Who would turn down the opportunity to buy stock at half price? Especially when the potential for gain is exactly the same, and the potential for loss is halved. This is exactly the benefit of trading DITM (Deep-in-the-Money) options. By purchasing an option as a proxy for a stock, but at about half the price, you can take advantage of the full extent of a market move. Because your initial investment is lower, your risk is decreased. However, because you get the same return as if you had bought the stock, your return on investment is doubled.
Many traders stay away from option trading, because it is often perceived as gambling. A trader will buy a cheap, OTM (Out-of the-Money) option, hoping that a market move will turn the option into an insanely profitable trade. It is true that options trading is often driven by greed more than sound strategy, and that because of the leverage involved in options trading, it is a lot more risky. However if option trading is based on a well planned strategy, it does not need to be risky or a gamble.
DITM option trading is an entirely different ball game – it cannot be classed in the same risk level as other types of option trading. In fact, it has a lower risk profile than ordinary stock trading. The reason for this is the powerful weapon of DELTA, which is one of the so-called “greeks”. Delta is a term that describes the degree to which an option price will increase relative to the price of the underlying stock. For example, say the Delta of a call option on stock XYZ is 50%. If XYZ increases in value by $1.00, the price of the option will increase by about $0.50. That is, 50% of the market move is captured. DITM options typically have a Delta of 90% or more, which means that more than 90% of a market move can be captured. The trick is that the cost of the option is usually about half the price of the stock.
This means that if a trader wants to buy 100 units of XYZ stock at $20 each, his total investment is $2,000. If the stock moves up to $22, he can sell for a $200 profit, which represents a 10% ROI. However, in this example, our trader could buy one call option (representing 100 units of stock). The cost would be about $1,000, if the Delta is close to 100%. If the stock went up to $22, he would capture the exact same $200 move. Because his initial investment is half that of a stock trade, his ROI is now 20% – exactly double.
There are only three disadvantages to trading DITM options. The first is that dividends are only paid out on stock actually owned, not on the option to purchase the stock. The second is that options always have an expiry date, and so if the market move has not been captured by the time of expiration, the option needs to be sold, or it will expire worthless. The third is that broker fees for options are slightly higher than for straight stock purchases.
Trading DITM options is a very effective strategy that is equivalent to swing trading, day trading or momentum trading. It is not suitable for long term traders, but is an extremely useful way of shorter term stock trading with half the risk and double the potential return.