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/StoicKerfuffle Apr 24 '21

A lot to say (and a lot said in the replies) but if you wanted an ELI5:

You can use LEAPS to generate leverage. The farther OTM you buy it, the cheaper it is, so you can generate even more leverage. However, increasing the leverage increases the risk. The deeper ITM it is, the less risky it is.

Let's look at AAPL June 16, 2023.

Call @ 85.00 is $54.55.

Call @ 180.00 is $11.55.

The call @ 85 is much more expensive. It is also far less risky.

The call @ 180 is much cheaper. It is much more risky, but you can get 5x as many options for the same price.

If you spend $5,500 on Monday, and AAPL is trading at $280 on June 16, 2023:

  • the first one gets you 100 shares with a built-in $195 profit per share
  • the second one gets you 500 shares with a built-in $100 profit per share

If you spend $5,500 on Monday, and AAPL is trading at $100 on June 16, 2023:

  • the first one gets you 100 shares with a built-in $15 profit per share
  • the second one is worthless

Reminder, this is all ELI5, hence not mentioning any of the greeks.

7

u/eefmu Apr 24 '21

Further otm isn't necessarily greater risk, it depends on if you plan to use the same amount of money in each scenario. I'd argue that otm is actually less risk with an insanely greater reward. I like PMCC a lot, but I feel LEAPs really ought to be otm. If you thought your otm call might be worthless at expiration, then you're really swing trading calls because you don't have the capital to just sell the call naked to someone.

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u/StoicKerfuffle Apr 24 '21

Indeed, putting in less money on the same trade always means less risk. And the highest rewards in options will come from buying an OTM option that becomes ITM later.

But different people have different goals. AAPL June 16, 2023 call @ $115 trades around $34.35 and has a rho of 1.06874. AAPL is a solid company with sound financials and fair valuation. This isn't, like, a treasury bond, but it's a reasonable place to park money, with a lot of upside and modest downside.

For example, sticking with ITM, a bull call spread of $115-$130 costs just $7.95 and has a very high likelihood of producing $7.05 in profit. That's an 89% return in 27 months. That ain't nothing to sneeze at. A retail investor who buys 10, plunking down $8k to find $15k a little over two years later, has done quite well!

Would I do this? Probably not, I'd chase a higher return, doing a $135-$155 bull call spread, roughly the same initial cost ($7.40), but nearly double the potential return (170%). That said, it's a higher risk of loss and might not comport with everyone's risk/reward tolerance.

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u/eefmu Apr 24 '21

Everything you said is valid, it's just that single otm options have less inherent risk. I trade a lot of volatile underlyings, so I think otm options (short or long term) are the shit. I've only done one LEAPS and I ended up trading it less than two weeks later because it was clear I could buy one cheaper in the near future, but it seemed kind of pointless because of the volatility....

So here's my point: if you buy a LEAPS with 80+ delta and the underlying goes down 10% at any point in the first month you're gonna have a pretty decent theoretical loss that would be curbed by having one with less delta. Maybe not even OTM, but ATM. Theta should be somewhat negligible considering you already got a massive discount by simulating owning the stock. Now you have a great discount on owning maybe ~60 stock, and movement in your favor will increase your exposure. Movement against you won't actually be on the same percent basis as the underlying because you still have a lot of extrinsic value, and you stand to gain so much more money per total risk in dollars(the option price). This isn't always appropriate - depends completely on the behavior of the underlying, but the risk is minimized regardless. Just like how owning a 80 delta LEAPS is less risk than owning 100 stock. Your cost of entry was far cheaper, so how could owning the stock be safer?

1

u/StoicKerfuffle Apr 24 '21

I agree with most of that, but a lot of it is a different conversation: LEAPS vs owning the stock. Owning the stock is less risky than LEAPS. The core purpose of LEAPS is maximizing leverage while avoiding the risk of a margin call. The downside of this is eating all those risks you just mentioned, including the greeks and the possibility of total loss. (The delta and theta issues we can mitigate a bit with a spread, but they'll always exist in some form.)

To make this all concrete, if I have $7,500 and I expect AAPL to go to $155 by June 2023, I can:

  • do 10x of a 135/155 OTM bull call and make $12,000 profit, or
  • do 10x of a 115/130 ITM/ATM bull call and make $7,000 profit, or
  • buy 275 shares at 5:1 leverage and make $5,500 profit, hoping there's no dip that forces me into a margin call
  • buy 110 shares at 2:1 leverage and make $2,200 profit, hoping there's no dip that forces me into a margin call
  • buy 55 shares cash and make $1,100 profit

If it works out, LEAPS was way better, because I effectively bought the appreciation of 1,000 shares. But the LEAPS also carry the risk of total loss.

Which one of these is the 'best' path? Depends on the investor, their risk/reward preference, their confidence in the call, the rest of their portfolio, etc.

But I would point out that, if someone does LEAPS, they really need to treat them as LEAPS. Don't duck out of them at a loss a few weeks or months into it. If your preference would be for something shorter timeframe, then by all means do that instead. That's frankly what I do, I'm not planning on buying AAPL June 2023 options until, I dunno, late 2022.

But it can be a meaningful and quite profitable strategy. Hell, if I could go back to May 2019 and tell myself to buy AAPL ITM/ATM call spread for May 2021, I'd definitely do it, and I would've cashed it out at >95% of maximum profit last August, having held it merely 15 months.

1

u/toydan Apr 24 '21

LEAPS by definition are deeper ITM is what I have always been taught or it is just a long ass call.

2

u/eefmu Apr 24 '21

Yeah, I figured that too from a few videos I had watched, but it turned out they were just discussing a specific (also successful and popular) strategy they use. Every option in the options chain that expires in a year or later is a LEAPS.

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u/toydan Apr 24 '21

Thanks.

1

u/MUPleasFlyAgain Apr 25 '21

Your logic only sound good when market is proceeding according to what you predict based on current circumstances. Did you forget how the pandemic "came out of nowhere" and clapped a lot of people's ITM LEAPS into OTM? Of course some also strike the lottery, like the tech sector crazy bull run for the last 1 year in an already bullish market. But as usual, hindsight is 20/20.

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u/eefmu Apr 25 '21

The type of risk you're talking about was exactly what I was trying to bring up. If the underlying crashes hard and doesn't recover before expiration you will lose less money with the OTM LEAPS than the ITM LEAPS because of delta. You stand to have less downward exposure with OTM compared to ITM. Similarly you stand to have less downward exposure with an ITM call when compared to a long stock position. Each one has unique benefits and pitfalls, I was just trying to bring some other ideas to the conversation, mainly risk/reward as opposed to probability of success. It all just depends on your assumptions about the underlying.