Mastering Derivatives: Why long ITM calls are not optimal

Venkatesh Bangaruswamy | Updated on: Jun 30, 2022

Losses would be larger for ITM calls when prices move adversely

A reader of this column posed this question: In-the-money (ITM) calls have lower time value than at-the-money (ATM) calls. As time decays with each passing day, would it not be optimal to buy ITM calls? Is liquidity the only reason we should avoid buying ITM calls? This week, responding to the reader’s question, we provide reasons why long ITM calls are not optimal for trading.

Delta factor

When the Nifty Index was at 15898, the next-week 15900 Nifty call traded at 225 points, whereas the 15700 call traded at 341. The entire premium of the 15900 call consists of time value. The 15700, being ITM by 198 points, has 143 points of time value.

But before you conclude that ITM calls have lower time value than ATM calls, you may want to check the time when the last trade was executed for the ITM call. Typically, traders prefer ATM and immediate out-of-the-money (OTM) calls to ITM calls. This is because ITM calls have higher absolute premiums. This means the last traded price of the ITM call could well reflect the premium paid when the index was at a lower level, say, 15800 and not 15898. So, time value would be higher than what we determined above.

Even if ITM calls are traded, the volumes would be lower. This, in turn, has a bearing on the time value. Why? Note that the time value is the function of time to maturity and implied volatility. A higher instantaneous demand for a strike will lead to an increase in its premium. This increase in premium feeds into the option price through implied volatility, which is a component of time value. Conversely, lower demand for a strike could lead to lower time value. Perhaps, this is the buyer’s way of demanding a risk premium (lower price) for lower liquidity.

There are other factors that you must consider before buying ITM calls. What happens if the underlying declines after you buy an ITM call? Suppose the Nifty Index declines to 15800 after you buy the 15700 call, the option could lose 62 points. In comparison, the 15900 call could decline by 48 points. Note that we assumed that the decline happens during the day to emphasis its impact on the option price without considering time decay. The ITM call tends towards ATM as the underlying declines. This means the ITM call will lose some of its intrinsic value when the underlying declines. This is the reason losses would be larger for ITM calls compared to ATM calls when prices move adversely — another reason why you should not buy such strikes.

Take note
Delta of the ITM call will decline as the underlying declines
If implied volatility increases, the delta of ITM options decline
Less liquidity means you cannot easily close your position to take profits

Optional reading

The delta of the ITM call will decline as the underlying declines. True, the gamma will slow down the decline in the delta when the underlying moves down. Nevertheless, the loss in intrinsic value could be large. There is another issue about ITM calls. If implied volatility increases, the delta of ITM options decline. Why? When volatility is low, an ITM call is more likely to stay ITM till expiry. Likewise, an OTM is more likely to stay OTM till expiry. But when volatility increases, ITM is more likely to become ATM. Likewise, an OTM call is more likely to become ATM. Therefore, when volatility increases, delta of the ITM call will decline while that of the OTM call will increase. A decrease in delta for ITM calls means that the change in option price is smaller for a one-point change in the underlying.

Finally, as our reader noted, ITM calls are less liquid. While this is generally true, it matters when you are trading options with European-style settlement. Less liquidity means you cannot easily close your position to take profits. For all these reasons, it is better to buy an ATM strike or OTM options within two strikes of the ATM.

The author offers training programmes for individuals to manage their personal investments

Published on June 30, 2022
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