There are various trading strategies -- some short-term, some long-term (even buy and hold). If one decides to use an option to implement a trading strategy, the time horizon of the strategy itself often dictates the general category of option which should be bought -- in-the-money vs. out-of-the-money, near-term vs. long-term, etc. This statement is true whether one is referring to stock, index, or futures options.
In this article, we'll lay out the basic types of option purchases that are dictated by the trading strategy being applied to the underlying. The general rule is this: the shorter-term the strategy, the higher the delta should be of the instrument being used to trade the strategy.
For example, day trading has become a popular endeavor -- at least if we are to believe the media reports. Statistics have been produced which indicate that most of these day traders lose money. In fact, there are profitable day traders -- it's just more and harder work than many are willing to invest. Many day traders have attempted to use options in their strategies. These day traders apparently are attracted by the leverage available from options, but they often lose money via option trading as well.
What many of these option-oriented day traders fail to realize is that, for day-trading purposes, the instrument with the highest possible delta should be used. That instrument is the underlying, for it has a delta of 1.0. That is, day-trading is hard enough, without complicating it trying to use options. So, if you're using a day-trading system based on S&P futures, you are most likely only complicating things if you try to trade it via S&P or $OEX options - trade the futures instead. For stock traders, this is equally true. If you're day-trading Facebook (FB), trade the stock, not an option.
What makes options difficult in such a short-term situation is their relatively wide bid-asked spread, as compared to that of the underlying instrument itself. Plus, since a day trader is only looking to capture a small part of the underlying's daily move, an at-the-money or out-of-the-money option just won't respond well enough to those movements. That is, if the delta is too low, there just isn't enough room for the option day-trader to make money.
If a day trader insists on using options, a short-term, in-the-money should be bought, for it has the largest delta available - hopefully something approaching .90 or higher. This option will respond quickly to small movement by the underlying stock, index, or futures contract.
Note that when we say "high delta", we are actually referring to the absolute value of the delta. That is, when buying calls we want to use ones with a delta of 0.90 or higher. But, if your strategy calls for shorting the underlying -- thus, buying a put if you are trading options -- then the put's delta should be -0.90 or less. That is, put deltas range from 0 down to -1.0, so a "large delta" for a put means that the absolute value of the delta is large.
Moving on to a somewhat longer-term oriented strategy, suppose you have one in which you expect to hold the underlying for approximately a week or two. In this case - just as with day-trading - a high delta is desirable. However, now that the holding period is more than a day, it may be appropriate to buy an option - as opposed to merely trading the underlying - because it lessens the risk of a surprisingly large downside move. Still, it is the short-term, in-the-money option that should be bought, for it has the largest delta and will thus respond most closely to the movement in the underlying stock. Such an option has a very high delta - usually in excess of 0.80. Part of the reason that the high-delta options make sense in such situations is that one is fairly certain of the timing of day-trading or very short-term trading systems. When the system being used for selection of which stock, index, or futures to trade has a high degree of timing accuracy, then the high-delta option is called for.
As the time horizon of one's trading strategy lengthens, it is appropriate to use an option with a lesser delta. This generally means that the timing of the selection process is less exact. One good example is using put-call ratios to select what to trade. While the track record of put-call ratios as a contrarian indicator is good, the timing of the forthcoming move is not exact, because it often takes time for an extreme in sentiment to reflect itself in a change of direction by the underlying.
Hence, for a strategy such as this, we want to use something with a smaller delta - figuring that we will limit our risk by using such an option, knowing that large moves are possible since the position is going to be held for several weeks - perhaps even a couple of months or more. Therefore, an at-the-money option can be used in such situations.
If one's strategy is even longer-term, an option with a lower delta can be considered. Such strategies would generally have only vague timing qualities - such as selecting a futures contract to buy, based on the general fundamental outlook for the commodity. In the extreme, it would even apply to "buy and hold" strategies.
Generally, I don't espouse buying out-of-the-money options in any event, but for very long-term strategies, one might consider something slightly out of the money. Or at least a fairly, long-term, at-the-money option. In either case, that option will have a lower delta as compared to the options that have been recommended for the other strategies mentioned above. In a similar manner, LEAPS options might be appropriate for stock strategies of this type.
The estimated holding period of a system's trades, and the exactness of the timing of the strategy, should dictate what type of option purchase is best used for that system: from very high delta options for short-term, exact timing strategies to low delta options for long-term, inexact timing strategies. If the options are extremely overpriced, though, it may be wiser to buy slightly deeper-in-the-money options than indicated above. Finally, note that this advice is for option buyers - if one is attempting an option spread, straddle, strangle or premium selling strategy, different option deltas and time horizons might be more appropriate.
Reprinted from The Option Strategist Newsletter, October 28, 1999.