When navigating the realm of options trading, comprehending the terms and strategies can be paramount to your success. One such term that every trader should be familiar with is deep in the money (DIM) options. This article seeks to explain what deep in the money options are, their implications for traders, and special considerations to keep in mind.
What Are Deep in the Money Options?
Deep in the money (DIM) options are options contracts that have a strike price significantly below (for call options) or above (for put options) the current market price of the underlying asset. The nature of these options means their value is primarily made up of intrinsic value—essentially, the difference between the underlying asset's market price and the option's strike price—rather than extrinsic or time value.
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Call Options: For a call option, which gives the holder the right to buy the underlying asset, a deep in the money option would have a strike price substantially below the market price. This implies that it is highly likely that the option will be exercised profitably.
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Put Options: Conversely, for a put option, which gives the holder the right to sell the underlying asset, a deep in the money designation means the strike price is significantly above the current market price.
Key Characteristics
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High Intrinsic Value: Deep in the money options hold considerable intrinsic value. If an option's strike price is well below the market price (for calls) or well above (for puts), the intrinsic value will be high.
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Delta Close to 1.00: The delta of deep in the money options approaches 1.00 (or 100%), indicating a direct correlation with the underlying asset's price movements. This means that for every point change in the asset's price, the option's price will likely change almost identically.
Differentiating Between Deep in the Money and Other Options
It's important to place deep in the money options in context:
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At the Money (ATM): Options that have a strike price close to the current market price of the underlying asset.
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Out of the Money (OTM): Options that have no intrinsic value, meaning a call option's strike price is above the market price, or a put option's strike price is below the market price. These options typically have deltas close to zero.
IRS Definitions of Deep in the Money Options
The IRS has specific definitions for deep in the money options, which includes:
- Any option lasting fewer than 90 days that has a strike price one strike less than the highest stock price available.
- An option with a term longer than 90 days, with a price less than two strikes lower than the highest stock price available.
A common threshold used within the trading community is that an option is deep in the money if it is in the money by more than $10. In the case of lower-priced equities, being $5 or less below the market price can also be deemed deep in the money.
Investing with Deep in the Money Options
Holding deep in the money options allows investors to mirror the price movements of the underlying stock with minimal capital outlay, providing various advantages:
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Lower Capital Requirement: DIM options require less investment compared to holding the underlying asset outright, allowing for smaller capital exposure while retaining significant profit potential.
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Leverage: Due to their high delta, DIM options provide leverage, allowing an investor to control a larger amount of the underlying asset per dollar invested.
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Limited Risk: Though options inherently carry risk, deep in the money options are often viewed as a safer choice compared to OTM options since they already have intrinsic value.
Special Considerations
While deep in the money options have several advantages, potential risks exist:
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Limited Lifespan: Unlike stocks, options have expiration dates. If the underlying stock does not move in the expected direction within the option's lifespan, the investor may incur losses.
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Time Decay: Options experience time decay, particularly as expiration approaches. If the stock stagnates, intrinsic value may diminish over time.
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Early Exercise: In the case of American-style options, traders often opt to exercise DIM options early to capture dividends or interest rates. However, this flexibility does not exist with European-style options, which may only be exercised at expiration.
Example of Deep in the Money Options
To exemplify, consider an investor purchasing a May call option for stock ABC with a strike price of $175 on January 1, 2019. If ABC closes at $210 on the same day, the strike prices for May call options available would be $150, $175, $210, $225, and $235. Given the significant difference, the option with a strike price of $150 would be considered deep in the money.
Conclusion
Understanding deep in the money options can furnish traders with a valuable tool for leveraging capital and engaging in strategic trades with limited risk. By grasping their characteristics, associated risks, and definitions, traders can make informed decisions and better capitalize on market movements. Like all forms of trading, comprehensive understanding and awareness of the associated risks are integral to successful investment strategies.
For more information about options trading and strategies, consult with a financial advisor or delve deeper into educational resources to expand your knowledge and capabilities in the trading landscape.