Credit: For beginning investors, the world of options can seem incredibly byzantine and utterly inaccessible.
[caption align="alignright" caption="Options aren't just for the big boys on Wall Street"] 
[/caption]
While more complex strategies like butterflies and iron corridors are inappropriate for non-sophisticated traders, there exist a number of options techniques that can enhance the portfolios of somewhat knowledgeable investors. One such strategy is to use deep-in-the-money options.
As Emerging Money writer Rich Rittorno discussed a few weeks ago , delta is very important when evaluating the effectiveness of a given option. While the other 'Greeks' - Greek-derived words that represent various elements of an option, are important for more complex strategies, for basic investors looking at a deep-in-the-money option, having a fundamental understanding of delta is sufficient.
The definition of delta is as follows : The ratio comparing the change in the price of the underlying asset to the corresponding change in the price of a derivative. While the definition seems inordinately complicated, in practice, it's quite easy. Simply, delta represents how much the value of an option will increase for every point gained/lost in the underlying equity.
For example, if an investor were to purchase a call option with a delta of .90, said investor would expect his option to increase by 90 cents if the stock were to increase by a point.
It is this fundamental concept that makes deep-in-the-money options attractive to long-term investors. By finding options with high deltas, long-term investors are able to increase their leverage to a given equity, while taking nearly full advantage of a move in the underling equity.
Let's take a real life example: Many investors are bullish on Apple ( AAPL , quote ) but also feel that $58,000 is a lot of money to pay for 100 shares. However, an investor could purchase a January 2013 425 call with a delta of .90 for roughly $16,500. While still expensive, such a strategy would allow for an investor to make 90% of the profits as if he purchased 100 shares of AAPL, but for less than a third of the price.
This does beg the question: Why would I suggest using an option that is so expensive, when an investor could buy a Jan 13 580 call for only $5,700? Simple: that option's delta is a mere .55. Looking at delta from a different perspective, the metric can also be used as an indicator of how much or little premium is baked into the options price: the lower the delta, the higher the premium, and vice versa.
Investors new to options are often seduced by the superficial cheapness of out-of-the-money options . However, because out-of-the-money options consist entirely of premium and no intrinsic value, a given stock would have to make a major move in order for such a strategy to be lucrative. In the event that the stock moves lower or stays even, the premium dissipates as the expiration date approaches. Because deep-in-the-money options have little premium, this time decay doesn't work as hard against you.
Essentially, this is why deep-in-the-money options are a great strategy for long-term investors, especially compared to at-the-money and out-of-the-money options. By gaining exposure to a given equity for a fraction of the price as owning one hundred shares of the underlying stock, while maintaining capital in the event your investment plan does not materialize as envisaged, deep-in-the-money calls can be a fantastic instrument, even for new investors.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
