Option Trading Subjects:
Choosing a Long Option Strike Price
ITM, ATM, or OTM?
A question you will often face when purchasing long call options is whether you should use an In-the-Money, At-the-Money, or Out of-the-Money option. This page discusses the advantages and disadvantages of each type of long call as compared to stock ownership and each other.
The graph below is different from most other graphs on this site. Instead of showing one strategy with it's entry date and check date lines, we are showing just the expiration lines for a stock position (the orange line), an ITM call (the blue line), an ATM call (the red line) and an OTM call (the green line). Each option position is one long call. The stock position is 100 shares. The stock price at entry of each position is $50.00, the time to expiration is 26 days, and the option IV is 33.33%.
Since the orange line represents 100 shares of the stock itself, the position obviously gains or loses $100 for each $1 gain or loss in the stock price.
The line most closely following the stock line is the blue line, which represents an option that was $5 in the money at the time it was bought: the 45 strike. If at expiration the stock is anywhere over the strike price, the only difference in the performance of this deep ITM call and the stock itself is the amount you paid that represented time value, which in this case was $32.00. If the stock is not over the strike price at expiration, you will lose the entire premium paid, which in this case was $532.00. However, that is also the maximum you can lose, no matter how low the stock might go. If you owned the stock itself, it is possible to have loses far exceeding $532.00. By using this ITM option, you have increased your leverage compared to stock ownership. If you own the stock and it goes to $60.00, your percentage gain is $1000/$5000 = 20%. If you own the option and the stock goes to $60.00, your percentage gain is $968/$532 = 182%.
The red line represents an ATM 50 strike call option. An ATM long call option has much more time value than an ITM option. In this case, the entire purchase price of the option is the time value of $184.00. This means the stock must rise to $51.84 before you begin to show a profit at expiration, and no matter how high the stock goes, you will always do $184.00 worse than owning the stock itself. However, instead of spending $5000.00 to buy the stock, you only spent $184.00 to buy the option, increasing your leverage substantially. If you own the stock and it goes to $60.00, your percentage gain is $1000/$5000 = 20%. If you own the option and the stock goes to $60.00, your percentage gain is $816/$184 = 443%.
The green line represents an OTM 55 strike call option. The entire purchase price of the option is the time value of $37.00. This means the stock must rise to $55.37 before you begin to show a profit at expiration, and no matter how high the stock goes, you will always do $537.00 worse than owning the stock itself. However, instead of spending $5000.00 to buy the stock, you only spent $37.00 to buy the option, increasing your leverage tremendously. If you own the stock and it goes to $60.00, your percentage gain is $1000/$5000 = 20%. If you own the option and the stock goes to $60.00, your percentage gain is $463/$37 = 1251%.
Stated as probabilities, the deep ITM long call has a higher probability of a smaller return. The ATM long call has about a 50:50 chance statistically of losing or gaining. The chances can be improved with a successful stock picking method. The OTM long call has a smaller probability of a larger return.
Knowing the advantages and disadvantages of each type of long call helps determine how they might best be used:
A deep ITM call makes an excellent reduced-risk, reduced-investment alternative to stock ownership. An investor accustomed to buying stocks during bull markets should be comfortable with this strategy. In addition, an investor who has trouble taking stop losses on stock positions might benefit from this type of call option, since a "stop loss" is built into the option itself - you can't lose more than the option cost. If this maximum loss is kept at a reasonable percentage of the investor's total account value (such as 1 or 2%), the investor may have better overall results (including "unrealized" losses) than buying stock.
The main difference with the option position is that the investor loses the luxury of unlimited time. Investing in options requires that you get the timing of your purchase correct. An investor not sure of their ability to get the timing right should start with options expiring in 3 months or more. This will increase the time value cost somewhat, but also bring back some of the ability to wait for the stock to move. Also, anyone needing dividend income will not want to replace stock ownership with options, since option positions do not pay dividends.
The stock investor interested in accumulating stock should remember that owning a long call gives the right to buy the stock at the strike price. This fact can be used as part of a trading strategy. For instance, maybe you like to buy stocks as they are "breaking out", but don't have sufficient funds to buy all the likely candidates you see. You might buy deep ITM calls on all the breakout stocks instead, spending far less than you would for the stocks themselves. The long calls on breakouts that actually work can then be exercised for stock, buying the stock at or near the breakout price (including the cost of the option), and the calls that don't work out can be sold for their residual value or just treated as an enforced stop loss.
The ATM call is a good choice for someone who might be described as an "investor-speculator". Perhaps this trader has developed a system that allows him to be correct in his judgment about stock direction more often than not. If so, the increased leverage when he is right will more than make up for the losses when he is wrong. As a risk management technique, this investor should keep records of all trades, and determine his current win percentage as well as the maximum number of bad trades in a row. He can then adjust his trading so that even if he takes the maximum number of bad trades in a row, he does not lose more than 1-2% of his total account value.
Someone interested in trading ATM calls might want to start by trading the bull call strategy first. The premium taken in for the short OTM call portion of the bull call will help soften the blow of any losses on the long ATM calls. If this trader starts to find that more often than not, the short calls are limiting his gains, then he might switch to trading straight long ATM calls.
The OTM call is for the speculator, since the characteristics of the option make it very similar to gambling. Someone using OTM calls could have many, many small losses, and the occasional big win. Whether the wins exceed the losses will be determined by the speculator's skill in choosing options in stocks that have a large percentage movement after the option is purchased. The speculator should remember that every loss is a total loss of the investment. Therefore, this strategy might best be used on a very small percentage of the account value, such that even having ten losses in a row only results in a 1 -2% loss in the account value. If the speculator finds he has trouble getting ahead after ten OTM options are traded, he might do well to start using ATM options instead.
Even though OTM calls are basically a speculative position, they can have their uses for other investors as well. One use can be as a relatively inexpensive way to "bottom fish" or play what you consider to be an overdone correction in a stock or the market itself. If you are wrong, your dollar loss is much smaller than "bottom fishing" with stock or the other types of call options, and you can try again at the next level that looks like it might be a bottom. If you are right, you can get a nice percentage gain, since the bounce off a real bottom can be substantial. Just be wary of thinking every dip is an opportunity - stocks and the market can go much lower than you think they might.
Every trader using long call options can benefit from keeping good records, including records of the options he does NOT buy. The ATM trader for instance can keep records showing the ITM and OTM option midmarket prices at the time he enters and exits his ATM trade. After every expiration a study of these records might reveal that the trader would be doing better trading one of the other types of options because of his personal style, his stock picking methods, or just the current market conditions.
And of course, there is no rule saying you must limit yourself to one type or the other. You could hedge your bets by using any mix of long call types that you want. Just be sure to limit your overall risk to a reasonable percentage of your account value such as 1-2%, based on the worst case scenario of every long option expiring worthless.