Trading in DITM options (Deep-in-the-money) is one of the best swing trading strategies. By exploiting the high delta of an options contract, you can effectively trade stocks for half the risk that you would with normal swing trading. If you can buy the rights to the same amount of stock at half the price but still make the same profit, you effectively double your return on investment.
This is a great strategy for those who are still intimidated by buying options, but love the challenge of swing trading stocks, and want to reduce overall risk and investment costs while also getting some leverage on the trade. . The reason this can be such a rewarding strategy is because it not only doubles the leverage on stock trades, but also minimizes the effect of time decay on the option’s value. Swing trades typically have a duration of three to ten days, and if you trade a DITM option for this short period, the time decay will not significantly affect the option’s price.
How do you trade DITM options?
First: Pick your stock.You can either 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.To identify a good swing trade suitable for DITM option trading you need to follow the following steps:
- trend analysis. Establish the trend of both the market and your stock. Don’t try to buy calls in a falling market!
- swing analysis. Find those stocks which are dipping in the lower side of the trend band. These are the stocks which are trading between 10ma and 30ema.
- Swing confirmation. Confirm the swing with a candlestick pattern. Check the RSI and VIX to make sure a swing reversal is not imminent.
Third: Choose your option and buy it!
- Pull up an option table that shows the delta of the option. Your broker software should have this feature. Either that or use an options calculator, which will require you 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 overvalued options! You will see that your business value is eroding. You’ll need to use software for this – I strongly recommend Volcone Analyzer Pro for this (the only bit 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 corroborated by a look at support and resistance levels, will help you do just that.
- Stop Loss – If you normally set a stop loss of 4% for your stocks, set a stop loss of around 8-10% for your options.
- Profit Target – Set a profit target based on the swing of the underlying stock. Either simply add the dollar value of your projected profit to the option price, or use an options calculator to work it out. Or use a trailing stop – whatever your preferred method is. 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 – if it hasn’t progressed by then, the swing analysis dynamics will have changed, and your trade is at risk.