Deep In The Money

What Is Deep In The Money?

Deep in the money is an option that 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 extrinsic or time value. Deep in the money options have deltas at or close to 100.

Deep in the money options can be contrasted with those deep out of the money, which instead have no intrinsic value and also minimal extrinsic value. These options have deltas close to zero.

Understanding Deep In The Money

The Internal Revenue Service (IRS) defines deep in the money options as either:

An option is usually said to be "deep in the money" if it is in the money (ITM) by more than $10. So, 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. 

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. 

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. 

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 (ATM) and out of the money (OTM) options. 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.

Special Considerations

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, despite costing less to purchase than the underlying asset. 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 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, leading the option to lose value and even potentially fall OTM. In that case, intrinsic value declines or completely disappears, leaving only the premium, which is at the mercy of time decay.

Traders will often look to close out deep in the money options by exercising them early, which is only allowed for American options — European options can only be exercised when they expire. Doing so can help clean up a trader's options position, while also capturing more favorable interest rates (in the case of deep puts) or dividends (in the case of deep calls).

This is because owning a deep put is effectively the same as being short the stock — but without being credited the short proceeds that can earn interest. Likewise, being long a deep call is effectively the same as being long the stock, but contract holders would not receive the dividends paid unless they owned the shares instead.

Deep in the Money Example

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. At the same time, these options both probably have deltas somewhere in the high 90s.