Trading DITM (Deep-in-the-Money) options is one of the best swing trading strategies out there. By exploiting the high Delta of an option contract, you can trade stocks effectively for only half the risk you would incur with normal swing trading. If you can buy the rights to the same number of shares for half the price, but still make the same profit, you will effectively double your return on investment.
This is a great strategy for those who are still a bit afraid of buying options, but love the challenge of trading stocks and want to get some leverage on a trade, as well as reduce the overall risk and cost of investing. The reason it can be such a rewarding strategy is that it not only doubles the leverage on a stock trade, but also minimizes the effect of time decline on the value of the option. Swing trades typically last three to ten days, and if you trade a DITM option during this short period, the time decay will not significantly affect the option price.
How are DITM options exchanged?
First: choose your action.You can use one of your favorite stocks or you can run a scan for “ready to roll” stocks that are perfect for DITM options. I find Stockfetcher to be the best free resource for finding these stocks, and I have a few scans set up for this purpose.
Second: Technical Analysis.You will need to perform the following steps to identify a good swing trade that is suitable for a DITM option trade:
- Trend analysis. Establish the trend of both the Market and your stock. Don’t try to buy calls in a falling market!
- Oscillation analysis. Find stocks that have fallen to the bottom of the trend band. These are stocks that trade between the 10th and 30th.
- Turn confirmation. Confirm the swing with Japanese candlestick patterns. Check the RSI and VIX to make sure a swing reversal is not imminent.
Third: Choose your Option and buy it!
- Open an option table showing the DELTA of the option. Your broker’s software should have this feature. Either that or use an options calculator, for which you will need to know the volatility of the options. Choose an option that has a DELTA that is at or close to 100.
- Option value. Don’t buy overpriced options! You will see the value of your trade vanish. You will need to use software for this. I highly recommend Volcone Analyzer Pro for this (the only part of this method that isn’t free!).
Fourth: Set your Stop Loss and Profit Target IMMEDIATELY!
Remember, this is not gambling! Your swing analysis, and confirmed by a look at support and resistance levels, will help you do this.
- Stop Loss – If you normally set a stop loss of around 4% for your stock, set a stop loss of around 8-10% for your option.
- Target Profit – Set a profit target based on the movement of the underlying stock. Simply add the dollar value of your anticipated gain to the option price, or use the Option Calculator to calculate it. Or use an end stop, whichever is your preferred method. Sell the option as soon as you reach your profit target – don’t wait until expiration, otherwise you will lose 100% of your investment! Plan to exit the trade within 10 days or so; if it hasn’t moved by then, the swing analysis dynamics would have changed and your trade is at risk.
