Why Buy Deep In The Money Call Options?

Options are financial contracts that derive their value from an underlying asset, such as a stock. These contracts grant the holder the right, but not the obligation, to buy or sell that underlying asset at a predetermined price, known as the strike price, on or before a specified date, the expiration date. Investors commonly use them to gain exposure to price movements without directly owning the asset.

Defining Deep In The Money Calls

A call option is considered “in the money” when its strike price is below the current market price of the underlying asset. A “deep in the money” (DITM) call option has a strike price significantly lower than the current market price.

DITM calls possess a high amount of intrinsic value. Intrinsic value is the immediate profit an option would have if exercised, calculated as the difference between the underlying asset’s current price and the option’s strike price for a call. For instance, if a stock trades at $100 and a call option has a strike price of $70, the intrinsic value is $30.

Conversely, DITM calls typically have a relatively low amount of extrinsic value, also known as time value. Extrinsic value is the portion of an option’s premium beyond its intrinsic value, influenced by factors like time remaining until expiration and implied volatility. Since most of a DITM option’s premium is already intrinsic, there is less premium attributed to these external factors.

DITM calls have a high delta, approaching 1 (or 100). Delta measures how much an option’s price is expected to change for every one-dollar movement in the underlying asset’s price. A delta close to 1 means the DITM call option’s price will move almost dollar-for-dollar with changes in the underlying stock’s price, mirroring the stock’s behavior.

Capital Efficiency in Trading

Buying deep in the money call options can be a capital-efficient method for gaining exposure to an underlying asset’s price movements. Options contracts allow an investor to control 100 shares of an underlying asset with a smaller capital outlay compared to purchasing the shares outright. This leverage means that a relatively small investment can control a much larger value of the underlying asset.

While leverage is present, the high delta of DITM calls ensures the trade behaves similarly to owning the stock directly in terms of directional exposure. For example, if a stock trades at $100 per share, acquiring 100 shares would cost $10,000. A DITM call option controlling those same 100 shares might cost a fraction of that amount, perhaps $1,000 to $2,000, providing similar participation in upward price movements.

The reduced capital outlay per share allows investors to free up capital. This freed capital can then be deployed into other investment opportunities, contributing to portfolio diversification. This approach helps investors manage their portfolio by optimizing capital allocation.

Premium Composition and Price Behavior

The premium of a deep in the money call option is predominantly composed of intrinsic value. This characteristic makes its price less susceptible to rapid decay from time, known as theta, compared to out-of-the-money options. As a result, DITM calls tend to hold their value more consistently as the expiration date approaches, primarily reflecting the underlying asset’s price.

This provides a more predictable price response than options with lower deltas, which are more sensitive to other pricing factors. If the stock increases by $1, the DITM call option’s value will increase by approximately $1.

DITM calls are also generally less sensitive to changes in implied volatility, measured by vega, than out-of-the-money options. While volatility still influences option prices, its impact is diminished for DITM options due to their high intrinsic value. This can lead to more stable price movements, as their value is less swayed by fluctuations in market sentiment or expected price swings.

Strategic Position Management

The most common method for investors to realize profits from a deep in the money call option is by selling the contract before its expiration. This allows the investor to benefit from any increase in the option’s intrinsic value as the underlying asset’s price rises. Selling the option allows for profit realization without needing to acquire the underlying shares.

Alternatively, an investor can choose to exercise the DITM call option. Exercising means purchasing the underlying shares at the option’s strike price. This action might be desirable if the investor intends to own the shares for the long term, or to capture dividends, as option holders do not receive dividends unless they own the underlying stock.

Investors must then decide whether to sell the option to capture remaining value or exercise it to take ownership of the shares. Brokers typically offer automatic exercise for in-the-money options at expiration unless instructed otherwise, but manual exercise is also an option.