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8 Reasons to Buy Deep in the Money Calls

F or many people, the term options trading is synonymous with risk and potential catastrophic downsides. However, there are a few options strategies out there that can help limit the possible risks, present decent money-making opportunities, and cost less than just buying stock outright. If that interests you, it’s time to learn about buying deep in the money calls.

Takeaways:

  • Deep in the money calls are low-risk, low-reward options contracts.
  • They have a high delta, so they usually move in sync with their underlying asset’s valuation.
  • Deep in the money calls are great for income generation and buy-write strategies.

What Is a Deep in the Money Call?

Image via Unsplash by Adeolu Eletu

Before you can understand what a deep in the money call is, you need a working knowledge of a few other options contract concepts.

Call Options

Call options give you the right, though not the obligation, to buy shares — usually 100 shares per options contract — by a specific day for a particular price. On the options contract, the specific day is known as the expiration date, and the price is known as the strike price. The amount of money you pay to purchase the call option is called the premium.

Intrinsic Value

Intrinsic value is an asset’s — in this case, an options contract’s — worth as determined either by an objective calculation or through financial modeling rather than using the current trade price of the associated underlying asset. One way you can calculate intrinsic value is by subtracting the strike price from the underlying asset’s market value.

In the Money

The term “in the money” means the options contract has intrinsic value, or the assigned value, rather than the market value of its underlying asset.

Deep in the Money

The IRS describes an option as being “deep in the money” if it:

  • Has a term of fewer than 90 days and the strike price is one strike price lower than the highest available stock price.

Or if it:

  • Has a term of more than 90 days and the strike price is two strikes lower than the highest available stock price.

Deep in the Money Call

Deep in the money calls differ from regular in the money calls in that the difference between the strike price and stock price must be greater than $10 or, in some cases, 10% of the overall cost. Additionally, as the money gets deeper, the delta gets higher, meaning that the option should move in step with the underlying asset in terms of valuation up or down. This differs from other options strategies in which the valuations do not move together.

How Do Deep in the Money Calls Work?

Deep in the money calls work in much the same way as buying traditional stock. As the delta approaches 100%, the option will perform just like the underlying asset, meaning buying a deep in the money call is basically like buying the underlying asset outright but at a discounted price.

When Should I Use a Deep in the Money Call?

A deep in the money call is a great strategy for specific investors and investing goals. Consider deploying a deep in the money call strategy if you:

  • Are selling the underlying stock: By selling the deep in the money call against your stock, you have the possibility of earning an extra time premium on stock you intend to sell regardless.
  • Want to protect your gains: If you own the stock outright and are concerned about a downswing in value, you can use a deep in the money call as protection, though there is the possibility for some loss here.
  • Want a stock replacement strategy: You can purchase a deep in the money call option rather than outright shares in the stock at a discount.
  • Are looking for income: As long as the underlying asset stays above the strike price, you’ll know exactly how much money you stand to earn at expiration.

Risks to Consider

Before you start buying up deep in the money call options, there are a couple of risks to consider:

  • Stock reversal: If the underlying asset moves in the wrong direction, then the intrinsic value of your options contract diminishes, and you’ll be left with the degrading premium.
  • Limited lifespan: You need the stock to move higher than the strike price before your option’s expiration date. Otherwise, you won’t make any money on the contract.
  • Percentage loss potential: While you probably won’t lose much money if your stock goes south, you’ll lose the vast percentage of your investment, which isn’t ideal.

8 Reasons Why You Should Buy Deep in the Money Calls

For most options traders, the advantages outweigh the disadvantages when it comes to deep in the money calls. Check out these eight reasons for why you should use this strategy:

  1. Low capital investment: You’re spending less on the options contract for a specific underlying asset than you would if you bought the stock outright for that same company on the exchange. Since you’re spending less money upfront, you have more money in your pocket for diversification and making additional investments.
  2. Limited risk: You’re limited on how much money you stand to lose. Unlike some other options strategies in which you can potentially lose an unlimited amount of money, the deep in the money call protects your downside.
  3. Leverage: You can leverage your options contract against the actual underlying asset’s stock to boost your profits even higher.
  4. No upside cap: There’s no technical upside cap on how much money you can make, so there’s outstanding profit potential from deep in the money calls.
  5. Positive ratio: The ratio of downside losses to upside profits is weighted in your favor. You stand to earn far more than you would lose should the stock move in an unfavorable direction.
  6. Stock-like behavior: These high-delta calls result in options contracts that act like regular stocks. This makes them substantially less volatile and easier to manage.
  7. Single position: You’re only working from a single position, since the stock and option are working in lockstep, rather than from two positions as you would in a covered call, where you have to manage both the call and the put.
  8. Income: You can make a small income using this strategy. While the rewards are generally low, so are the risks. If you plan out your deep in the money calls effectively, you could calculate how much money you stand to earn ahead of buying the options and build in a profit.

Deep in the Money Example

Deep in the money calls make the most sense when you see how they work in actual practice. Consider this example deep in the money call for a better understanding of how this strategy works.

You’re interested in making some income on a company through a deep in the money call option. You purchase a call option for December at a strike price of $85 in July. On the day you made your purchase, the closing price was $150, and other strike prices for December call options were $70, $85, $125, $150, $170, and $190. Since the term on the option is more than 90 days, the deep in the money options are either $85 or $70 since they are both two strike prices below the stock price.

Using a deep in the money call can be a powerful strategy for risk-averse investors who are still interested in getting in on the power of options trading. With so many great reasons to implement this strategy, you’re just leaving profits on the table if you don’t give it a chance.