Investoid

As I’ve mentioned before, when you trade options you are working with a product whose value will change in a non-linear manner with respect to the underlying. When you are working with out of the money options, this means that you will experience very high percentage changes to the option value for every dollar change in the underlying asset. However, the farther along the option chain you go into the in the money options, the closer the change resembles the movement in the underlying asset.

Take for instance a ‘deep in the money’ (DITM) option. Let’s say you have a stock worth $50 and you buy a call option with a strike price of $40. That means that right now, the option is worth $10 + some time value (which depends on its expiry date). If the stock declined to $49 in one day, in theory the option value would decrease to $9 + time value. If the option has a far away expiry (at least 4 months, preferably 8-12), then it is likely the option value would only go down $1 since the daily time decay on such options is very small. Similarly, if the stock rose to $51 then the option is now worth $11 + time value. In option terms, the option’s delta is very close to 1.0.

Since these options behave very closely to the underlying, if you hold a DITM option you essentially have a long (or short) position in the underlying, until such a point that the stock has moved closer to the strike price (ie. against your position). When you’re buying a long term DITM option, you are making a leveraged buy or short decision against the stock. This leverage ratio can be greater than what your broker would provide you on margin, and does not have any interest to pay. It is an interesting strategy to use if you are bullish or bearish on a stock with liquid options.

Lenny Dykstra uses this strategy and chronicles his trades in his thestreet.com column. He has a pretty good track record when using this strategy, although as of yet it isn’t that long.

There are a couple of things you need to watch out for when using this strategy:

• Don’t buy these options at the ask price. Longer term options are relatively illiquid and will have bid/ask spreads of at least 20 cents. Place a limit order at a price you like and make sure you adjust it if the underlying moves significantly.
• Determine your stop loss and profit limits for these trades. Since you are highly leveraged, a small move in the underlying can make a big difference in your return. I haven’t used this strategy yet, but I’d be looking for a max risk of about 15% with similar upside (ie. risk reward ratio of 1).
• Look for options whose time value seems reasonable, meaning that implied volatility isn’t too high. Compare prices across expiry dates as well as strikes, to find a reasonable entry point.

I am thinking about using this play on a short basis against the US Real Estate Industry, via Dec 07 or Jan 08 put options on the iShares ETF IYR. Today the index was higher but gave up its gains. If another rally occurs without any material change in the fundamentals of the space, I’ll be looking to make an entry.