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.
I look for buying a call option only at the money, but first understand the background above:
Let's suppose X stock is being traded by $10.00 and it's January
The call option is being traded by $0.20 with strike $11.00 for February. (I always look for 2% prize or more)
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) -
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) -
(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) -
(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.
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.
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.
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.