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Using In-The-Money Options to Take Advantage of Option Price Disparities
by Dave Caplan
The “in-the-money-debit-spread” (purchasing an in-the-money option and selling an out-of-the-money option of the same expiration month) is a position that can be used to take advantage of a trending market, and also provide us with significant benefits over a straight “long or short” future’s position.
We have always recommended that option positions be used when they can provide us with an advantage (“trading edge”) over futures. In conventional futures trading, after using your favorite analysis method (technical, fundamental, trend-following, etc) to determine a market direction, you then initiate your trade by purchasing or selling a futures contract. If the market does not move in the direction predicted, you lose money on this trade. In fact, often money is lost even when the market moves as predicted, after first making a sharp move against you, thereby “stopping” you out of your position.
This is where the proper use of options and option strategies becomes important and can provide us with a real “trading edge”. First, when buying an option, since risk is limited to the premium paid for the option, we can trade without “stops”, since we no longer have to worry about unlimited losses if the market moves against us. This can prevent us from losing our position (and our money) when the market makes a sharp, temporary, short-term move.
In addition to not being “stopped out” in temporarily adverse circumstances, this strategy can be successful even in some cases when the market fails to move in our desired direction, as we will collect premium because of the declining value of the out-of-the-money option that we have sold.
This type of position can be successful if the market moves in the direction that we predicted (put spread – lower; call spread – higher), or even if the market is stable! Only if the market changes direction will this position be unprofitable. It is for this reason that we recommend this position be entered only in the direction of the existing trend. Since the probability is that a trend in force tends to continue, this will add to our mathematical probability of success.
This is the advantage of this position. A market can move only in three directions:
Higher
Lower
Neutral
This position is profitable both if the market moves in our desired direction (higher or lower), and in many cases, if the market remains neutral; thereby creating a successful position in two out of the three instances. Compare this with conventional futures trading where not only is our trade profitable in only one out of the three circumstances, but since we can also be stopped out at times even when we are correct on our market direction, our chances for success are closer to 25%.
However, our advantages do not stop here. In addition to more than doubling our odds of success on a trade, this position also allows us to take advantage of disparity in option pricing (overvaluation), and the time decay of option premium. And, unlike a futures position where the risk is always unlimited, the risk in this strategy is absolutely limited to the premium deficit (plus commission and fees).
In the past, we avoided using in-the-money options, since they are both expensive, providing us with very little leverage – which is one of the significant benefits of using options; and at times they can be relatively illiquid, causing slippage (losses arising from the difference between the bid and ask) when entering and exiting the trade. However, after extensive research we have determined that the benefits from using these in-the-money options can far outweigh the disadvantages.
We have found out that by purchasing the in-the-money options and selling one or more further out-of-the-money options we can construct a position that takes advantage of:
The trend of the market;
The overvaluation of out-of-the-money options;
The time decay of out-of-the-money options;
The tendency of in-the-money options to hold their value better than out-of-the-money options under most market conditions.
This position works to help us take advantage of the overvaluation of the out-of-the-money options. Many times we find that the out-of-the-money options are overvalued anywhere from 10% to 50% or more, as compared to the in-the-money options. This means that the premium a trader pays for the out-of-the-money option is much higher than the in-the-money option, and it will decay at a much faster rate.
The best circumstances for using this position are:
A trending market;
Markets where the out-of-the-money options are trading at a premium of at least 20% over the in-the-money options.
Another advantage of this strategy is that usually we need less capital to enter a position, thereby allowing both more leverage and diversification of funds. While a future’s position in the S&P 500 currently requires $12,000 initial margin, a “debit spread” requires only a $2,500 premium, a reduction of almost 90%. We recommend initiating an “in-the-money-debit-spread” when the out-of-the-money option we are selling has a higher implied volatility rate (is more overvalued) than the closer-to-the-money option we are purchasing. We also should not expect the market to move beyond the level of the out-of-the-money option we are selling (so our potential profits will not be limited).
We would not recommend a bull or bear spread in the initial stages of a trending market, because normally at the time the out-of-the-money options do not have enough premium because of the low volatility. Further, we do not want our profits limited at this initial stage where the market may be in its “blast off” stage. Net option purchases and “free trades” are preferred here.
In the second stage of trending markets, where the trend has begun to mature, is the most opportune time to initiate “in-the-money-debit-spreads”. In this case, a more “normal” trend can be expected, and significant benefit can be obtained by initiating an “in-the-money-debit-spread” which both limits risk and allows us to take advantage of the more over-priced out-of-the-money options.
It is in the last stage of trending markets out-of-the-money premium really soars, when the market is less likely to make an extremely large move in the direction of the trend, that ratio spreads become our preferred vehicle. The “ratio spread” (when initiated at a credit) provides the best of all worlds by providing the following benefits:
Continuing profits if the market moves in the direction we expect;
Profits (the amount of the credit received) if the market moves lower or remains in a trading range;
The ability to take significant advantage of the higher priced out-of-the-money over valued options.
Finally, this position can also be effectively used as a hedge for your cash or future portfolio. For example, if you own a stock portfolio, put positions can be constructed to hedge your downside risk at a minimum cost. Similar hedges can also be constructed to protect bond, currency, metal and agricultural positions.
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