ATM options

My first thought after labelling this post was that I might be talking about options trading at your bank machine....right.

I was doing some thinking about my ITM long term expiry option trades last night and decided to look at ATM or At The Money options.

In the money options have a high delta which means the value of the option moves close to the value of the stock, partly due to the intrinsic value appreciating at the same rate as the stock price. So the long term ITM options seem to be a good buy as they will, most likely, always be worth something and the delta increases as they get farther into the money, increasing the symmetry of price movement.

ATM option prices move down around the 0.5 delta range so they move about half...give or take as I have not looked at too many yet as this is just a new idea forming. The advantage is that the option is cheaper as there is no intrinsic value so I would not be paying for any ITM value and could buy more contracts. This is also the downside as the extrinsic value will decay and shift due to time, volatility and price movement against the trade. Ultimately I think that buying enough contracts to offset the variance in delta would probably produce a similar risk so it only allows me to effectively trade options cheaper rather than with more leverage.

Any trade is made with the idea that the stock price will move into a profit position, otherwise why trade at all? Keeping this one tenet firmly in mind there would be no reason to have to pick ITM options over ATM options. I do a fair amount of testing with no expectation of profit, so those trades do not follow this idea, but that is just me.

Using IPI as an example I noted the options data for the Jan calls ranging from strike of $20 up to $30. The stock closed yesterday at $25.40 (a nice even $1 per share for me in one day BTW) which puts the price in the middle of the strike range.

From strike of $20 to strike of $30 the IV drops from $5.40 to zero while the EV starts at $1.30, raises to $3.40 (ATM) and back down to $1.90. The ITM option that I bought was strike $20 so I bought about $4.40 of IV.

The risk with options is restricted to the entire purchase price of the options contracts. With ITM options the risk is larger in this respect due to the IV. ATM options, being that they are pure EV premium means that the risk can be lower as long as the expiry is long term, six months or better. In the last three months to expiry the EV gets eaten up quickly and will reduce to zero as the option expires with no IV. The plan is not to hold them into this last phase anyway.

One of the other "Greeks" used in options is Theta. This represents the erosion of EV based on time decay alone. In the IPI example the Theta ranges from 0.011 to 0.014. My understanding of this number is that it represents the expected loss of EV per day of the option...so the options ranging from $20-$30 strike have very little difference between them. That being the case there is little sense in considering time decay between strike prices a problem this far from expiry.

So, if EV erosion is the same or similar for the range 5 strikes either side of neutral and an ATM option is purchased and the price moves in my favour then the IV increases penny for penny, the EV goes down to result in a net of about a 50 cent option move for every dollar of stock move (real rough).

Other things happen here as well...the EV erosion lessens the farther ITM the option goes increasing the correlation of option price to stock price moves. The farther Out of The Money the option goes the lower the delta and therefore the non-linear relationship effectively slows down the loss rate. This works the same for ITM options so no surprise, it's just that the mechanism is slightly different. Should the implied volatility jump so will the EV. This I have not studied too slosely yet though so I am not sure the relationship.