To explore the concept of a deep in the money call option strategy, we need to first define our terms so that we can move on from all the jargon and get into the strategy itself and why it can be a better alternative to simply purchasing the underlying shares.
For those new to options trading, the expression "in the money" as far as call options are concerned, basically means that the strike, or exercise, price of the options contract is lower than the current market price of the stock.
So if the stock is trading at say, $50.00, then for the option to be "in the money" its strike price needs to be less than that.
It means that if the option expires tomorrow and the stock is trading at $50.00, there would be some "intrinsic value" meaning that you could buy the stock for under $50.00 and immediately dump it back into the market for a profit.
Now for a call option to be DEEP in the money, it needs to be at least $10 "in the money". So the strike price in our current example would need to be $40 or lower, giving it $10 worth of intrinsic value.
When we look at put options the principle applies in reverse. The strike price of the put would need to be at least $10 higher than the current market price of the stock - in this case, $60 or higher.
So let's dig into the deep in the money call option strategy.
The idea here is, that if your plan is to profit from an anticipated increase in a stock price then you are much better off buying a deep in the money call with a long expiration time than you are from just outright purchasing the stock.
From the perspective of analyzing risk to reward ratios, buying the stock can be insanely inefficient and can tie up a lot of capital in your account that could be used for other investment opportunities.
So we going to use a worked example here to demonstrate the difference between a deep in the money call option strategy vs buying the underlying stock outright.
Before we start, we should note that there are a lot of moving pieces here, so there's no one way to do it. You have a choice of contract expiration months, strike prices and the number of calls you wish to purchase.
Variations in these will affect the dollar amount of your risk as well as how much unrealized profit or loss you will accrue in response to the price action of the underlying security.
We want to touch on as many of these variations as we can.
So let's take the example of Netflix. Netflix is a popular stock. In May 2018, Netflix was trading around the $340 mark. This means that if you were to purchase 100 shares in Netflix, it would cost you $34,000. For most people, that would tie up all their account and then some. So most people probably don't have enough money to do it.
Even if you did have the funds, we propose that outlaying $34,000 for 100 shares of Netflix in the hope of realizing profits when the price reaches say, $400 per share, is not the most efficient use of your trading capital.
Cashing in at $400 per share would return $40,000 (less brokerage costs) giving you a profit of $6,000.
But a $6,000 return on an outlay of $34,000 is only a 17.65% return on risk, plus any dividend that you may have collected along the way.
An alternative way to invest in Netflix is to go long synthetically, using a deep in the money call option strategy.
Before doing this, the trader needs to do some analysis. How far out in expiration time do you want to go? 30 days? 60 ... 90 ... 120 days, or even take LEAPS options which are at least one year out? What strike price will you choose?
So let's do a comparison. We decide to buy the January 2019 contracts which are over 250 days out from expiration. So on the assumption that in May 2018 you are really bullish on Netflix for whatever reason and you want to get into a long position and are prepared to hold it for a long time.
If you were to buy the $270 strike call options, which are more than $10 in the money, very deep in the money in fact, one contract would cost you $8,800. By doing this you can replicate the same position in Netflix for only $8,800 compared to the $34,000 on 100 shares as mentioned before.
So if you risked only $8,800 instead of $34,000 you would potentially have another $25,200 for other trading opportunities. Historically, Netflix rose to $400 per share by July 2018 at which time, in this scenario, we decide to close the position and take profits.
Now here's where it gets interesting.
In May 2018 when Netflix was trading at $340, your $270 call options had an options delta of 80. This means that for every $1 upward move in the price of Netflix shares, the value of your options contract would initially increase by 80 cents.
As the Netflix share price continued to rise, thus sending the call options deeper into the money, this ratio would increase up to a maximum of $1 for every $1 move.
So this means that initially, your $270 call options are going to replicate about the profit or loss of 80 shares as the stock price is moving.
So keeping it simple and ignoring a changing delta, when Netflix price rose from $340 to $400, your call options would experience an unrealized profit of 80 percent of the profit that you would've had if you had bought the shares outright.
See the difference?
But let's choose a different in the money strike price for our calls and see what happens.
Looking at the $225 call options which in May 2018 were even further in the money, the cost for one contract would be $12,000. So still significantly lower than buying Netflix outright. But these deeper in the money call options have a delta of 90, so they are going to replicate a position equivalent to 90 shares.
It's going to mimic Netflix like as if you have 90 shares in your account, or like your trading 90 shares of stock.
So the further you go in the money, the greater the cost. But you also start to replicate a greater slice of the stock's price action.
Ultimately, it's up to the trader to decide how they want to do this. If you were bullish on Netflix and wanted to use this type of strategy, you would want to analyze the potential outcomes in order to maximize your reward from the level of risk that you take.
We have described this process as going long "synthetically". This term basically means that you replicate share positions using options. There are other ways to synthetically go long a stock.
For example, buying calls and at the same time, selling an equal number of puts, both at the same strike price and expiration, is another way to create a synthetic stock position. It also costs very little, if anything, because the income from the sold options offsets the cost of the bought ones.
The downside of this type of synthetic position is, that it has a risk profile similar to a futures or CFD contract. The downside risk could hurt you badly.
However, this risk can be offset by purchasing a put option. The combination of a synthetic stock position as just described, together with a put option at the right strike price for hedging, is known as the "Three Legged Box" spread. It has a very impressive risk to reward ratio, requires no stop losses, has unlimited profit potential.
But just like the deep in the money call option strategy, it requires some analysis beforehand. Personally, I prefer the Three Legged Box strategy and highly recommend it.
Return to Stock Option Trading Page
or Go To
Options Trading Mastery Home Page
New! CommentsHave your say about what you just read! Leave me a comment in the box below.