Call options, also known as calls, are derivative contracts that grant the holder the right to purchase a security on a specific date and at a predetermined price. The owner of the call may keep the difference as profit if this price is less than what it would cost to purchase the security on the open market. Options trading is more difficult than regular stock trading, even though it can be profitable. We go over a few advantages of purchasing in-the-money options below.
Deep in the money (ITM) call options are a powerful tool in the arsenal of any options trader. They offer a unique combination of high intrinsic value, limited downside risk, and potential for significant returns. However, understanding when and how to utilize them effectively is crucial for maximizing their potential and mitigating risks.
This comprehensive guide will delve into the intricacies of deep ITM call options, exploring their characteristics, advantages, and optimal usage scenarios. We will also address common questions and misconceptions surrounding these options, providing you with the knowledge and confidence to make informed trading decisions.
What are Deep In The Money Call Options?
Deep ITM call options are options contracts with a strike price significantly lower than the current market price of the underlying asset This means that the option buyer has the right, but not the obligation, to purchase the underlying asset at a price substantially below its current market value
For instance, if Apple stock is trading at $153 per share, and you purchase a call option with a strike price of $145, you have the right to buy Apple shares at $145, even though they are currently trading at a higher price. This difference between the strike price and the market price is known as the intrinsic value of the option
Advantages of Deep ITM Call Options
1. High Intrinsic Value:
The primary advantage of deep ITM call options is their high intrinsic value. This inherent value provides immediate profit potential upon purchase, unlike out-of-the-money (OTM) options, which require the underlying asset price to rise above the strike price to generate profit.
2. Limited Downside Risk:
The maximum loss on a deep ITM call option is limited to the premium paid for the option. This limited downside risk makes them an attractive choice for traders seeking to minimize potential losses while still benefiting from potential gains.
3 Leverage and Potential for Large Returns:
Deep ITM call options offer significant leverage, allowing traders to control a large number of shares with a relatively small investment. This leverage can amplify potential returns if the underlying asset price moves favorably.
4. Time Decay Mitigation:
Deep ITM call options experience slower time decay compared to OTM options. This slower decay rate provides more time for the underlying asset price to move in the desired direction, increasing the chances of profitability.
When to Buy Deep ITM Call Options
1. Strong Conviction in Underlying Asset Price Increase:
Deep ITM call options are ideal when you have a strong conviction that the underlying asset price will increase significantly in the near future. This could be due to positive company news, favorable market conditions, or other catalysts.
2. Limited Capital Availability:
If your capital is limited, deep ITM call options can provide exposure to a larger number of shares than purchasing the underlying asset outright. This allows you to participate in potential gains with a smaller investment.
3. Hedging Existing Long Positions:
Deep ITM call options can be used as a hedging strategy to protect against potential losses in your existing long positions. By purchasing deep ITM call options, you can limit your downside risk while still participating in potential upside gains.
Why Would Someone Sell Deep ITM Call Options?
1. Generate Income without Taking on Significant Risk:
Selling deep ITM call options can generate income for the seller without taking on significant risk. This is because the high intrinsic value of the option reduces the likelihood of it being exercised by the buyer.
2. Hedging Against Short Positions:
Traders with short positions in the underlying asset may sell deep ITM call options to hedge against potential losses. If the asset price rises, the gains from the call options can offset losses from the short position.
Examples of Buying Deep ITM Call Options
Scenario: Apple stock is trading at $153 per share, and you purchase a deep ITM call option with a strike price of $145. The premium for this option is $11 per share.
Potential Outcomes:
- If Apple’s stock price increases to $160 per share: Your intrinsic value increases to $15 ($160 – $145), and you can exercise your option to buy Apple shares at $145, resulting in a profit of $4 per share ($15 – $11).
- If Apple’s stock price remains at $153 per share: You can still exercise your option and buy Apple shares at $145, resulting in a profit of $8 per share ($153 – $145).
- If Apple’s stock price falls below $145: You will not exercise your option, and your maximum loss will be limited to the premium paid, which is $11 per share.
Deep ITM Call Options vs. OTM Call Options
1. Intrinsic Value: Deep ITM call options have a higher intrinsic value than OTM call options, providing immediate profit potential.
2. Premium Cost: Deep ITM call options are more expensive than OTM call options due to their higher intrinsic value.
3. Leverage: Both deep ITM and OTM call options offer leverage, but deep ITM options provide greater leverage due to their lower strike price.
4. Risk/Reward Profile: Deep ITM call options have a lower risk/reward profile compared to OTM call options. They offer limited downside risk but also have a lower potential for large returns.
5. Time Decay: Deep ITM call options experience slower time decay than OTM call options.
Deep ITM call options can be a valuable tool for options traders seeking to capitalize on anticipated increases in the underlying asset price. However, it’s crucial to understand their characteristics, advantages, and limitations before incorporating them into your trading strategy. By carefully considering the factors discussed in this guide, you can make informed decisions about when and how to utilize deep ITM call options to maximize your trading success.
Frequently Asked Questions
1. Is it good to buy deep ITM call options?
The decision to buy deep ITM call options depends on your individual trading goals and risk tolerance. If you have a strong conviction in the underlying asset price increase and limited capital, deep ITM call options can be a suitable choice. However, it’s essential to carefully consider the premium cost and potential time decay.
2. Why buy deep OTM options?
Deep OTM options offer the potential for large returns with a smaller upfront investment. However, they also have a lower probability of expiring in-the-money and require a more significant price movement to generate profit.
3. What is the difference between deep ITM and OTM call options?
Deep ITM call options have a strike price significantly lower than the current market price, while OTM call options have a strike price higher than the current market price. Deep ITM options offer immediate profit potential and limited downside risk, while OTM options offer the potential for larger returns but also carry higher risk.
4. When should I buy deep ITM call options?
Consider buying deep ITM call options when you have a strong conviction in the underlying asset price increase, limited capital, or want to hedge existing long positions.
5. How do I choose the right strike price for deep ITM call options?
The optimal strike price depends on your risk tolerance, expected price movement, and time horizon. Consider the premium cost and potential time decay when selecting a strike price.
A Game for Professionals
Generally speaking, it is best to leave the game of options trading in real money to the professionals. All options must be exhausted eventually, but it usually doesn’t make sense to do so until close to the expiration date. This entails wild trading on triple witching days, which are when a lot of futures and options contracts expire.
Typically, small investors would want to sell their options well in advance of their expiration date rather than exercising them.
The majority of individual investors are not well-versed in exercising call options, nor do they have the necessary funds or discipline. The most important issue of them all is money. Assume that an investor buys a call option that expires in a year at a price of 3% of the underlying stock’s value and is currently out of the money. In the event that the stock increases by twenty-two percent in the upcoming year, the investment’s value will have tripled (22.2%20-%2013%20=%209, or three times the original). That sounds good, but there is a potential hitch.
Assume the investor invested $3,000 of the $100,000 in the previously mentioned call option. If the remaining 20% had been in cash earnings of 200 percent, the 3% that was at risk would now be 9%, for a total gain of 6%. Right now, all that the investor truly has is the ability to purchase stocks valued at $113,000 instead of $122,000. Unfortunately, the investor only has $97,000 in cash. That isn’t sufficient to exercise the call option, so you’ll need to visit the market makers.
Advantages of In the Money Call Options
For many investors, the value of a call option increases when it enters the money. Given that they only have extrinsic value, out-of-the-money (OTM) call options are extremely speculative.
It is feasible to exercise a call option once it enters the money in order to purchase an asset for less than the going rate. This can be vital because it allows one to profit from the option regardless of the state of the options market at the time.
Parts of the options market can be illiquid at times. It may be challenging to sell calls on thinly traded stocks and calls that are significantly out of the money at the prices suggested by the Black Scholes model. For this reason, it is very advantageous for a call to go into the money. In fact, because they capture the conversion of out-of-the-money options into in-the-money options, at-the-money (ATM) options are typically the most liquid and traded.
Practically speaking, options are seldom exercised prior to expiration since doing so negates any residual extrinsic value. The primary anomaly occurs in the deep money options, where the extrinsic value accounts for a very small portion of the total value. Call option exercise becomes more feasible as expiration draws near and time decay sharply increases.