When To Use "In The Money" Calls

Submitted by Daniel M. Harrison on November 6, 2007 - 7:58pm.

There has been some discussion as of late about the proper use of "in the money" options.

In the money call options are a type of option where the strike price of the option is below the stock price of the underlying asset. So, for example, if Google stock trades at $720, and the option's excercise value is $650 a share, the option is in the money, in the sense that when you cash in your option, it automatically pays out.

The problem is, in the money options are not a free ticket to riches, as many novice investors think of them. In a market with extreme volatility, an in the money option can leave you seriously out of pocket. Let's say Google plunges $50 tomorrow, and another $50 over the year: your in the money option, comparatively more expensive than a regular vanilla, is costing you a fortune and more to cash in.

The reason this debate has been around so much as of late is that the market has seen a stadily rising level of volatility recently. It's a counter-intuitive thought, but the more in the money you are in a high growth climate, the more at risk you are of losing your shirt.

Posted in | Daniel M. Harrison's blog »

Tatyana Shumsky said:
November 7, 2007 - 11:42am

I think it makes a huge difference whether you are holding a Euro or US style call.

An American December call gives you the freedom to cash in tomorrow if you'd like.

A Euro December call can only be executed on a specific day, say December 22.

Even if your Euro call is in the money now, you are still taking a huge bet on the company's shares being the same or higher in 2 months.

Combing through your reasoning, I find one flaw: you forget to mention premiums.

Time value, existing and potential upside, the volatility of the share - they all bear an impact on the price of the option: it's premium.

You bought a call with $650 strike, when the spot is $720. The difference, $70, is included in the call premium (the cost of the call).

Remember that is just one aspect. Let's say hypothetically, you paid a further $40 for the the time value, the volatility implied in the stock, et cetera.

This brings the total price of the call to $110. Realistically, Google needs to go up $40 for you to break even.

Let's assume Google drops down below your strike, you lose only what you paid: $110. You wouldn't exercise the option.

If it dropped from $720 to $680, you are still in the money, but you are netting a loss. By exercising the option and selling the shares at market, spot680 - strike650 = $30, you get a $30 profit. However, you paid a $110 premium, so you net a $80 loss.

Obviously $80 is a smaller loss than the $110 in premium, but you've clearly missed the money train.