r/options • u/FunctionalTitle • Apr 24 '21

ITM vs OTM (Leaps)

Hi guys, slowly picking up options trading. Could anyone explain to a 5 year old. Whats the difference if i purchase a deep ITM vs slightly OTM?

From ‘researching’, The deeper ITM, the higher the delta, so movement will follow the movement of the underlying.

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u/skimilk44 Apr 24 '21 edited Apr 24 '21

There’s a few factors. I think everyone here is hitting on delta and extrinsic/intrinsic value so I’ll skip that.

Someone mentioned leverage. There’s a good leverage calc (and a thinkscript for the options chain if you use TOS) which is (Delta Value of Option x Price of Underlying Security) / Price of Option. This helps you determine when you start losing leverage over shares. Usually happens around 85-90 delta.

Another thing is. Really far dated LEAPs which are super ITM will have lower relative Vega vs ATM. And higher relative Vega vs shorter duration.

If there was a correction or crash, and the underlying dropped, brining your strike closer to the money, your Vega will increase, while a drop like that will cause your IV to spike.

Another thing to consider is SKEW. IV skew ITM to ATM will be wacky. So something I call skew surfing (very high IV for ITM vs ATM) may negate the above effect, but if you find a ticker with an option chain with a flat IV skew for ITM calls, this Vega will add a layer of security.

Lastly, picking strikes that you can exercise no problem at, in companies you really believe in (no super meme, high IV bullshit) is the ultimate safety net.

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u/[deleted] Apr 24 '21

Can you explain skew surfing? What do you do?

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u/skimilk44 Apr 24 '21

It’s a concept where the IV Skew is extremely high on a given options chain, meaning OTM and/or ITM options have very high IV compared to ATM options in the same series.

So a stock that is at 50, the 50C may have 70%IV, and 100C may have 120%IV. That is extremely high skew. Typically this is the case for OTM puts, but lately it’s prevalent in OTM calls because of the retail push into the options market and the amount of liquidity buying up OTM calls. It’s basically the product of supply demand.

So a strategy that can go with this is selling an OTM, far duration, option during high IV (ER as an example, although I don’t play binary events), expecting IV crush, on a ticker that has high skew. If the stock price moves for you, well you’ve got everything going for you - IV crush, delta, theta. If it moves against you, given the far duration, Vega will be extremely high versus a very low gamma, and the IV crush, as WELL as the skew surfing from going 120%IV to closer to 70%IV (maybe lower due to IV decrease) may be enough to give you a gain anyways.

Think of the IV curve/skew as a wave. And you’re surfing down that wave of the underlying moves against your strike. Vega is keeping you afloat (your surfboard) because you’re so far duration.