So it appears that the purpose of the long options game, for the most part is buy an option that is OTM and sell it when it is ITM.
So I get the selling part...but why would anyone be buying an option that is ITM?
Why not just by the stock on the market...if you want the stock?
Why not purchase an OTM option and reap all of the rewards of it becoming ITM? The only reason I can see is that if you pay $2000 for an option that is deep ITM you may be able to eek out another $200 or so if the stock continues on its trend prior to expiry...and I suppose this is better than paying $200 for an OTM option, that never reaches your B/E price...
One reason, and from a futures point of view, you can buy options, both OTM and ITM that would cost less than the amount of Margin that would be required for a futures contract. A reason to buy an ITM option is still you don't have to worry about spikes and getting stopped out and then having the market move on in your favor. Also, if the trend is up and you buy an ITM on a retracement, then your option has higher odds of expiring in the money than one that was bought OTM. Depending on how far OTM it is of course. You could potentially have a retracement the last week of trading on the OTM option that WAS in the money just a few days before expiry, but then the retracement happens and it closes 1 penny below your strike and it expires worthless. BUT, if you bought the ITM, it would possibly have higher odds of still being in the money at expiration because the option has a lower strike price. Just a higher odds play is all.
I don't trade options currently, but back around 1997 - 2004 I traded options on futures and one of my main plays was a Delta Option Trade. I would buy 3 or 4 OTM's that would equal aprox. the margin of the underlying futures contract and if the market made a decent move in the direction I thought it would I would make 2 to 4 times the amount I would have on a 1 futures contract and still had aprox. about the same amount of money laid down. My biggest trade doing that was in Silver and I had bought 4 OTM calls that was a Delta trade and shortly after, Warren Buffet made an announcement of how much physical Silver he had in his own storage and BAM! the Silver market went north hard and I made over $15,000 on those 4 options. Best options trade I ever made. But I had NO CLUE that Mr. Buffet was going to make an announcement. It was a purely technical trade. Picked a bottom I DID!
Buying an ITM Call is the same as buying the Underlying and an OTM put.
With equities I would suspect/believe that buying the ITM requires less margin/cash.
With span margining I'm not sure the same is true with Futures.
The potential gains from buying a deep out of the money call that goes in the money are large, but most of the time they don't work out, and the option expires worthless.
The potential gains from buying an in the money call are less, but still can be large. Say you buy a 35 call while the stock is selling at 37. Your price will include an intrinsic value of 2.00, the amount it's in the money, and a time value based on whatever the market is currently valuing the probability of the stock moving up in the time left. Arbitrarily, say your total cost is 4.00, reflecting intrinsic value of 2.00 (37.00 - 35.00) and time value of, say, 2.00.
Now assume the stock pops up in a fairly short time from 37 to 41, a gain of 4.00. Your option will gain the 4.00 in additional intrinsic value, plus whatever time value the market gives it. So, assuming no significant change in time value, you could see a price of about 8.00 (intrinsic value now of 41.00 - 35.00 = 6.00, time value assumed still around 2.00.)
To make that 8.00, you put up 4.00. That is an OK return.
Time value will drop off quickly as the option approaches expiration, so you may end up selling it only for the intrinsic value of 6.00 if you hold it until near expiration date, and if the stock price doesn't change again. So suppose the time value declines to a few cents, and the stock is still at 41 when you sell. Your sale price is then only about 6.00 ( = 41.00 - 35.00), which is a profit of 2.00 on your original 4.00. Instead of making 100%, you had to settle for 50%. That's still OK.
If you had bought it when deeply out of the money, your cost probably would have been much lower, so if it worked out the same way, your gain would have been much better. But your probability of success would have been much lower also. Most options bought out of the money stay out of the money, and expire worthless, and so you either sell before then and see a loss, or just wait until expiration and see a total loss. Buying OTM is much riskier than ITM.
Note that most buyers of calls have no interest in buying the stock, and are just looking for the option price to have a good-sized change in their favor. This may not be a great idea, much of the time. This is a worse idea, generally, if the option is out of the money, and only has time value when you buy it. Time value decays fairly quickly.
Also, all buying of options outright, meaning not in a hedging or spreading strategy against some other position, are pretty risky on the whole, and have more losers than winners.
But generally you will notice that volume picks up as they go ITM, as there will be more reason (less risk) to take the chance of buying them then.
Last edited by bobwest; October 17th, 2015 at 12:06 PM.
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Thanks, it makes sense then if you are looking to flip the contract for profit...or if you buy it OTM and then purchase stock when it becomes ITM...but I still don't see why anybody who wants to buy the stock would need to buy an ITM contract once it is expired or near expiry. I don't see how they are getting any benefit from it once you factor in premiums...at least in my example below.
I buy a call for xyz, strike price 30. Current stock price is 28. My price is 2.00 intrinsic value plus something in time value. I'll just take an arbitrary number of 1.00 for this example, so I spent a total of 3.00. The time value could be large or small, depending on how much time is left, volatility, cost of money, and whatever else the market is factoring in for it.
I wait. Stock goes to 40. I exercise. I pay 30.00 to get the stock (ignoring commissions.) I have now paid 30.00 to get the stock, plus 3.00 to get the option = 33.00. The stock is now worth 40.00. I could sell it and I would have made 7.00 cash in hand. Or, I could just hold it and my cost to own the 40.00 stock would be 33.00, so I'm still up 7.00.
Or, I could have spent 30.00 in good cash money when the stock was selling at 30.00, and ignored all this option stuff. So if it had gone up to 40.00, I would be up 10.00, which is better than being up 7.00.
But if it had gone down to 25.00 I would have been down 5.00. If I had just bought the call and not the stock, I would be only out the option price, which was 3.00. I wouldn't have the stock, either, which might be OK in this case.
You pay for an option because it gives you an option -- a choice -- that you might or might not want to take in the future. If you don't take it, you lost the purchase price of the option. That's just what the deal is: you pay to have the choice. Maybe you take it, maybe you don't.
Sure, if I ***know*** that the stock price will go up, I should forget this option stuff and just buy the stock as soon as I can. But I don't know. So I pay for the chance to wait and see. It will cost me to get that chance. It might not be worth it, either. Then I lost what I paid. But it might. So I have to figure out whether I want to do it that way, considering that I don't, and can't, know the future. I am paying to reserve a price that may or not turn out to be a good one, and I can't know until some time in the future.
Winning strategy: "Only buy a stock that goes up. If it don't go up, don't buy it." -- I think that is a quote from Will Rogers.
When you're looking at a market, one question to always find the answer to is, "why does this market exist?" If not for the fact that it gives you an option, in advance, that you might or might not want to take, once you see how things develop, there would be no reason for an options market.
It's no different from having an option on a piece of real estate: you put up some money that gives you the right to reserve it at a price you and the seller agree on. You have to pay for that right, and if you don't buy the property, you lose your option money but you aren't stuck with the property. If the prices of real estate in that area fell though the floor, you wouldn't want to buy at that price and would walk away. If they went up through the roof, you would come back and get it at the price you had contracted for. Your option money is gone in either case, and whether you elect to get the property depends on what happens after you have gotten the option, which you do not know in advance.
There is not one bit of difference, other than in details of how things are carried out, between this real estate example and the stock example.
PS, I did see your other example in the post you mentioned, but decided to not dig into it. (I may later....)
Of course no one is going to pay that ask price, on settlement date with the bid/ask spread so high. What does the person making the offer care? Maybe someone will pay him, which probably would surprise him, too. The option is going to expire that day. There is no time left at all, and no point in the option, unless someone is doing some last-minute scalping.
Follow a range of prices over a period of time, and not on settlement, and see how they act. You will find that the market prices do make sense if seen in the right light.
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