than the cost of 1 ITM option. Comparing apples to apples, our profit for the same (actually a slightly less) investment in the OTM options would be $3.24 (vs. $2.45 for the ITM option). For about the same investment, the OTM option resulted in higher profit and return on capital. The benefit of the leverage of the OTM option combined with finding opportunities using the Masters In Trading tools clearly shows why we suggest OTM options.
How To Choose Which Options To Buy
The choice is ultimately yours based on your trading goals and desired risk/return profile. OTM options combined with the tools identified above can give a trader an edge. If you’re unsure, paper trade and analyze your results!