New To Options? Consider The Deep In The Money Strategy - Part ll

 |  Includes: AA, BAC, F, GE
by: John R. Conway

On January 31, 2012, I wrote an article on the deep in the money option strategy. While anybody can use this strategy, my target audience was the beginner trader who wanted an alternative to buying stock using options. Please refer back to my first article to view advantages, disadvantages and other relevant information to this strategy. In this article I would like to present more deep in the money picks and why you need to have a complete game plan when trading options. Alcoa (NYSE:AA) is a stock I mentioned in my first article and if one had bought when I recommended Alcoa congratulations, the trade is above your break even price and you made some money. When reading SeekingAlpha articles I come across comments where people write (to other contributors) such comments as, "I am losing money what should I do?" Or "I have made money in a trade what should I do?" In my opinion as a trader you need to have a complete game plan before you begin the mission of being a successful options trader.

Prior to investing, I spent eight years in the U.S. Army. The skills that I have learned from the military still stick with me today. Sometimes I have a tendency to over analyze, but when constructing your mission of being profitable (whatever your strategy may be) one thing that I believe most traders can't disagree on, is why having a complete game plan from the time you start the trade to the time you exit the trade is important. When being involved in an options trade, if you're not sure where you want to exit, profit, accumulate, roll over or convert to a spread then success could be hampered. Everyone's game plan is most likely going to differ. Some investors focus on technical indicators and others use a blend of fundamental and technical analysis. When constructing a game plan for your trade, here are some ideas about what should be included. These are in no particular order.

1) Keep track of the stock and the option prices by using a trade journal. Write down important news facts, company events and what are the positive and negative effects of this news.

2) Buy low and sell high. Once you have a group of stocks that you have done some research on and are looking to make an investment your goal is to get the lowest price possible. Look at technical indicators such as Relative Strength, Bollinger Bands and Full Stochastic. For example, you do not want to buy when relative strength is over 70, which is considered overbought.

3) Give yourself enough time and within that time ask yourself where you would buy more, sell, rollover or convert to a spread. Before putting a trade on, ask yourself hypothetical questions on what are you going to do when you see your stock/option price move upward or downward. Practice using a play money account since option prices can move very rapidly at times. Time decay is also a big factor in options and a lot of times your idea is right, you just don't have the time. For more information on time decay click on this link.

4) Be Patient. Generally, I like to buy deep in the money calls at least 3 to 4 months out using the seep in the money strategy. The time decay generally won't be as volatile as weekly or front month options. Also, using a minimum of 3 to 4 months provides a buffer where you give yourself time to be profitable on the trade and can hopefully weather out any short-term storms. While it's important to watch your stock, you have to remember that your stock is not always going to go up. In my opinion the deep in the money strategy is a way for you to take advantage of a small movement in price. With a lower break-even point and a decent time frame, investors can have a higher probability to profit using options rather than tying up capital buying the common stock. Investors will always have to analyze the trade and should be prepared to ask themselves whether they should close out the trade; buy more on dips, rollover, etc.

5) Learning how to react. Reacting when a trade may not be going your way is important since this could save or make you a lot of money. Investors should have price targets on where you want to sell or buy more. Investors may not always hit their price targets, but this gives investors a reference point to where you might have to react. For example, let's say you have 10 deep in the money call contracts and you're now profitable; what do you want to do? Should you sell eight contracts and play with the houses money on the other two contracts? Or should you close out eight contracts and let the other two ride out, but sell upside calls thus creating a vertical call spread? I would suggest practicing this strategy first, using a hypothetical play money account so you know how to react to a situation and this will help you with your game plan.

While there are many more ideas one can put inside one's game plan, for the sake of time I only wanted to focus on five. I understand the market moves fast, but once you have a solid game plan just give yourself some time and you will be able to implement your strategies faster over time. If you liked the option play on Alcoa, here are some more deep in the money call picks that I am considering if these stocks pull back.

General Electric (GE)

I have been successful at trading General Electric ever since the stock was at 15 by buying the 13, 15 and 16 strikes and riding the momentum higher. My 2012 price target on General Electric is $20. As of January 23, 2012, Credit Suisse has a $22 price target as it cites, "industrial profits return to growth." If you believe that the U.S. will continue to get better General Electric is a conglomerate that give investors exposure to financial, industrial and medical sectors. This diversified exposure can also be seen as a defensive play. I feel that General Electric can get to $20, but after a nice 26% rally (if you were buying at 15) to its current price of 19.02 (at the time this article is being written) I would wait to pull the trigger. Currently, I am looking at the $18.50 level before buying a deep in the money call. In my opinion if the stock can hold above $18.85 then we may be able to make a run for $20, but if not I am going to watch the price action as this stock gets closer to $18.50

Bank of America (BAC)

Bank of America is another stock that has been on a tear ever since it was near $5 and investors have been making nice gains in the options market. When reading Frederic Ruffy's articles on options, this stock has a lot of big call buying going on in the April 8 strikes. For me, this has lately been more of a speculative trade, since there are better banks than Bank of America. While sentiment was generally bearish for 2011, it looks like 2012 is becoming a different story. I believe the stock will see $8, but I'd rather buy this one on dips and trade for a swing trade using deep in the money call options.

Ford (F)

Despite Ford missing earnings by 0.05 cents the last quarter, this stock has been up 19% in the last 60 days. In my opinion Ford is a stock that is a play on a continuing improving U.S. economic conditions and Europe. When reading through analyst's reports, Ford currently has a mixed view for 2012, and for every positive point on Ford you can find a negative one. When looking back on Ford, the last two years have been about growth, change and cost cutting (just to name a few). With Ford showing it can grow, change and effectively cost cut and still earn profit, I believe we are at the point where the stock is starting to look fairly valued. I am currently looking for $13-$14 as my price target for 2012. As mentioned in the trade above, I will be looking for deep in the money calls if the stock pulls back to $12 barring no major negative news.

Disclosure: I am long AA, GE.