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How would one make trade-offs between buying a call option a few dollars ITM (in the money), ATM (at the money), or OTM. I mean I understand the plain dollar differences / calculations on the surface, but I don't understand how folks choose these on a stock that they are long in. Any/all advice/thoughts appreciated.

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3 Answers

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I look for buying a call option only at the money, but first understand the background above:

  1. Let's suppose X stock is being traded by $10.00 and it's January

  2. The call option is being traded by $0.20 with strike $11.00 for February. (I always look for 2% prize or more)

  3. I buy 100 stocks by $10.00 each and sell the option, earning $0.20 for each X stock.

    • A Scenario - X Stock price goes to $11.50 (more than strike) -
  4. I will have to deliver my stocks by $11.00 (strike value agreed). No problem for me here, I took the prize plus the gain of $1.00.

    • B Scenario - X Stock price goes to $9.00 (lower than strike) -
  5. (continuing from item 3) I still can sell the option for the next month with strike equal or higher than that I bought. For instance, I can sell a call option of strike $10.00 and it might be worth to deliver stocks by $10.00 and take the prize.

    • C Scenario - X Stock goes to $8.00 (very lower than the price I paid) -
  6. (continuing from item 3) Probably, it won't be possible to sell a call option with strike at the price that I paid for the stock, but that's not a problem.

  7. At the end of the option life (in February), the strike was $11.00 but the stock's price is $8.00. I got the $0.20 as prize and my stocks are free for trade again.

  8. I'll sell the call option for March with strike $9.00 (taking around 2% of prize). Well, I don't want to sell my stocks by $9.00 and make loss, right? But I'm selling the call option anyway.

  9. Then I wait till the price of the stock gets near the strike value (almost ATM) and I "re-buy" the option sold (Example: [StockX]C9 where C means month = March) and sell again the call option with higher strike to April (Example [StockX]D10, where D means month = April)

PS.: At item 9 there should be no loss between the action of "re-buy" and sell to roll-out to the next month. When re-buying it with the stock's price near the strike, option value for March (C9) will be lower than when selling it to April (D10).

This isn't any rule to be followed, this is just a conservative (I think they call it hedge) way to handle options and stocks.

Few free to make money according to your goals and your style.

The perfect rule is the one that meet your expectation, don't take the generalized rules too serious.

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Thanks Johnny, I'm a little confused with part 6. Can you expand / clarify? –  Ray K Nov 16 '11 at 17:50
    
Also, per your first line/comment, isn't one paying the most (time value) for options at the money, when buying them? –  Ray K Nov 16 '11 at 18:16
    
Thanks for the comments Ray K. I'm sorry for my confused answer. English isn't my born language and I'm not used with the financial vocabulary. I'll edit my answer to make it clearer. –  Johnny Nov 16 '11 at 20:30
    
Johnny, your English is very good! :-) I just didn't understand the scenario in step 6. I assume you are trying to correct for step 5 (bad situation). When you say "at the time the stock hits the strike", is this $9.00? If so, won't you have to pay a lot to buy this option (back) now -- the $9.0 strike option -- since it is right at the money? –  Ray K Nov 17 '11 at 0:06
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Great Johnny, I get it. Thanks so much for explaining it. This sounds like a good strategy, since if the stock should increase in price, you can roll out the option in a way that is profitable. Have you tried this with weekly options? You've probably noticed, but just in case, CBOE added lots of weekly options in the last 1.5 years, e.g. SLV, GLD, APPL, HAL, etc. Full list here: cboe.com/micro/weeklys/availableweeklys.aspx. For some reason finance.yahoo and finance.google don't show these correctly. –  Ray K Nov 17 '11 at 16:26
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You can do some very crafty hedging with the variety of options.

For instance, deep out of the money options are affected more by changes of market volatility, knowing this you can get long or short vega very easily, as opposed to necessarily betting on changes in the underlying asset.

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Thanks CQM, can you embellish a bit? I assume vega stays fairly constant? And with that constant, changes in volatility affect the option price? But it is really changes in implied volatility? Can you please embellish with an example, and or typical ranges you see. Much appreciated. –  Ray K Nov 16 '11 at 17:45
    
deep out of the money, the gamma and delta are so low that typical fluctuations in the underlying asset don't affect the price of the option more so than theta and overall market volatility will –  CQM Nov 16 '11 at 18:37
    
Interesting, thank you. –  Ray K Nov 17 '11 at 0:03
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1 reason is Leverage.... If you are buying out of the money options you get much more bang for your buck if the stock moves in your favor. The flipside is it is much more likely that you would lose all of your investment.

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Leverage usually has trade-offs. What's the trade-off in making the choice? –  Ray K Nov 16 '11 at 17:41
    
well the tradeoff is generally the same whenever whenever you use leverage. The potential losses are much larger. In the specific case of using way out of the money options it takes the specific form of a much larger chance of losing your entire investment. –  Pablitorun Nov 17 '11 at 19:42
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