Mastering Deep in the Money Call Options: A Comprehensive Guide

1. What are deep in the money call options and why are they useful?

Deep in the money call options are a type of option contract that gives the buyer the right, but not the obligation, to buy an underlying asset at a specified price (the strike price) before or on a certain date (the expiration date). The term "deep in the money" means that the strike price is significantly lower than the current market price of the underlying asset. This implies that the option has a high intrinsic value and a low time value. In other words, the option is worth more than its premium and has a high probability of being exercised.

Deep in the money call options are useful for various reasons, depending on the perspective of the buyer or the seller. Here are some of the benefits and drawbacks of using deep in the money call options:

1. For the buyer, deep in the money call options offer a lower risk and higher reward strategy than buying the underlying asset outright. The buyer can profit from the appreciation of the underlying asset without paying the full price. The buyer also has limited downside risk, as the maximum loss is the premium paid for the option. Additionally, deep in the money call options have a high delta, which means that they move almost in sync with the underlying asset. This reduces the impact of volatility and time decay on the option value. For example, suppose a stock is trading at $100 and a call option with a strike price of $50 and an expiration date in six months is trading at $52. The buyer can pay $52 to buy the option instead of $100 to buy the stock. If the stock rises to $120, the option will be worth $70, giving the buyer a profit of $18 ($70 - $52), while the stock buyer will have a profit of $20 ($120 - $100). However, if the stock falls to $80, the option will be worth $30, giving the buyer a loss of $22 ($52 - $30), while the stock buyer will have a loss of $20 ($100 - $80).

2. For the seller, deep in the money call options offer a way to generate income and hedge against a decline in the underlying asset. The seller can collect a high premium for selling the option, which can offset the cost of owning the underlying asset or provide a steady cash flow. The seller also has a limited upside risk, as the maximum gain is the premium received for the option. Furthermore, deep in the money call options have a low gamma, which means that they are less sensitive to changes in the underlying asset price. This reduces the risk of being assigned early and having to deliver the underlying asset. For example, suppose a stock is trading at $100 and a call option with a strike price of $50 and an expiration date in six months is trading at $52. The seller can receive $52 for selling the option and use it to buy the stock or invest in another asset. If the stock rises to $120, the option will be worth $70, giving the seller a loss of $18 ($52 - $70), while the stock seller will have a loss of $20 ($100 - $120). However, if the stock falls to $80, the option will be worth $30, giving the seller a profit of $22 ($52 - $30), while the stock seller will have a profit of $20 ($100 - $80).

As you can see, deep in the money call options are a versatile and powerful tool for investors and traders who want to leverage their positions, reduce their risks, or enhance their returns. However, they also come with some challenges and limitations, such as liquidity, bid-ask spread, commission, and tax implications. Therefore, it is important to understand the characteristics and risks of deep in the money call options before using them in your portfolio. In the next sections, we will explore some of the strategies and scenarios that involve deep in the money call options and how to use them effectively.

2. How to buy, sell, and exercise call options?

In this section, we will explore how to buy, sell, and exercise call options, providing insights from different perspectives. Let's dive in:

1. understanding Call options:

- A call option consists of a strike price, expiration date, and underlying asset.

- The strike price is the predetermined price at which the asset can be bought.

- The expiration date is the deadline for exercising the option.

- The underlying asset is the security or commodity that the option is based on.

2. Buying Call Options:

- When you buy a call option, you pay a premium to the option seller.

- The premium is the price you pay for the right to buy the underlying asset.

- Buying call options allows you to profit from an increase in the asset's price.

- If the asset's price rises above the strike price before expiration, you can exercise the option and buy the asset at a lower price.

3. Selling Call Options:

- As a call option seller, you receive the premium from the buyer.

- Selling call options can be a strategy to generate income or hedge against existing positions.

- If the option buyer exercises the option, you are obligated to sell the underlying asset at the strike price.

4. Exercising Call Options:

- Exercising a call option means utilizing your right to buy the underlying asset.

- You can exercise the option before or at expiration, depending on your investment strategy.

- If the option is in-the-money (the asset's price is above the strike price), exercising can result in a profit.

- If the option is out-of-the-money (the asset's price is below the strike price), it may not be beneficial to exercise.

Example: Let's say you buy a call option for XYZ stock with a strike price of $50 and an expiration date of one month. If the stock price rises to $60 before expiration, you can exercise the option and buy the stock at $50, making a $10 profit per share.

Remember, call options involve risks, including the potential loss of the premium paid. It's essential to understand the underlying asset, market conditions, and your risk tolerance before engaging in options trading.

3. Higher delta, lower theta, and lower implied volatility

One of the most popular strategies among options traders is buying deep in the money call options. These are call options that have a strike price significantly lower than the current market price of the underlying asset. For example, if the stock of XYZ is trading at $100, a call option with a strike price of $50 is deep in the money. Buying deep in the money call options has several advantages over buying at the money or out of the money call options. In this section, we will explore these advantages from different perspectives, such as delta, theta, and implied volatility.

- Higher delta: Delta is a measure of how much the option price changes in response to a change in the underlying asset price. Delta ranges from 0 to 1 for call options and from -1 to 0 for put options. The higher the delta, the more the option behaves like the underlying asset. Deep in the money call options have a delta close to 1, which means they move almost in sync with the underlying asset. This allows the option buyer to capture most of the upside potential of the asset without paying the full price. For example, if the stock of XYZ rises from $100 to $110, a deep in the money call option with a strike price of $50 and a delta of 0.9 will increase in value from $50 to $59, a gain of 18%. An at the money call option with a strike price of $100 and a delta of 0.5 will increase in value from $5 to $10, a gain of 100%. However, the absolute profit is higher for the deep in the money call option ($9 vs $5). Moreover, the deep in the money call option has a lower breakeven point ($100 vs $105), which means it is more likely to be profitable at expiration.

- Lower theta: Theta is a measure of how much the option price decreases over time due to the erosion of time value. Theta is always negative for option buyers, as they lose money as time passes. The closer the option is to expiration, the faster the theta decay. Deep in the money call options have a lower theta than at the money or out of the money call options, which means they lose less value over time. This is because deep in the money call options have a higher intrinsic value (the difference between the underlying asset price and the strike price) and a lower extrinsic value (the premium paid for the option above its intrinsic value). Theta mainly affects the extrinsic value of the option, which is minimal for deep in the money call options. For example, if the stock of XYZ is trading at $100, a deep in the money call option with a strike price of $50 and a theta of -0.01 will lose $0.01 per day due to time decay. An at the money call option with a strike price of $100 and a theta of -0.1 will lose $0.1 per day due to time decay. Over a period of 30 days, the deep in the money call option will lose $0.3 in value, while the at the money call option will lose $3 in value. This means the deep in the money call option buyer can hold the option longer without worrying too much about the time decay.

- Lower implied volatility: Implied volatility is a measure of how much the market expects the underlying asset price to fluctuate in the future. implied volatility affects the option price, as higher implied volatility means higher uncertainty and higher risk. Option buyers pay a higher premium for options with higher implied volatility, as they have a higher chance of making a profit. However, implied volatility can also change over time, depending on the market conditions and the supply and demand of the options. If implied volatility decreases, the option price will also decrease, which is bad for option buyers. Deep in the money call options have a lower implied volatility than at the money or out of the money call options, which means they are less sensitive to changes in implied volatility. This is because deep in the money call options have a lower vega (a measure of how much the option price changes in response to a change in implied volatility). For example, if the stock of XYZ is trading at $100, a deep in the money call option with a strike price of $50 and a vega of 0.05 will change in value by $0.05 for every 1% change in implied volatility. An at the money call option with a strike price of $100 and a vega of 0.2 will change in value by $0.2 for every 1% change in implied volatility. If implied volatility drops from 30% to 20%, the deep in the money call option will lose $0.5 in value, while the at the money call option will lose $2 in value. This means the deep in the money call option buyer can avoid the negative impact of implied volatility fluctuations.

As you can see, buying deep in the money call options has many advantages over buying at the money or out of the money call options. However, this does not mean that deep in the money call options are risk-free or always superior. There are also some disadvantages and trade-offs that you need to consider, such as higher initial cost, lower leverage, and lower liquidity. In the next section, we will discuss these disadvantages and how to overcome them. Stay tuned!

4. Higher cost, lower liquidity, and higher risk of early assignment

Deep in the money call options are call options with a strike price significantly below the current market price of the underlying asset. They have a high intrinsic value and a low time value. They are attractive to investors who want to profit from a bullish outlook on the underlying asset, as they offer a high delta and a low theta. However, deep in the money call options also have some disadvantages that should be considered before buying them. In this section, we will discuss three main drawbacks of deep in the money call options: higher cost, lower liquidity, and higher risk of early assignment.

- Higher cost: Deep in the money call options are more expensive than at the money or out of the money call options, as they have a higher intrinsic value. This means that the investor has to pay more upfront to buy them, which reduces the potential return on investment. For example, suppose that XYZ stock is trading at $100 and the XYZ 80 call option (with a strike price of $80) is trading at $22. The investor has to pay $2,200 to buy 100 contracts of the XYZ 80 call option, which is equivalent to buying 100 shares of XYZ stock at $80. The breakeven point for this trade is $102, which means that the stock has to rise above $102 for the investor to make a profit. On the other hand, the XYZ 100 call option (with a strike price of $100) is trading at $4. The investor can buy 100 contracts of the XYZ 100 call option for $400, which is equivalent to buying 100 shares of XYZ stock at $100. The breakeven point for this trade is $104, which means that the stock has to rise above $104 for the investor to make a profit. The investor can buy more contracts of the XYZ 100 call option with the same amount of money as the XYZ 80 call option, which gives them more leverage and a higher potential return on investment.

- Lower liquidity: Deep in the money call options are less liquid than at the money or out of the money call options, as they have a lower trading volume and a wider bid-ask spread. This means that the investor may have difficulty finding a buyer or a seller for their deep in the money call options, which can affect their ability to enter or exit the trade at a favorable price. For example, suppose that XYZ stock is trading at $100 and the XYZ 80 call option (with a strike price of $80) has a bid price of $21.50 and an ask price of $22.50. The bid-ask spread for this option is $1, which is 4.5% of the option price. The investor has to pay $22.50 to buy the option and can only sell it for $21.50, which means that they lose $1 per contract due to the bid-ask spread. On the other hand, the XYZ 100 call option (with a strike price of $100) has a bid price of $3.90 and an ask price of $4.10. The bid-ask spread for this option is $0.20, which is 5% of the option price. The investor has to pay $4.10 to buy the option and can sell it for $3.90, which means that they lose $0.20 per contract due to the bid-ask spread. The bid-ask spread for the XYZ 100 call option is smaller in absolute terms than the XYZ 80 call option, which makes it more liquid and easier to trade.

- Higher risk of early assignment: Deep in the money call options have a higher risk of early assignment than at the money or out of the money call options, as they are more likely to be exercised by the option holders before the expiration date. This means that the investor may lose the opportunity to profit from the appreciation of the underlying asset, as they have to sell it at the strike price. For example, suppose that XYZ stock is trading at $120 and the XYZ 80 call option (with a strike price of $80) has an expiration date of 30 days. The option holder has the right to buy 100 shares of XYZ stock at $80, which gives them an instant profit of $40 per share. The option holder may decide to exercise their option early and buy the stock at $80, which means that the investor who sold the option has to deliver the stock at $80 and lose the potential profit of $40 per share. On the other hand, the XYZ 100 call option (with a strike price of $100) has an expiration date of 30 days. The option holder has the right to buy 100 shares of XYZ stock at $100, which gives them a profit of $20 per share. The option holder may decide to wait until the expiration date and see if the stock price goes higher, which means that the investor who sold the option has more time to benefit from the stock price increase. The risk of early assignment for the XYZ 100 call option is lower than the XYZ 80 call option, which gives the investor more flexibility and control over their trade.

5. Ways to protect your position from adverse price movements or volatility spikes

One of the challenges of trading deep in the money call options is that they are very sensitive to changes in the underlying stock price and implied volatility. A small drop in the stock price or a spike in volatility can erode the value of your option position quickly. Therefore, it is important to have a hedging strategy that can protect your position from adverse price movements or volatility spikes. Hedging is the practice of reducing or eliminating the risk of holding a certain position by taking another position that is negatively correlated with it. In this section, we will discuss some of the ways to hedge deep in the money call options and their pros and cons. Here are some of the hedging methods you can use:

1. Buy a put option. A put option gives you the right to sell the underlying stock at a certain price (strike) by a certain date (expiration). Buying a put option can hedge your deep in the money call option by limiting your downside risk. If the stock price falls below the strike price of the put option, you can exercise the put option and sell the stock at the strike price, offsetting the loss on your call option. For example, suppose you buy a deep in the money call option on XYZ stock with a strike price of $50 and an expiration date of March 31, 2024. The stock is currently trading at $60 and the call option is worth $12. To hedge your position, you buy a put option on XYZ stock with a strike price of $55 and an expiration date of March 31, 2024. The put option costs $3. If the stock price drops to $50 by March 31, 2024, your call option will be worth $0 and your put option will be worth $5. You can exercise the put option and sell the stock at $55, making a net profit of $2 ($5 - $3) on the put option and a net loss of $12 on the call option, for a total net loss of $10. This is better than losing $12 on the call option alone. However, buying a put option also has some drawbacks. First, it reduces your potential profit on the call option. If the stock price rises above $60 by March 31, 2024, your call option will increase in value, but your put option will decrease in value. For example, if the stock price rises to $70 by March 31, 2024, your call option will be worth $20 and your put option will be worth $0. You will make a net profit of $8 ($20 - $12) on the call option and a net loss of $3 on the put option, for a total net profit of $5. This is less than the $10 profit you would have made on the call option alone. Second, buying a put option increases your breakeven point on the call option. Your breakeven point is the stock price at which your net profit or loss on the option position is zero. In this example, your breakeven point on the call option alone is $62 ($50 + $12). However, when you buy a put option, your breakeven point increases to $65 ($50 + $12 + $3). This means that the stock price has to rise above $65 by March 31, 2024 for you to make a profit on the option position.

2. Sell a call option. A call option gives you the right to buy the underlying stock at a certain price (strike) by a certain date (expiration). Selling a call option can hedge your deep in the money call option by reducing your exposure to changes in the stock price and implied volatility. When you sell a call option, you receive a premium upfront, which lowers your cost basis on the call option you bought. However, you also give up the right to profit from any increase in the stock price above the strike price of the call option you sold. This creates a capped profit potential on your option position. For example, suppose you buy a deep in the money call option on XYZ stock with a strike price of $50 and an expiration date of March 31, 2024. The stock is currently trading at $60 and the call option is worth $12. To hedge your position, you sell a call option on XYZ stock with a strike price of $65 and an expiration date of March 31, 2024. The call option pays you $2. This reduces your cost basis on the call option you bought to $10 ($12 - $2). If the stock price stays below $65 by March 31, 2024, your call option will be worth more than the call option you sold, and you will make a profit on the option position. For example, if the stock price drops to $55 by March 31, 2024, your call option will be worth $5 and the call option you sold will be worth $0. You will make a net profit of $5 ($5 - $0) on the call option you bought and a net profit of $2 on the call option you sold, for a total net profit of $7. This is better than losing $7 on the call option alone. However, if the stock price rises above $65 by March 31, 2024, your call option will be worth less than the call option you sold, and you will make a loss on the option position. For example, if the stock price rises to $70 by March 31, 2024, your call option will be worth $20 and the call option you sold will be worth $5. You will make a net profit of $10 ($20 - $10) on the call option you bought and a net loss of $3 ($2 - $5) on the call option you sold, for a total net profit of $7. This is less than the $20 profit you would have made on the call option alone. Selling a call option also has some drawbacks. First, it limits your potential profit on the call option. You cannot make more than the difference between the strike prices of the call options minus the net cost of the option position. In this example, your maximum profit is $5 ($65 - $50 - $10). Second, selling a call option increases your risk of being assigned. If the stock price rises above the strike price of the call option you sold, the buyer of the call option can exercise their right to buy the stock from you at the strike price. This means that you have to deliver the stock to them, which requires you to either buy the stock at the market price or exercise the call option you bought. Either way, you will incur additional costs and lose the opportunity to profit from the stock price increase.

6. When to roll, close, or exercise your options?

One of the most important decisions that you have to make as an option trader is how to manage your deep in the money call options. Deep in the money call options are call options that have a strike price significantly lower than the current market price of the underlying asset. They have a high intrinsic value and a low time value, which means that they are very sensitive to changes in the price of the underlying asset and less affected by the passage of time.

There are three main ways to manage your deep in the money call options: rolling, closing, or exercising. Each of these methods has its own advantages and disadvantages, depending on your goals, risk tolerance, and market conditions. In this section, we will discuss each of these methods in detail and provide some examples to illustrate how they work.

- Rolling: Rolling is the process of closing your current option position and opening a new one with a different expiration date and/or strike price. Rolling allows you to extend the duration of your option position and capture more profits if you expect the underlying asset to continue to rise in price. However, rolling also involves paying additional commissions and fees, and may expose you to more risks if the underlying asset reverses its direction or becomes volatile.

For example, suppose you bought a call option on XYZ stock with a strike price of $50 and an expiration date of March 31, 2024, when the stock was trading at $60. The option cost you $12 per share, or $1,200 for a 100-share contract. By January 30, 2024, the stock has risen to $80, and your option is worth $30 per share, or $3,000. You have a profit of $1,800, or 150%. You decide to roll your option to a later expiration date, say June 30, 2024, and a higher strike price, say $60. You sell your current option for $3,000 and buy a new one for $2,500. You have locked in a profit of $500, or 41.67%, and still have a chance to make more money if the stock goes above $62.50 by June 30, 2024. However, you also have to pay commissions and fees for both transactions, and you have increased your breakeven point from $62 to $62.50. If the stock drops below $62.50 by June 30, 2024, you will lose money on your new option.

- Closing: Closing is the process of selling your option position and taking your profits or losses. Closing allows you to realize your gains or losses and free up your capital for other opportunities. However, closing also means that you give up any potential upside or downside that your option position may have in the future.

For example, suppose you bought a call option on XYZ stock with a strike price of $50 and an expiration date of March 31, 2024, when the stock was trading at $60. The option cost you $12 per share, or $1,200 for a 100-share contract. By January 30, 2024, the stock has risen to $80, and your option is worth $30 per share, or $3,000. You have a profit of $1,800, or 150%. You decide to close your option position and sell your option for $3,000. You have realized your profit of $1,800, minus commissions and fees, and you no longer have any exposure to the stock. If the stock continues to rise above $80, you will miss out on any additional profits. If the stock falls below $80, you will avoid any further losses.

- Exercising: Exercising is the process of using your option to buy or sell the underlying asset at the strike price. Exercising allows you to acquire or dispose of the underlying asset at a favorable price and benefit from any dividends or voting rights that the asset may have. However, exercising also involves paying the strike price and any taxes that may apply, and may result in a lower return than selling the option in the market.

For example, suppose you bought a call option on XYZ stock with a strike price of $50 and an expiration date of March 31, 2024, when the stock was trading at $60. The option cost you $12 per share, or $1,200 for a 100-share contract. By January 30, 2024, the stock has risen to $80, and your option is worth $30 per share, or $3,000. You have a profit of $1,800, or 150%. You decide to exercise your option and buy 100 shares of XYZ stock for $50 per share, or $5,000. You now own 100 shares of XYZ stock worth $8,000, and you have a profit of $3,000, or 60%. However, you also have to pay taxes on your capital gain, and you have invested more money than if you had sold the option. If the stock pays a dividend, you will receive it, but if the stock drops below $50, you will lose money on your stock position.

As you can see, there is no one-size-fits-all answer to how to manage your deep in the money call options. You have to weigh the pros and cons of each method and choose the one that best suits your situation and objectives. You also have to monitor the market conditions and adjust your strategy accordingly. By doing so, you can maximize your returns and minimize your risks when trading deep in the money call options.

7. A summary of the main points and a call to action for your readers

You have reached the end of this comprehensive guide on mastering deep in the money call options. In this section, I will summarize the main points that you have learned and give you some tips on how to apply them in your trading strategy. I will also invite you to take action and start using deep in the money call options to enhance your returns and reduce your risks.

Here are the key takeaways from this guide:

1. Deep in the money call options are call options with a strike price that is significantly lower than the current market price of the underlying asset. They have a high delta, which means they move almost in sync with the underlying asset, and a low theta, which means they lose value slowly due to time decay.

2. Deep in the money call options are ideal for bullish traders who want to leverage their capital and profit from a rise in the underlying asset price. They offer several advantages over buying the underlying asset outright, such as lower cost, higher return on investment, lower breakeven point, and lower risk of loss.

3. Deep in the money call options can also be used as a substitute for owning the underlying asset, especially for dividend-paying stocks. By buying deep in the money call options and selling out of the money call options, you can create a synthetic long stock position that mimics the payoff of owning the stock, but with lower capital requirement and lower downside risk. You can also collect dividends by exercising your deep in the money call options before the ex-dividend date.

4. Deep in the money call options are not without drawbacks, however. They have lower liquidity than at the money or out of the money call options, which means they have wider bid-ask spreads and lower volume. They also have higher opportunity cost, as you could have invested your capital in other assets with higher potential returns. Moreover, they have higher exposure to implied volatility changes, which can affect their value significantly.

5. To trade deep in the money call options effectively, you need to consider several factors, such as the underlying asset price, the strike price, the expiration date, the implied volatility, the interest rate, and the dividend yield. You also need to have a clear exit strategy, whether it is to sell the option, exercise the option, or roll the option to a later expiration date.

- Review the concepts and examples in this guide and make sure you understand them well.

- Practice trading deep in the money call options on a paper trading account or a simulator before risking real money.

- Find a reliable broker that offers deep in the money call options with reasonable commissions and fees.

- Choose an underlying asset that you are familiar with and have a bullish outlook on.

- Select a deep in the money call option that suits your risk-reward profile and time horizon.

- Monitor your position and adjust it as needed according to your exit strategy.

Thank you for reading this guide and I wish you all the best in your trading journey. Remember, deep in the money call options are not a magic bullet that guarantees success, but a skill that requires practice and discipline. As long as you follow the principles and guidelines in this guide, you will be well on your way to mastering deep in the money call options. Happy trading!

Read Other Blogs