Trading DITM options (thorough-in-the-Money) is one of the best swing trading strategies around. By exploiting the high Delta of an option contract, you can effectively trade stocks for only half the risk that you would incur with normal swing trading. If you can buy the rights to the same amount of stock for half the price, but nevertheless make the same profit, you effectively double your return on investment.
This a great strategy for those who are nevertheless a bit scared of buying options, but love the challenge of swing trading stocks, and want to gain some leverage on a trade in addition as reducing overall risk and cost of investment. The reason that it can be such a rewarding strategy is that it not only doubles the leverage on a stock trade, but the effect of time decay on the value of the option is minimised. Swing trades usually have a duration of three to ten days, and if you trade a DITM option for this short period, time decay will not considerably affect the price of the option.
How do you trade DITM Options?
First: Pick your Stock. You can either use one of your favourite stocks, or you can run a examine for “ready-to-roll” stocks that are perfect for DITM options. I find that Stockfetcher is the best free resource for finding these stocks, and I have some scans set up for this purpose.
Second: Technical examination. You will need to perform the following steps in order to clarify a good swing trade that is appropriate for a DITM Option trade:
- Trend examination. Establish the trend of both the Market and your stock. Don’t try and buy calls in a falling market!
- Swing examination. Find stocks that have dipped to the bottom of the trend band. These are stocks that are trading between the 10ma and 30ema.
- Swing Confirmation. Confirm the swing with Candlestick Patterns. Check the RSI and VIX to make sure that a swing reversal is not imminent.
Third: Choose your Option and buy it!
- Pull up an options table which shows the DELTA of the option. Your broker software should have this characterize. Either that or use an Options Calculator, for which you will need to know the volatility of the options. Pick an option that has a DELTA that is at or close to 100.
- Option Value. Don’t buy overvalued options! You will watch your trade value bleed away. You will need to use software for this – I strongly recommend Volcone Analyser Pro for this (the only bit of this method that is not free!).
Fourth: Set your Stop Loss and Profit Target closest!
Remember, this is not gambling! Your swing examination, and confirmed by a look at sustain and resistance levels, will help you do this.
- Stop Loss – If you typically set a stop loss of 4% for your stock, then set a stop loss of about 8-10% for your option.
- Profit Target – set a profit target based on the swing of the inner stock. Either simply add the dollar value of your expected profit to the option price, or use the Option Calculator to work it out. Or use a trailing stop – in any case is your favourite method. Sell the option as soon as you hit 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 examination dynamics would have changed, and your trade is at risk.