A long time reader wrote in asking if you get more bang for the buck buying an out of the money option, or a deep in the money option on a stock that makes a big move. Interestingly the answer isn’t perfectly cut and dry. Let’s look.

If you buy an in the money option, that option will indeed track the movement of the underlying stock more closely than an at the money option. The Delta or measure of value is much higher, so when the stock moves, the option tends to move also.

If you buy an out of the money option, the stock can actually rise a bit, and yet your option could actually fall. How? When an option is out of the money, the entire value of the option is simply based on time. For instance, lets say the XYZ company is trading at 50 bucks a share. The September 60 dollar call options are 75 cents. That 75 cents is all time value considering the fact that XYZ is still ten dollars shy of the strike price.

So, it’s quite likely that XYZ could move up to 52 dollars a share, which is a two dollar move, and yet the September call option falls to 50 cents. Why? We have come closer to the expiration day, and some of the time value has eroded.

In a deep in the money option, a 2 dollar stock move could be as high as a 1.95 move in the option. So, looking at it like that, standard theory says that deep in the money options will move more on a big stock move and for the most part you can consider that to be true. But there is always the exception, and if you look at percent returns, that’s where things really get screwy.

Let’s say you bought September 25 dollar calls on XYZ. You paid 29.00 for them, considering that XYZ is 50.00 a share, you are already 25 bucks in the money and they are charging a 4 dollar premium over that for time. Now, XYZ announces that it’s cured cancer and runs to 90 dollars a share. Your call option is going to soar. At very minimum it’s going to be worth 65 dollars, and more likely over 70. So, you’re return is quite nice right? Right. In fact you’ve made somewhere north of 124%.

But, lets say you had those XYZ out of the money 60 dollar calls for just 75 cents. If XYZ ran to 90 those calls would be worth a minimum of 30 bucks, if not 35 ( depending on how much time was left) Now look at the percent return. It’s 3,900 percent.

So, here’s the deal. For the most part, deep in the money options will reward you more frequently and with more gains than at the money or out of the money options. But, in those rare events where a home run gets hit, an out of the money options bought for pennies will far outperform any in the money options.

You’re better off buying deep in the money and using smart trading strategies. But occasionally it’s a lot of fun to be able to say I made 2000 percent on my latest trade! Think about it.

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The cyclical bull market, which began in March 2003 (or October 2002 by some estimates), within the structural bear market, that began in March 2000, was fueled by monetary policy. The FOMC began an easing cycle in January 2001 when it lowered the Fed Funds Rate from 6.50% to 6%. The FOMC continued to lower the Fed Funds Rate, until it reached 1% in June 2003, and kept there for a year. In June 2004, a tightening cycle began. The Fed Funds Rate reached 5.25% in June 2006 (to neutral from accommodative), and then the FOMC paused in August for the first time in over two years. Consequently, there has been a great deal of speculation that the tightening cycle is over (a restrictive stance won’t be taken) and perhaps an easing cycle will begin in 2007.

Below is a daily chart of NYSI (red line and right scale) and SPX (black line and left scale). NYSI made lower highs, while SPX made higher highs over the cyclical bull market. Currently, NYSI is near the top of the downtrend line, which indicates SPX is near an intermediate-term top, although NYSI pinpoints lows better than highs. Below the price chart is the NYMO 50-day MA, which is at a level similar to recent SPX intermediate-term tops. However, sentiment indicators, including the CPC 50-day MA (above price chart), which fell from an all-time high, and AAII and ISEE (not shown) show a great deal of pessimism, which is SPX bullish. It seems, almost everyone is expecting SPX to fall.

So, monetary policy and intermediate-term technical indicators are market bearish, while sentiment indicators are market bullish. Also, mid-September through much of October is historically the weakest market period. Consequently, there are major mixed signals. Nonetheless, the intermediate-term uptrend will turn into a downtrend at some point before the end of the year, if it hasn’t turned already. Given December and January are bullish months, there may be an intermediate-term downtrend in September through November. However, sentiment indicators suggest an SPX trading range, although a quick rise to 1,350 and/or a capitulation below 1,200 shouldn’t be ruled out. Unfortunately, there’s little clarity at this point.

Free chart available at http://www.peaktrader.com Forum Index Market Forecast category.

Arthur Albert Eckart is the founder and owner of PeakTrader. Arthur has worked for commercial banks, e.g. Wells Fargo, Banc One, and First Commerce Technologies, during the 1980s and 1990s. He has also worked for Janus Funds from 1999-00. Arthur Eckart has a BA & MA in Economics from the University of Colorado. He has worked on options portfolio optimization since 1998.

Mr Eckart has developed a comprehensive trading methodology using economics, portfolio optimization, and technical analysis to maximize return and minimize risk at the same time and over time. This methodology has resulted in excellent returns with low risk over the past four years.