Why Would Someone Buy Deep In The Money Calls?

In the world of options trading, deep in the money calls are a fascinating topic. These are options that have strike prices significantly below the current market price of the underlying asset. But why would a trader or investor opt for these seemingly expensive contracts? To unravel this, let’s dive deep into the reasons behind purchasing deep in the money calls, exploring their strategic benefits, risks, and applications.

Understanding Deep In The Money Calls

To grasp why someone would buy deep in the money calls, it’s crucial to first understand what these options are. A deep in the money call option is a contract that gives the holder the right to buy an underlying asset at a price well below its current market value. For instance, if a stock is trading at $150, a call option with a strike price of $100 would be considered deep in the money.

Strategic Benefits

1. Leverage with Lower Premiums: One of the primary reasons traders buy deep in the money calls is to gain significant leverage with a relatively lower premium compared to buying the stock outright. Since these options are already in the money, they tend to be more sensitive to movements in the underlying stock, offering a higher delta (i.e., the option's sensitivity to the stock's price changes). This means that for each dollar the stock price moves, the deep in the money call option’s price will move approximately one dollar, less the premium.

2. Lower Time Decay Impact: Deep in the money calls have lower time decay compared to out of the money or at the money options. Time decay, or theta, refers to the reduction in the value of an option as it approaches its expiration date. Deep in the money calls retain more of their intrinsic value, and hence, are less affected by time decay. This can be advantageous for traders who want to hold positions for longer periods without significant erosion of their investment due to time decay.

3. Increased Intrinsic Value: Because deep in the money calls have significant intrinsic value (the difference between the stock price and the strike price), their value is less affected by volatility and more by the movements in the underlying stock’s price. This can be beneficial for traders who expect substantial price movement in the underlying asset.

4. Reduced Risk of Losing Entire Premium: Unlike out of the money options, which can become worthless if the stock price does not move as anticipated, deep in the money calls have intrinsic value even if the stock price remains stagnant. This reduces the risk of losing the entire premium paid for the option.

Applications and Strategies

1. Directional Bets: Investors who are highly confident about the direction of an asset's price movement might choose deep in the money calls. For instance, if a trader believes a stock will rise significantly, purchasing deep in the money calls provides a leveraged bet on that upward movement without the need to buy the stock outright.

2. Hedging: Deep in the money calls can be used as a hedge in a portfolio. For example, if an investor holds a short position in a stock, they might buy deep in the money calls as insurance against a sharp upward move in the stock’s price.

3. Tax Efficiency: In certain jurisdictions, trading in options might offer tax advantages compared to trading the underlying stock directly. By using deep in the money calls, investors can potentially benefit from favorable tax treatment on capital gains.

Risks and Considerations

1. High Premium Costs: One of the main drawbacks of deep in the money calls is their higher premium cost compared to at the money or out of the money options. This higher initial investment can be a barrier for some traders, especially if the stock price does not move as expected.

2. Liquidity Concerns: Depending on the underlying asset and the specific option contract, deep in the money calls may have lower liquidity, making it harder to enter or exit positions without affecting the market price.

3. Market Conditions: In highly volatile markets, the intrinsic value of deep in the money calls can fluctuate significantly. While they are less affected by time decay, their market value can still be influenced by broader market conditions and news.

Conclusion

Buying deep in the money calls can be a powerful strategy for investors looking for leverage, reduced time decay impact, and intrinsic value. However, it’s essential to weigh these benefits against the higher premium costs and potential liquidity issues. For those with a strong conviction about an asset's price movement or those seeking hedging strategies, deep in the money calls offer a viable option, though they require careful consideration and understanding of the associated risks.