An in the money option is one that has intrinsic value because the strike price is below the current market price of the underlying asset for a call or above the current market price of the underlying asset for a put. When that value becomes quite large the option is then referred to as “Deep in the Money” (DTM). When an option is deep in the money its value is nearly completely intrinsic, with a minimal amount of time value. Another defining characteristic of an option which is deep in the money is that it has a delta which is at or close to 100. An option that is deep in the money can also be contrasted with an option that is deep out of the money. An option like this has zero intrinsic value and very minimal time value. In addition, it would have a delta that is very close to zero.
Summary of Deep in the Money Options
- An option which is said to be deep in the money consists almost entirely of intrinsic value and has a strike price that is significantly above or below the current market price of the underlying asset.
- Deep in the money options have a delta that is at or near 100, which means their price changes at a nearly 1:1 ratio with the price changes of the underlying asset.
- When options are seep in the money traders are likely to exercise them early.
Understanding Deep In the Money Options
The Internal Revenue Service, which is the U.S. tax office, defines an option as deep in the money whenever it has an expiration that is fewer than 90 days away and where the strike price of the option is one strike less than the highest available strike price. Or an option which has greater than 90 days until expiration where the strike price is less than two strikes from the highest available stock price.
In practice traders typically consider an option as deep in the money when it is in the money by $10 or more. This applies to both call and put options and both types can be deep in the money. For a call option it means that the strike price is at least $10 below the current price of the underlying asset, and for a put option it means that the strike price is at least $10 above the current market price of the underlying asset. Where the options are written on lower priced equities, such as those with a market value of $20 or less, $5 or even less could be the level required for the option to be considered deep in the money. When an option is deep in the money like this it has a very high delta level approaching 100, and that means that the option price moves at a nearly 1:1 relationship with the underlying asset.
One of the most notable characteristics of options that are deep in the money is their extreme intrinsic value. When calculating the value of a call option you can subtract the strike price of the option from the current market price of the underlying asset. To calculate the value of a put option you would add the strike price to the current market price of the underlying asset. The deeper into the money an option moves, the closer to 100 its delta moves. Once the delta is 100 it means that every move in the underlying asset is matched by a change in the price of the option point for point.
This characteristic makes deep in the money options an ideal strategy for long-term investors. That is especially true when comparing deep in the money options with in the money options and out of the money options. Because the price of a deep in the money option moves nearly in lock step with the price of the underlying asset it is quite similar to investing in the underlying asset. However, the option has the benefit of a lower outlay of capital, leverage, greater potential profit, and limited risk.
Special Considerations for Deep in the Money Options
Because option premiums are smaller than the actual price of the underlying asset, purchasing deep in the money options gives a trader the opportunity to profit nearly as much from the actual price movements of the underlying as holders or short sellers of the actual asset. However, it is important to note that while deep in the money options comes with lower capital outlay and risk, this doesn’t mean they are risk-free. Because an option has a lifespan that is limited by its expiration date, which isn’t true for the underlying assets, the trader still needs the underlying asset to move in the desired direction within the specified time frame of the option if they want to make a profit.
It is always possible the underlying asset will move in the opposite direction to the one the trader desires, which would make the option less in the money, and could even bring the option to be at the money, or out of the money in extreme cases. When that happens the intrinsic value of the option can disappear completely, leaving only the option premium, which will decline due to time decay. In most cases a trader will look to close out any option that is deep in the money early, however this is only allowed with American options. Their European counterparts can only be exercised at their expiration. By exercising the deep in the money option early the trader is able to clean up their positions while also capturing the most favourable dividends (in the case of deep in the money calls) or interest rates (in the case of deep in the money puts).
This is true because owning a put that is deep in the money is effectively the same as shorting the underlying asset, but without the credit of the short proceeds that can earn interest. In the same manner having a call option deep in the money is effectively the same as owning the underlying asset, however the option holder does not benefit from receiving any dividends paid out by the underlying asset.
Example of Deep in the Money Option
Let’s say you purchase a September call option on a stock with a strike price of $85 on June 1, 2020. On that day the closing price of the stock was $125 and the strike prices of the September call options on the stock that day were $75, $85, $100, $125, and $150. Because the term of the option is more than 90 days under IRS rules the call option with a strike price of $85 (two strikes below $125) is considered as a deep in the money option. If we took the time to calculate the deltas for these options, we would likely find that they are in the high 90s.