Saturday, 27 November 2010

Buying an option ‘in the money’

Some traders claim it‘s foolish, others will tell you it ‘s smart.
Buying a call option ‘in the money’, you pay up the intrinsic value: the actual stock price minus the strike of the option plus a premium, mainly depending on the time left to expiration and on (implied) volatility.

I'm trying to make my point with an example of call options on Yamana Gold:
Hereby an options grid with all strikes (call options only) and with the ‘Greeks’ mentioned on the right. 

Yamana Gold ended the week on $11.26 down a dime on the (shorter) trading session.
That ‘s what a call buyer doesn’t like, unless he’s waiting to get on board. Now, what ferry to take? I consider only the Jan 2011 calls, the Dec calls being too short and heavily losing premium. March calls might be an alternative, but the seasonal gold bull has usually dropped dead by then.

Buying into ITM $10 calls, you have a delta of 0.8 while time Greek Theta is –0.0043. What does that mean? If AUY recovers the dime lost by next tuesday, that adds 0.07999 – 2*0.0043 to the option price; now its mean is 1.44, the profit would then be 4.9 % .
Buying into the OTM $14, you would gain 0.01217 – 2*0.0035 or 4.3%. While the percentage difference is little, it gets worse for options further OTM: the strike $17.5 option would be flat, with time premium loss balancing the gain through the stock rising.
Now, does it matter whether you buy the $14 call for as little as $0.11 or the heavyweight $10 call for as much as $1.44? Percentage profits seem similar.
The matter is that delta and its fellow Greeks aren’t constant over time. I like to illustrate this with the 17 Dec call below.
Dec 2010 call options on Yamana. Series traded yesterday have strike prices between $10 and $15
You immediately notice that the range is shorter: $17.5 strike doesn’t trade for December 10: it's worthless. Delta for the $14 call is as little as 0.0578, slashed in half when compared to the Jan 11 call, It trades for a 0.035 average, only a third left. The time Greek theta has eaten away its value. 
If Yamana lingers on the way it has last few weeks, this is where your $14 strike Jan 11 call is going to end up after Christmas.
Is the situation any better for the $10 call? It is. The delta for the Dec $10 call is 0.9181, meaning that the ITM call will see its stock price sensitivity rise instead of fall. Theta has done its ugly work, but the option is still worth 1.30, a loss of barely 10%.
Buying the ITM option implies a higher value at risk, so your total loss will be acerbated if Yamana really screws things up. Yet buying larger quantities of OTM options versus a smaller position of ITM options seems really unwise.
Don’t take my word for the Evangile: always DYOD.

More on the greeks: http://en.wikipedia.org/wiki/Greeks_(finance) or Investopedia
Data were retrieved from: http://www.888options.com/   

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