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Options are one of the most versatile tools for traders.
One of the most common ways I use them is through my short-term mean reversion strategy. I look for stocks that have overshot in one direction, and I aim to profit when they snap back the other way.
If all goes to plan, I can be in and out of the option trade in a day or two… up to a couple of weeks. And all with clearly defined risk…
But while options can be a great tool in short-term trading strategies, they have plenty of other uses. They can also work with longer-term strategies, too.
So today, let’s check out another way that you can benefit from using options…
Intrinsic Value versus Extrinsic Value
Some folks mistakenly believe that options only suit short-term use.
Someone bullish on a stock might buy a call option if they thought that the stock was about to rally sharply. But if they thought the move might take longer, they’d buy the stock instead.
After all, options expire. If the move doesn’t pan out in time, the option could lose a big chunk of its value or even expire worthless.
These are valid concerns. But we also need to consider other factors…
When traders use call options to capture short-term moves, they typically employ options trading around the current stock price (at-the-money, or ATM options) or above the stock price (out-of-the-money, or OTM options).
In this case, the call option has no “intrinsic” value. Its value is entirely “extrinsic.”
These terms can be a bit of a mouthful, so let’s break them down further…
Intrinsic value is the difference between an option’s strike price and the market price of the underlying stock. For example, a call option has intrinsic value if its strike price is below the current stock price. If a stock is trading at $100, a $90 call option has $10 of intrinsic value.
Extrinsic value, on the other hand, takes into account the intrinsic value and the premium the option is worth. If that $90 call option is worth $15, then its extrinsic value is $5 ($15 − $10 of intrinsic value). That $5 of value comes from things like the option’s time until expiration and volatility.
Notably, that $90 call option in the example is said to be in-the-money (ITM).
And deeply ITM options can be a handy tool to capture longer-term moves…
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A Substitute for Buying Stock
Take the stock that’s trading at $100.
If I thought it was going to rally over the next six months or more, I could buy 100 shares for roughly $10,000.
Alternatively, I could buy a deeply ITM call option with a strike price of $70. That way, I could gain access to the move for a fraction of the cost of buying shares. An options contract (which covers 100 shares) might cost around $2,500 to $3,500, for example. That’s roughly a third of the cost of buying the shares.
Because this option is so deeply ITM, its delta will be extremely high.
Delta gauges how much an option price should change for each $1 move in the underlying stock. In this case, the delta might be around 0.95 to 1.0. That means that the option will move at almost the same rate as the underlying stock.
Better still, the option’s price will have a significant amount of intrinsic value. Its extrinsic value (e.g., from volatility and time decay) will have a far smaller effect on the option’s value.
This can be beneficial during heightened volatility. Time decay won’t start chewing up the option’s value (like ATM or OTM options) as you close in on its expiration date.
So buying deep ITM call options can be a great way to gain exposure to an anticipated move higher in the stock. It can take a fraction of the cost of buying the underlying shares. That frees up your capital for other trades…
And because ITM options have a high degree of intrinsic value, they are less impacted by volatility and time decay.
That enables you to capture a longer-term view on a stock in a whole new way…
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
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