Stop Selling In the Money Spreads. Do This Instead.

Key Concepts

• Intrinsic Value: The portion of an option's premium that represents the actual value of the option if it were exercised immediately (the difference between the strike price and the current stock price).
• Extrinsic Value: The "time value" or "volatility value" of an option; it is the portion of the premium that exceeds the intrinsic value.
• In-the-Money (ITM): Options that have intrinsic value.
• Out-of-the-Money (OTM): Options that have no intrinsic value; their premium consists entirely of extrinsic value.
• Bid-Ask Spread: The difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept.
• Synthetic Equivalence: Using different combinations of options to replicate the risk/reward profile of another position (e.g., a synthetic long stock position).

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1. Option Valuation Dynamics

• OTM Options: Composed entirely of extrinsic value. If the option expires OTM, its value drops to zero.
• ITM Options: Composed of both intrinsic and extrinsic value. Intrinsic value is static relative to the stock price, meaning it does not decay over time.
• Strategic Trade-off:
  • Buying OTM options offers higher percentage gains if the stock moves toward the strike, but carries the risk of total premium loss.
  • Buying ITM options is more expensive. As an option moves from OTM to ITM, it gains intrinsic value but loses extrinsic value, which can dampen the percentage return compared to an OTM play.

2. Strategy Differentiation: The Liquidity Advantage

The core argument presented is that traders should prioritize Out-of-the-Money (OTM) spreads over In-the-Money (ITM) spreads to optimize execution.

• Liquidity and Spreads: OTM options typically have significantly higher open interest and tighter bid-ask spreads compared to ITM options.
• Execution Efficiency: By choosing the OTM counterpart of a trade, a trader can often cut the bid-ask spread in half. Over a large sample size (e.g., 1,000 trades), this reduction in slippage significantly improves overall profitability.
• Synthetic Equivalence:
  • Selling an ITM put spread is synthetically identical to buying an OTM call spread.
  • Buying an ITM call spread is synthetically identical to selling an OTM put spread.
  • Actionable Insight: Always check the OTM side of the trade to see if the market is more liquid.

3. Capital Efficiency and Synthetic Positions

The video highlights how options can be used to replicate stock ownership with higher capital efficiency:

• Case Study: Owning 100 shares of SPY and selling a call (covered call) requires significant buying power (e.g., $35,000).
• The Alternative: Selling an ITM put creates the exact same risk profile as a covered call but requires significantly less capital (saving over $20,000 in buying power effect).
• Trade-off: While the ITM put may have a wider bid-ask spread than an OTM option, the capital efficiency gained by avoiding the purchase of 100 shares often makes it the superior choice for the trader.

4. Key Takeaways

• Prioritize Liquidity: Always compare the bid-ask spreads of ITM vs. OTM spreads. The OTM side is almost always more liquid, leading to less slippage.
• Understand Value Composition: Remember that ITM options retain intrinsic value, while OTM options are purely extrinsic and prone to total loss if the move does not occur.
• Synthetics for Efficiency: Use ITM options to synthesize stock positions when capital efficiency is the primary goal, but be mindful of the wider bid-ask spreads associated with those specific strikes.
• Consistency: The strategy of choosing the more liquid side of a trade is a long-term play; the benefits of tighter spreads compound over hundreds of occurrences.

"We’re always going to lean with out-of-the-money options when we’re strategizing because you’re going to get a more narrow bid-ask spread 99% of the time, and that can result in less slippage over time." — Mike, Options and Action