The deep in the money call option strategy was the first option strategy that I used, when I got into options trading several years ago. I first ran into this strategy by watching an episode of CNBC's Mad Money hosted by Jim Cramer. While I'm not the biggest fan of Mad Money, I found this strategy interesting and a good beginning strategy to use. Now, I know there are going to be some people that are going to say the best strategy is to not use options, but if options are understood and used properly they can be an alternative to buying stock. There is nothing wrong with going out and buying stock, but if you are looking for a cheaper way to play stocks then outright buying shares, using a deep in the money call strategy may be for you.
Deep in the money options can be used on calls or puts and for those that are not familiar with deep in the money options, according to investopedia,
An option with an exercise price, or strike price, significantly below (for a call option) or above (for a put option) the market price of the underlying asset. Significantly, below/above is considered one strike price below/above the market price of the underlying asset. For example, if the current price of the underlying stock was $10, a call option with a strike price of $5 would be considered deep in the money.
In my opinion you don't always have to go five strikes below the stock price to be considered deep in the money, but for myself I consider one to two strikes (for calls) below the share price to be considered in the money and three or more strikes below the stock price to be considered deep in the money for stocks under $15. The higher the price of your stock, the more the strikes are going to be adjusted to be considered deep in the money.
With every trading strategy there are always risks. Here are some advantages and disadvantages of buying in the money or deep in the money options that you should consider.
- Deep stock protection.
- Higher delta to match stocks movement upward or downward.
- More upside profit than owning stock.
- Investors can control a stock with less money at risk vs. cash purchase for stock. Hypothetically, for example, 1000 shares of xyz at $10 = $10,000 or buying 10 contracts of XYZ at $1.00 = $1,000.
- Low breakeven point to profit.
- Time decay can hurt option price as expiration nears.
- Wider bid/ask prices.
- Options do not pay dividends.
- Time is defined compared to owning stock where your time is infinite, until you sell or company is no longer traded.
- If you don't have enough money in your account to buy the stock when your contract expires then you have to sell before expiration. Also, if investors let contract expire then it will be exercised automatically.
There are many more advantages and disadvantages to the deep in the money call strategy, but these are just a few. The deep in the money strategy can be used on any stock that has options traded on them. A stock that is under $15 to consider buying deep in the money calls is Alcoa (NYSE:AA).
Alcoa produces and manages aluminum that is used for a variety of industries. Some of the industries include consumer cyclical, automobiles and aircraft. Alcoa Q4 earnings reported a loss of 0.03 cent which was in line with consensus. The last three times Alcoa has given earnings the stock has sold off, but this time is different. In the last 5 days Alcoa is up 2.2% and the last 30 days Alcoa is up over 20.6%. Whether you want to look at Alcoa as a trade or investment, with Alcoa's high beta, you sometimes have to be careful. I believe Alcoa will bounce upward and downward as the price of aluminum, supply and demand affect the stock positive or negative. Look for the $9 level as good support since Alcoa bounced off these levels twice. Despite Alcoa's run over the last thirty days there still might be some more room to run upward as we see demand in aluminum from aerospace, building and construction are all expected to increase from last year. One thing that caught my eye in the 8-K was Alcoa's free cash flow increased from last quarter. In September 30, 2011 Alcoa reported 164 million of free cash flow and on December 31, 2011 this now jumped to 656 million of free cash flow. In my opinion if you are looking to get into Alcoa this is not a buy and hold play. If investors are looking to make a long term investment be prepared to average cost down. For more information on averaging down, check out this article written by Kevin O'Brien. Generally, I like to give myself a minimum of three months till expiration when looking to buy options. The April options are not too far away, so if investors want additional time, look toward the July or even longer January 2013 deep in the money calls.
While Alcoa is only one stock out of the hundreds out there, I am also watching Bank of America (NYSE:BAC) and Ford (NYSE:F). These two commonly known and traded names also have a beta over one. If you are new to options, I would strongly consider using a practice portfolio first before you get your feet wet. This way you can track the stock and get familiar on how the stock has been trading. I would also do a fundamental and technical analysis of the stock you're interested making an options play. Make sure you read the 8-K, review the balance and income statements. On the technical side look at support and resistance levels so you can gauge an attractive entry point. If you have a broker that has tools available for technical analysis such as relative strength index, overbought/oversold, Bollinger bands, etc. I would get familiar with these tools.
If you're bullish about a certain stock and want a cheaper way to get in, then this strategy can work for you. However, you need to make sure you do your homework and don't get discouraged on a down day.
Disclosure: I am long AA. I have April $8 calls.