Options Trading Tutorial

in call options why buy an option with a strike price below the current stock price im confused...?

why would you choose a strike price that is actually below the current value of a stock (I'm looking at an option chain and noticing that you can buy options in the money but how would that work for you if you are seeing that the stock is going to go up even further away from the strike price that is already below the stock price... I thought the whole idea of buying a call was because you thought the value was going to increase over time

Public Comments

1. First, keep in mind that speculation in options is primarily a volatility play. You're not really betting that the stock will go up, rather just that it is more likely to make a huge move one way or the other. I say this, because the main reason for buying out of the money options is to match cash flows in a way that doesn't just pay you more when the stock goes up. Specifically, you can create a number of payoffs that pay or don't pay in certain situations. These allow you to either fine tune your strategy according to your information (if you are a speculator), or to better manage your cash flow needs under certain contingencies if you are a straight up investor or manager.
2. There are any number of reasons I might choose a call options with a strike price below the stock price. The most common would be that I want to to buy an option with a higher delta to bring a spread back toward delta neutral without excessive gamma risk. If you don't trade spreads, probably the biggest advantage of buying an in the money (ITM) call is that it requires less of change in the stock price to make a profit. For example, assume Tom, dick and Harry each bought an AAPL January 09 call at today's closing ask quote. Tom bought a $90 strike for $6.90 Dick bought a $95 strike for $3.90 Harry bought a $100 strike for $1.96 If all three hold until expiration, the stock will have to be over $96.90 for Tom to make a profit, the stock will have to be over $98.90 for Dick to make a profit, and the stock will have to be over $101.96 for Harry to make a profit. If the stock closes at $102.00 at expiration Tom's profit will be $5.10 per share Dick's profit will be $3.10 per share Harry's profit will be $0.04 per share. <<<I thought the whole idea of buying a call was because you thought the value was going to increase over time>>> Excluding hedging transactions, that is true. In the example I gave clearly Tom was made the most because he bought an ITM option. ----- I am not trying to say that buying an ITM option is always the best choice, but certainly there are times it is the most profitable choice.
3. it's because the chance to profit is higher
4. It seems that you are asking, "why would a person purchase a more expensive option (one already "In the Money" ITM) instead of a less expensive option (one projected to be ITM in the future but "out of the money" OTM now)? There are two primary reasons that I can think of off hand why an trader in options might choose to do that and both answers have somewhat to do with the option's "delta". You cannot see an option's delta by looking at an option's chain. An options delta (as well as the other option "greeks" such as gamma, theta, rho, and vega) are determined via elaborate calculations which you can do by hand if you have the knack and the know how (good luck!) or which you can find online, perhaps through your online broker and the tools they provide at their site, or perhaps through an options program such as "OptionVue 5". An options delta does various things and is very useful to an options trader. Getting back to my comment about the two primary reasons why an investor might purchase an ITM option instead of an OTM option, the first reason has to do with "probability" and the second reason has to do with an ITM option having a greater price movement than an OTM option. Both have to do with delta. PROBABILITY In the first case, typically, it is wise to enter into trades that have a higher probability of success. When you purchase an ITM option you already are purchasing an option with a higher probability of expiring 'in the money'. Exactly what is the probability of success? Again, there are in depth calculations to help option traders determine that, but a good rough estimate of an option's probability of success is ... the delta. For example, an ATM (at the money) option will have a delta of .5. One use of delta (deltas are valued from .0 to 1, or 0% to 100%) is to roughly see your probability of the option ending in the money. Being ATM the option currently has a 50-50% chance of ending ITM (In the money) or OTM (out of the money). Your option's success is a coin toss. The more ITM you are, the higher the delta is. An ITM option that is one or two strike prices ITM may have a delta of .862, or 82.6% probability of expiring in the money. If the option is even deeper ITM (four or five strike prices ITM) it will have a delta of 1, or 100% probability of expiring in the money. DEGREE OF PRICE MOVEMENT In the second case, typically, when you purchase an option you want the value of the option to increase. Delta also determines the degree that the option's price changes based upon the change of the underlying asset (stock). For example, if you purchase an OTM option, though it is cheaper, it will also have a lower delta, of say .32. This means that when your stock makes a movement in a desired direction (yeah!) the option's value will only increase by 32% of the stocks price movement. In other words, for every 1 point change in stock your option will only move .32 of that movement (boo!). If you purchase an ATM option (more expensive) it will have a delta of (roughly) .5. This means that for every 1 point increase in the stock's price, the price of the option will increase only .50, or 50% of the assets movement. But if you purchase an ITM (example: delta .826), and a deeply ITM (example: delta1.0), then for every 1 point increase in the underlying asset your option will increase in value accordingly: 82.6% price increase for the ITM option and an equal (100% of the underlying stock's movement) price increase in the value of the option. Therefore, for these reasons, for the sake of having a greater probability of expiring in the money, and because an ITM option has a greater price increase as the underlying stock price increases, many option traders would prefer ITM options over OTM. Both of these reason lead to the one true reason for buying an ITM option over an OTM, which is greater PROFITABILITY. You can sell your purchased ITM option for a greater profit when it has increased in value. Because it is ITM, as I have hoped to show you, it's value will increase more dramatically than it's OTM counterpart. This, of course, doesn't take into effect different option strategies, or the amount of money you have to trade with, which may cause you to want to risk OTM options. OPTION GREEKS Regarding finding option Greeks, I would see if your online broker has a site for them. You may try exploring cboe website (the Chicago Board of Options Exchange) as they may list them for no charge. There are various programs out there that compute the greeks for you, such as the already mentioned OptionVue 5 (recommended!!). For some good books that explain option Greeks see my references below. Good luck and I hope this helps.