Deep in the money Options

F

frostengine

I have a swing trading strategy with an average holding period of 3-10 days. The strategy trades only the DOW 30 stocks. I plan to use approx 30k of my account trading this strategy. After margin I would have roughly 60k for overnight holdings. The system is designed to put roughly 10k into any one trade.

However the system often has more than 6 active positions. This uses up all of the 60k buying power. The strategy is designed to take all signals, therefore selecting at most 6 active positions is not an option. Reducing 10k into each trade is not an option either.

Therefore, what I am thinking of doing is buying deep in the money calls instead. This should in theory give me more leverage and allow me to hold more positions at a time. I have a few concerns/questions that I do not yet know the answer to.

#1 How much do I gain using this method? Glancing at a few options on DOW stocks it looks like a typical 10k position will cost me 1 to 2k instead to open using DITM options. Does this seem realistic? If so I should be able to open closer to 15 positions at a time instead of 6.

#2 My next fear is related to the spreads on DITM options. I have not done much trading in DITM options before so I am not too familiar with typical spreads. I know with most ATM options splitting the spread and placing the order at the midpoint seems to normally work. Does that hold true on DITM options as well?

#3 Extrinsic value concerns. Most DITM options will have only a slight premium I would imagine. If I am holding for only 3 to 10 days, is it likely I will get most of this premium back when I sell? I know these options should lose premium much slower than ATM.

Are there other issues I should look into about using this method to increase the number of positions I can open at a time?
 
Your idea in theory is good, but not in practice. ITM options that have close to a 100 delta typically have wider spreads. The cost of entry and exit will get expensive. If you have enough assets for a Customer Portfolio Margin account, you can get up to 6.67 to 1 leverage to run your strategy.

Bob
 
frost - i use a similar strategy. since i'd like to capture a large part of the "middle move" (not top or bottom) i want higher rather than lower deltas but the spreads are usually so wide that it gives up a substantial portion of profit (or adds to losses!). so i stick to between .5 and .75 for delta. be careful buying calls w/ a lower delta (.5 rather than .9 or .95) b/c the iv drop will kill the option premium if the UL rises as you expect it to.

you're correct that since you're only holding for a few trading days you won't lose much time premium. but never do this buying the front month unless you have at least 2 weeks until expiry and then it's still risky b/c the theta bleed is exponential. i'd suggest going out another month (front+1).

another suggestion (not telling you how to trade just advice) is if you're only buying calls what happens when the black swan hits - how will you protect yourself? try placing a small amount of your port (10-20%) in otm dia puts. you'll take a loss on these most of the time but the one time that the market gaps down 10% b/c of whatever you're going to be glad your account is mostly intact instead of wiped out.

if you have any other suggestions for me (or anyone else) pls post them so we can all improve.
 
I just assumed you could overcome those wide spreads on DITM options by submitting close to the mid point and the MM would fill you. Maybe submit the order a few cents above midpoint. No reason a MM should not fill you there and take their arbitrage opportunity. Does this not work in practice? Based on these responses sounds like you have to essentially eat the whole spread to get filled?

Another option I am kicking around is using Synthetics instead. This will get me only a little extra leverage maybe 12 positions instead of 6 or so. The problems I have here are:

#1 Two spreads instead of 1. But they will be ATM on highly liquid dow stocks so spreads should be very thin.

#2 Two commissions instead of 1, but with IB the commissions are pretty low on options so not much of an issue

What other issues might I run into using a Synthetic position (long call, short put).
 
Quote from frostengine:

I just assumed you could overcome those wide spreads on DITM options by submitting close to the mid point and the MM would fill you. Maybe submit the order a few cents above midpoint. No reason a MM should not fill you there and take their arbitrage opportunity. Does this not work in practice? Based on these responses sounds like you have to essentially eat the whole spread to get filled?

Another option I am kicking around is using Synthetics instead. This will get me only a little extra leverage maybe 12 positions instead of 6 or so. The problems I have here are:

#1 Two spreads instead of 1. But they will be ATM on highly liquid dow stocks so spreads should be very thin.

#2 Two commissions instead of 1, but with IB the commissions are pretty low on options so not much of an issue

What other issues might I run into using a Synthetic position (long call, short put).
More...

A MM trading the other side electronically will most likely look for around .05 of edge on each side with those ITM options. That means, that buying and selling those options instead of stock where it was trading at the time, your giving away at least .10 round trip, and might miss doing the calls at the time you chose, with limit orders.

I synthetic long position with a long call, short put in a REG-T account will not give you any leverage. In a PM account, your haircut will be similar. There is really no advantage to doing this with options, as long as the options are priced correctly for the current market.

You can call me if you'd like to ask more questions.
 
My expectancy per trade is .50 per share. Therefore giving up .10 per share in spread may not be that bad of a trade off for having the ability to increase the number of positions
 
Quote from frostengine:

My expectancy per trade is .50 per share. Therefore giving up .10 per share in spread may not be that bad of a trade off for having the ability to increase the number of positions
More...

You can increase the number of trades by using portfolio margin. You can find a partner or an investor. In the above instance, your giving up 20% edge vs straight stock trading. You have to take into account that your expected return is .50/trade, but do the math with the times you lose money and the times you break even. Then remove 20%.

I believe a traders job is to find edge. Then do it over and over until it stops working, and you lose your edge. Then, find it some place else. By using ITM, illiquid, wider spread strikes, your losing your edge vs the common.

Just my opinion.......
 
Quote from frostengine:

Therefore, what I am thinking of doing is buying deep in the money calls instead. This should in theory give me more leverage and allow me to hold more positions at a time. I have a few concerns/questions that I do not yet know the answer to.

#1 How much do I gain using this method? Glancing at a few options on DOW stocks it looks like a typical 10k position will cost me 1 to 2k instead to open using DITM options. Does this seem realistic? If so I should be able to open closer to 15 positions at a time instead of 6.

#2 My next fear is related to the spreads on DITM options. I have not done much trading in DITM options before so I am not too familiar with typical spreads. I know with most ATM options splitting the spread and placing the order at the midpoint seems to normally work. Does that hold true on DITM options as well?

#3 Extrinsic value concerns. Most DITM options will have only a slight premium I would imagine. If I am holding for only 3 to 10 days, is it likely I will get most of this premium back when I sell? I know these options should lose premium much slower than ATM.

Are there other issues I should look into about using this method to increase the number of positions I can open at a time?
More...
The answers to #1 and #3 would be obvious by observing some option chains over the course of a few days.

As for #2, splitting the bid is fine for working your way into positions or trying to exit positions a stagnant underlying. But if you have to get out, expect to pay the full load.
 
Quote from rmorse:

I synthetic long position with a long call, short put in a REG-T account will not give you any leverage. In a PM account, your haircut will be similar. There is really no advantage to doing this with options, as long as the options are priced correctly for the current market.
More...
Naked option margin is approx 20% versus overnight equity margin of 50% so a synthetic provides better than twice as much leverage.
 
Quote from frostengine:

My expectancy per trade is .50 per share. Therefore giving up .10 per share in spread may not be that bad of a trade off for having the ability to increase the number of positions
More...
Again, a fairly simple answer. If the system is vibrant enough to overcome the add'l slippage and commissions then leveraging via options is a good thing. If not, it's bad.
 
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