Go long!
No, we don’t mean sending the wide receiver out for a long pass. We’re talking about using the most basic of options trades: initiating a position with a call option instead of buying 100 shares of a stock to create a long position. Options are a great way to take a position in a stock or an index. One option contract represents 100 shares of the underlying asset.
In future articles we will go into the details of options and pricing. For today let’s examine one of the reasons to use long call options instead of buying stock outright.
The term long call option means you are buying a call option. The term short a call option means you are a seller of a call option and have collected the option premium instead of paying it.
As of this writing June 13, 2013, IBM is trading at $203/share. Let’s say based on your technical analysis you felt that IBM was going up in the next two weeks. Buying 100 shares of the stock would cost you $20,300. However, you can buy a call option instead, allowing you to control 100 shares of IBM.
The right option can act almost exactly like IBM does in price movement. We do this by buying a “deep In-the-money” call option, one that has a delta of close to 1.0. Buying a “deep In-the-money” call means that you are purchasing a call with a strike price well below the current price of the stock.
The delta represents the price change of the option in relation to a one-dollar move in the stock. So if you buy an option with a delta of 1, it would move dollar for dollar with the stock as it moves up. If you buy one with a delta slightly less than 1.0 (say .99 or .98) and the stock moves up, the delta would increase until it gets extremely close to 1.0.
Understanding an options delta can be a little tricky. If you are a new options trader, give yourself some time to fully understand the relationship.
Back to our example, we can purchase a July 175 call option with a delta of .97 for a price of $28.50. Since it “controls” 100 shares of IBM stock we need to multiply that cost by 100 to give us a total cost of $2,850 for the option—14% of the cost of the stock.
This allows us to free up $17,500 of capital to use for other purposes. This also means that if we’re right and the stock goes up, our return on capital invested will be much higher that the straight out stock purchase. Of course the opposite is true as well—if we’re wrong, our percentage loss on invested capital would be greater with the option purchase.
But assuming that we exercise the same risk management as we would have with stock, then the deep in the money call should create no meaningfully larger loss (nor gain) as if we had purchased 100 shares of the stock. Even if one takes into consideration the 50% margin that brokers will grant typically for stock purchases, the gap in invested capital to make essentially the same trade is still very large in favor of the deep-in-the-money call.
Deep-in-the-money call options are a great way to take a position in a stock, index, or ETF for a fraction of the normal cost, even after margin considerations, and a great alternative to add to your trading arsenal.
Seth Freudberg and Michael Schwartz
no relevant positions
One Comment on “How to Trade In-the-Money Call Options”
I like the idea of using deep in-the-money calls to control roughly 100 shares of stock. My only concern is there are usually extremely wide bid/ask spreads on deep in-the-money calls. To achieve the same means I’d prefer to put on a long synthetic stock position by buying an at-the money call and selling an at-the-money put. The at-the-money options should also have much tighter bid/ask spreads so you should get better fills on entry and exit. In addition, a synthetic stock position would provide you with same 100 deltas as buying the deep in-the-money calls, but with less capital; that is if you’re trading in a margin account. However, in a cash secured account like an IRA it may be better to buy the deep in-the-money calls. For every put you sell you’d be responsible for setting aside the amount of money it would cost to cover your position if the stock went to $0. In this case, buying a deep in-the-money call would make a lot of sense.