Why trade Deep-in-the-Money Options?

Why Trade DITM Fx Options?

Profit from the FULL movement of the price. DITM options exploit the power of DELTA, which is the greek symbol that measures the rate of change of the price of an option. If the Delta of an option is 0.98 , that means the price of the option will change by 98 cents for every $1 change in the price of the underlying currency pair.
Buy the currency pair for far less than the initial margin you will be paying to a broker. Trading DITM options is EXACTLY the same as swing trading. Short term, in and out - a trade is seldom carried for more than 10 days. Doing it this way means you don't have to keep buffer cash in your account to face temporary loss or drawdown and get affected psychologically.
DITM options have a lot of intrinsic value and less time value.

Buying DITM (Deep-in-the-Money) options takes full advantage of the DELTA of an option, so that swings in the currency pair price are matched dollar for dollar with the changes in the value of the option and you get better return on Investment in margin deposit.

This a great strategy for those who are still wary of buying OTM or ATM options for fear of losing by way of Time Decay value , but want to trade like spot currency and want to reduce overall risk and cost of investment by way of Margin.

Theta represents the portfolio's sensitivity to the passage of time by indicating the rate at which the market value of your portfolio will change with time. This metric calculation is based on the assumption that all other variables remain unchanged, including the underlying price, implied volatility and interest rate.

It suits traders who are afraid of losing money through Stop Loss but have a firm bias for Direction and the timeline within which they expect the currency pair to go their way.

Example: I have a view that EURUSD will weaken in a couple of days (maximum of 10 days) from its existing futures price of 1.1333 and is likely to drop to 1.1183, a difference of 150 pips. The 150 pips will be my profit if the trade goes in my favour. If because of market sentiment, it drops by 50-60 pips in a couple of hours, I may take profit and not necessarily wait for the 150-pip drop.

Taking this view, I have a choice of choosing instruments depending on my expectation of returns and investment criteria.

Unit of investment: US$125,000 the value of a standard EURUSD contract offered by Chicago Mercantile Exchange.

Expectation of Return: US$1250 or 100 points (pips) of profit

Choice of Instruments

1. Exchange money : My view is that USD will become stronger. So I will purchase US dollars from a currency exchange dealer. And sell it back when Euro drops.

Return on investment of US$125,000 : 1%. Loss: Can not define in advance.

2. Forex Leverage: FX broker provides you leverage or credit facilities after collecting a cash collateral for setting up margin deposit. The broker will lend the money to trade for the full contract value and charge an interest fee (swap costs) on overnight balance. The broker will ensure I keep enough maintenance money in my account to bear the loss or temporary loss.

I have to put up a margin deposit of 5% of contract value if the broker extend me a leverage of 20 times of the margin (SFC in Hong Kong permits maximum leverage of 1: 20) in addition to keeping maintenance margin (buffer cash) to cover my temporary loss. If I buy a spot fx contract of US$125,000, I should start with a deposit of US$10,000. Initial margin will be 5% or US$6,250 and balance of $3,750 as maintenance margin and buffer cash

Return on investment of US$10,000 in margin deposit: 12.5%. Loss: Uncertain. Can not define in advance.

3. Currency Futures: Chicago Mercantile Exchange (CME) provides me the leverage and the price includes interest fee upfront . So the broker does not charge me interest fee and just collects enough margin deposit and ensures I keep buffer cash in my account to bear the loss or temporary loss.

I am required to pay Initial Margin of US$3,478 and Maintenance Margin of $2,783 (Total: $6261) plus keep $3,739 as buffer cash.

Return on investment of $10,000 in margin deposit : 12.5% .Loss: Can not define in advance.

4. Currency Futures Options: CME provides me the leverage and I pay just the purchase price (plus commission) to the broker. I enjoy the leverage provided to me by the exchange and I don't need to pay any margin deposit to the broker. I can buy options which are Deep Out-of-the money (DOTM) Out-of-the-money (OTM) or At -the-money (ATM) or In-the-Money (ITM) or Deep In-the-money (DITM) depending on my investment outlay.

Investment will be in buying of the option and setting up minimum account balance required by a broker and not for margin deposit. If, for instance, an option purchase price costs US$250, then you just have to invest that amount. But brokers will not set up an account just with US$250. They need a minimum account opening amount.

Interactive Brokers needs US$10,000 to open an account. After that you can take out as much as you want and they let you trade as long as you have enough to cover the purchase price of future option or margin on the instrument you are selling.

A few brokers just need US$1,000 in your account to begin trading. They allow only buying of options and not selling of options.

Loss: Defined before Trading.

Location of Strike Price vis-a-vis the existing spot price determines the purchase price of options.

If you buy at a price which is out of the money by .........points will cost ............

(a) Buy DOTM: No intrinsic value. You can buy an DOTM option from..........

(b) Buy OTM: No intrinsic value. You can buy an OTM option from ...........

(d) Buy ITM: Have intrinsic value. You can buy ITM option from .........

(e) Buy DITM: Have more than 85% intrinsic value. You can buy DITM from ................

Why did I choose DITM?

I bought a DITM with a strike price of 1.17 with 60 days expiry. I don't have to put up any Margin or worry about Margin Call. I am buying outright an option. I bought the Put option (my view is price will drop) when the underlying Futures price was 1.1330. I paid 380 points (or pips) premium. In return I got intrinsic value of almost 366 pips. Extrinsic value or Theta is 14 pips (roughly 0.36% of the option price). My total buying cost is 380 pips or US$4,275 that includes $154 towards Time decay cost.

If I were to buy option at a strike price of 1.1450 (when underlying futures price was 1.1329) and at a delta of 78%, I could buy it by paying 138 pips valued at US$1,725 for the expiry period of less than 4 weeks. In this case because delta is 78% the price will not move dollar to dollar, with the time decay value costing more.

See the picture below:

What happens when price moves in my direction?

If after I buy at 310 pips and the price drops by 100 pips next day I will immediately gain by 98 pips because of a delta of 0.98.

When I buy at lower price I have to pay more for Time Value (shown highlighted in Yellow)

If I buy with 138 pips premium and the price drops by 100 pips next day, I will immediately gain by 68 pips because of lower delta of 0.78

In both cases, I can sell back the option to the market any time prior to expiration. If, it takes ,say 10 days or even 55 days (Expiration is 60 days) for the price to drop I will gain between 95%-98% (depending on the delta) for every 100 pips decrease. In this period of 50 days the price might have travelled upwards crossing even the strike price by 100 pips to touch 1.18, the trade remains (though the value of the option will drop temporarily), unless I choose to close it. I will wait for a reversal favouring my trade . In the meantime, my option price will keep increasing or decreasing and without me having to put in any additional margin.

My loss is defined when taking the trade. I know what I am doing and my psychology stays stable. I can sell the option anytime I feel my direction bias is not going to work.

How does ATM or OTM Work?

Options that are ATM (At-the-Money), or trading very close to the price of the currency pair, usually have a Delta of between 45 and 55, and for most currency pairs, hover around 50. This means that when a currency pair moves, only 50% of that move is captured by the change in the price of the option. So, if the currency pair price increases by $10, an option with a delta of 50 will change in price by $5 . ATM options (or near-the-money options) are cheap, but their price movement is much smaller than that of the underlying currency pair.

The choice of DITM options is based on the fact that you will find options (calls or puts) that have a delta of 98 or as close to 100 as you can find. This means that for every dollar that the position increases or decreases, price will nearly be matched by the option.

If you have less funds, still you can go ahead and choose a striking price that meets your budgetted investment.

Now, if your DELTA is 100, or close to 100, you will get the full benefit of the swing. Percentage wise, it is even better! For example, if you are aiming for a 7% profit swing in your price, the effect will be a 10% of what you have paid for margin deposit. Much better odds!

Trading DITM options is an excellent method of exploiting the DELTA of an option, whereby you can take full advantage of the price movement of an underlying, get double the Return on Investment, or effectively buy stocks for half the price

Advantages of Trading DITM Calls and Puts:

You invest less money to capture the full movement of a currency pair; it reduces your risk.

You gain about 98% of the price movement;

Not only you have less downside risk you can extricate yourself out of the situation any time when your view about the market changes.

You get a higher return on investment (ROI), You enjoy a higher leverage than the offered by broker accepting your Margin deposit.

NOTE:

Base your trade on a movement in the currency pair that you anticipate because of your skill in Swing Trading. Do not buy options that have too much time incorporated - DITM options are also affected by Time Decay!

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