Chris Rowe

Buying In-the-Money Calls

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3 BENEFITS OF BUYING IN-THE-MONEY CALL OPTIONS

So, what are you getting in return for your willingness to lose 73 cents during the course of a few months on a $60 stock that really only equates to 1.21%?

No. 1: Broader Market Downtrends are Less Nerve-wracking

You know that your absolute maximum downside risk is the $18.50 (or $9,250) that you invested in the call option, instead of the $60 (or $30,000) on the stock that likely wouldn't lose all of its value. But, as we know, a loss of anything between 1 cent and $30,000 is possible.

There are many benefits here that one wouldn't consider at first. One of them is the psychological gain. I mean, you would be a lot less worried about the stock market crashing, and this would allow you to feel more confident about buying when people are fearful. That means that you would be buying when things are down.

Also remember that you should usually play both sides of the market. So, you can also buy in-the-money put options to bet on the downside. That means if the stock is at $60, and you were betting that it would trade lower, you would buy the in-the-money Jan 75 Puts.

No. 2: Similar Gains to Buying the Stock

If your stock moves higher, you are making almost the same amount that you would have made on the stock.

No. 3: Lesser Losses

If your stock moves lower, you are probably going to lose much less than you would have on the stock.

A very basic hypothetical example is that if the stock trades up 10 points, you will probably make 9 to 9.5 points, but if the stock trades down 10 points, you will probably lose about 7 points.

So you see, the downside-versus-upside ratio is less-than-par.

You only get the downside-versus-upside ratio benefit if you do two important things:

1) Buy the options that are in-the-money by a few strike prices.

2) Buy an option that has a long while to go until expiration day. This "long while" should probably be one year or more. So, in the example used above, January can be the furthest-out-available LEAP (i.e., if it's 2008, you can buy the 2010s; if it's 2009, buy the 2011s). The ultimate goal is to be out of the position at least three months before the option expires.

Chris Rowe is the Chief Investment Officer for Tycoon Publishing's The Trend Rider. To learn more about him, click here to read his bio.