Why I buy In The Money (ITM) options

July 1st, 2008 | Posted in Investing, Stocks

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During times of high volatility, ITM options are a good way for directional trading. This is because high implied volatility will eventually normalize. When this occurs the at-the-money (ATM) and out-of-the-money (OTM) options are going to lose value.

Deep in-the-money (ITM) options will for the most part be unaffected. This is because deep ITM options have little time value. It is the time value or extrinsic value of an option that is effected by changes in implied volatility.

So that is my reason. I’m not trading the volatility per se. There are many volatility trading strategies.

For example if your stock price expectation of a stock is flat and volatility is higher than normal (market expects strong price movement), you could sell some deep out-of-the-money (OTM) options with the expectation that volatility will drop. A drop in volatility will reduce the price of the OTM options. This is one potential volatility trading strategy.

Another way to trade volatility is to trade ahead of earnings. Below is a chart of Apple’s volatility. You could buy options a few months before earnings when volatility is relatively lower. As earnings approaches the options volatility tends to spike as high as 20% (circled in chart). During those spikes option premiums go up. Of course you must balance your time decay against your gains from volatility so you’d want to have a longer term option if you use this strategy. You could buy during low volatility a few months ahead of earnings and sell near earnings.