What is Deep In The Money?

A deep in the money option has an exercise, or strike price, significantly below (for a call option) or above (for a put option) the market price of the underlying asset. The value of such an option is nearly all intrinsic value and minimal premium.

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In The Money Options

Understanding Deep In The Money

The Internal Revenue Service (IRS) defines deep in the money options as any option with a term of less than 90 days which has a strike price which is one strike less than the highest available stock price or an option with a term of more than 90 days with a price less than two strikes than the highest available stock price.

An option is said to be "deep in the money" if it is in the money by more than $10. For options, both a call and a put option can be in the money. Therefore, if a call option is "deep in the money," it means that the strike price is at least $10 less than the underlying asset, or $10 higher for a put option. For lower-priced equities, $5 or less may be the level necessary to be deep in the money. Such deep in the money options have a very high delta level, meaning that the options will move nearly in lock-step with the underlying asset. 

The most important characteristic of this type of option is its considerable intrinsic value. To calculate the value of a call option, one must subtract the strike price from the underlying asset's market price. For a put option, you would add the strike price to the underlying asset price. 

As a call option moves deeper into the money, its delta will approach 100%. At this delta, every point change of underlying asset price results in an equal, simultaneous option price change in the same direction.

For this reason, deep-in-the-money options are an excellent strategy for long-term investors, especially compared to at the money and out of the money (OTM) options. Therefore, investing in the option is similar to investing in the underlying asset, except the option holder will have the benefits of lower capital outlay, limited risk, leverage, and greater profit potential.

Key Takeaways

  • Deep in the money options have strike prices that are significantly above or below the option price.
  • They are excellent investments for long-term investors because they have nearly a 100% delta, meaning that their price changes with every point change in the underlying asset's price.
  • The downside to deep in the money options is that there is a possibility that the stock may move in the opposite direction and diminish profits or magnify losses.

Some Considerations

Since options cost less to purchase than the underlying asset, deep in the money options allow the investor to profit the same or nearly the same from a stock's movement as the holders (or short sellers) of the actual stock. While the deep money option carries a lower capital outlay and risk; they are not without risk. 

Because options have a limited lifespan, unlike stocks, the investor still needs the underlying stock to move in the desired direction (higher for calls and lower for puts) within the specified period to make a profit.

There is always the possibility that the stock will move in the opposite of the desired direction, making the options less of the money or even out of the money. In that case, intrinsic value declines or completely disappears leaving only the premium, which is at the mercy of time decay.

Example of Deep in the Money

Suppose an investor buys a May call option for stock ABC with a strike price of $175 on 1 Jan 2019. The closing price for ABC was $210 on 1 Jan 2019 and strike prices for May call options on the same day were: $150, $175, $210, $225, and $235. Because the option term is more than 90 days, the call option with a strike price of $150 (two strikes less than $210) is a deep in the money option.