Trading Deep-In-The-Money Options

I was going to write up an explanation on trading deep-in-the-money (DITM) but Steven Gabriel M.D. has already done a great job in his http://www.tradingmarkets.com/ article:


http://www.tradingmarkets.com/.site/community/articles/favorite_strategy/How-I-use-Options-to-Enhance-my-Trading-Performance.cfm


Here are a couple additional points that are critical/specific to my own trading style and set-ups:


Slippage - For many stocks, DITM options are thinly traded. Therefore, there can be a significant spread between the bid and ask...$0.10-$1.00. Mentally, this is one of the biggest hurdles to get over to trade these options. Giving up $0.50-$1.00 on options can mean thousands of dollars if you're trading 10, 20 or 50 calls/puts. If you're scalping a few cents here and there, DITM options make no sense. However, I see this as an acceptable cost to participate in a pending big move. Next point...


Stock Selection - One of the main factors that helped me turn the corner to profitability was to narrow my watchlist down to the strongest (weakest if I'm trading puts) stocks. Based on my set-ups, I'm looking for stocks that can potentially move $5-$10+. Why buy MSFT and wait 3-6 months for a $5 move when AAPL will give it to you within a day or two? If I can participate in a move like this, the slippage becomes easier to accept. Look at the oil, fertilizer, metal and financial stocks this past week. Many of these stocks had $5+ swings EACH day! The challenge is to be on the profitable side of the move and to honor your stops if you're not. Next point...


Stops - Since I am trading options based on the moves of the underlying stock, I need to place my stops based on the stocks. I use http://www.optionsxpress.com/ which allows me to place "contingent" orders based on the stock price. 80% of the time, my stops are set to execute a "market" sell order. When I want out, I just want out. However, occasionally, the bid is priced BELOW the intrinsic value in which case I'll place a limit order. As an example, if the current price of a stock is $45.00 and I'm trying to sell the Aug 40 Call, the bid should at least be $5.00, representing the intrinsic value of the option. On occasion, the market maker may price it at $4.80, which is $0.20 below the intrinsic value in which case I'll place the sell order as a limit at $5.00:


$45.00 stock price - 40 strike price = $5.00 - intrinsic value


I used to trade with TD Ameritrade a few years ago but they had too many technical problems (supposedly still do) and their stops were based on the options. For thinly traded options, this can be a disaster. The stock may have traded $2 below your stop level but if the option has not traded, your stop will not have triggered and you may still be stuck in the trade. It has been a few years and I know many platforms (i.e. Think or Swim, OptionsHouse, etc.) have upgraded their features for options trading but I have had no reason to try them out...yet.


Option Selection - Steven's article sums up my own option selection pretty well. I also look to trade DITM options where the premium is less than $1 above the intrinsic value. However, because I am swingtrading within a short period, I ALWAYS trade the front-month options. Also, because I focus on momentum stocks, I have found that there is too much risk and premium to go 1+ months out on the options. Worst case, if the stock is trending well and I want to stay in the trade, I'll roll the options into the next month on expiration week. As I mentioned previously, on expiration week, I transition to at-the-money (ATM) options and lever up. The key here is to maintain your risk level or tighten up your stops so you don't end up losing more on the trade if it goes against you.


When it comes to options, there are tons of literature that talk about option pricing (Black Scholes, volatility, alpha, gamma, etc.) and option set-ups (calendar spreads, bull spread, straddles, etc.). Yes, it can all be very complicated but I have learned to keep it very simple. I'll place the occasional straddle/strangle or bull spread to manage risk. However, at the end of the day, I'm just looking for a strong stock with a potential trend and a low-risk/high-reward set-up for entry. Once that is identified, DITM options just become a vehicle for participating in the price movement.