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How Deep in the Money Call Options Work
SmartAsset Team
5 min read
An investor researches how deep in the money call options work.
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One common way to help increase investment returns is to use deep in the money call options. These options have strike prices much lower than the current market price of the asset, giving them high intrinsic value. This makes them less affected by market volatility, offering a more stable investment option when compared with at-the-money or out-of-the-money options. A financial advisor could work with you to determine how deep in the money call options and other strategies fit into your portfolio.
How a Call Option Works
A call option is a financial contract that gives the buyer the right-but not the obligation-to purchase a specific quantity of an underlying asset at a predetermined price, known as the strike price, within a specified time frame. This type of option is commonly used in stock markets, where the underlying asset is typically shares of a company.
When an investor buys a call option, they pay a premium to the seller for the right to purchase the asset at the strike price before the option expires. If the market price of the asset rises above the strike price, the call option becomes “in the money,” allowing the investor to buy the asset at a lower price than the current market value. This can lead to significant profits if the asset’s price continues to climb. However, if the asset’s price does not exceed the strike price by the expiration date, the option expires worthless, and the investor loses only the premium paid.
Investors often use call options as a strategic tool to capitalize on potential price increases in the underlying asset without committing to a full purchase upfront. By purchasing call options, investors can protect themselves from missing out on gains if the market moves favorably. Call options can also serve as a hedge against potential losses in other investments.
Additionally, investors can make use of call options to generate income through a strategy known as covered calls, where an investor sells call options on assets they already own. This approach allows them to earn premiums while potentially selling their assets at a favorable price if the options are exercised.
What Is Deep in the Money?
Deep in the money refers to options that have a high intrinsic value. For call options, this means the stock’s market price is well above the strike price, while for put options, the stock’s market price is far below the strike price. These options are considered “deep” because they are already profitable and have a high likelihood of remaining so, making them an attractive choice for investors seeking lower risk opportunities.
Deep in the money options can provide investors a greater degree of leverage and a higher delta, which measures how much the option’s price is expected to change for every $1 shift in the underlying asset’s price. Because these options are already profitable, they tend to move more closely with the underlying asset, offering a more predictable return. This can make them appealing for investors who want to capitalize on price movements without the full capital outlay required to purchase the underlying asset outright.
Pros and Cons of Deep in the Money Options
An investor compares the pros and cons of deep in the money options.
Deep in the money options can be a valuable tool for investors seeking stability and leverage in their portfolios. However, they come with higher costs and require a thorough understanding of market dynamics. Comparing the pros and cons can help you determine if this strategy aligns with your financial goals and risk tolerance.
Here are three benefits to consider before investing:
Higher intrinsic value: Deep in the money options have a higher intrinsic value when compared with at-the-money or out-of-the-money options. This means they are less affected by time decay, providing a more stable investment as the option’s value is closely tied to the underlying asset’s price.
Lower volatility impact: These options are less sensitive to changes in volatility, which can be advantageous in uncertain markets. Investors can benefit from a more predictable performance, as the option’s value is primarily driven by the stock price rather than market fluctuations.
Potential for leverage: Deep in the money options allow investors to control a larger number of shares with a smaller capital outlay. This leverage can amplify returns if the underlying asset moves favorably, making it an attractive strategy for those with a bullish outlook.
And, here are three drawbacks:
Higher premiums: The cost of purchasing deep in the money options is generally higher due to their intrinsic value. This can limit the potential return on investment, as a significant price movement is needed to cover the initial premium paid.
Limited upside potential: While these options offer stability, they also have a capped upside compared to out-of-the-money options. Investors may miss out on larger gains if the underlying asset experiences a substantial price increase.
Complexity and risk: Trading deep in the money options requires a solid understanding of options strategies and market conditions. Investors face the risk of losing the entire premium if the market moves against their position, highlighting the need for careful analysis and risk management.
Bottom Line
An investor reviews his investment portfolio.
Understanding deep in the money call options can be beneficial for investors aiming to enhance their market strategies. These options have a strike price much lower than the current market price of the asset, providing high intrinsic value and making them less sensitive to market fluctuations. Their stability attracts investors looking for lower risk and higher gains.
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