Deep In The Money (DITM) options are financial derivatives with strike prices significantly below the market price (for call options) or significantly above the market price (for put options) of the underlying asset. These options are referred to as “deep in the money” because their intrinsic value is very high relative to their extrinsic value or time value.
Definition and Characteristics
- Intrinsic Value: The intrinsic value of a DITM call option is the difference between the current market price of the underlying asset and the strike price. For a DITM put option, it is the difference between the strike price and the current market price.
- Extrinsic Value: Also known as time value, this diminishes as the option approaches its expiration date and is often lower for DITM options.
- Premiums: The premium for DITM options is higher due to their increased intrinsic value.
Mathematical Representation
For a Deep In The Money Call option:
For a Deep In The Money Put option:
Where:
- \( S \) = Current market price of the underlying asset
- \( K \) = Strike price of the option
Usage in Trading
DITM options are utilized by traders and investors primarily for two reasons:
- Leverage: They provide significant leverage, allowing traders to control larger positions with smaller amounts of capital.
- Reduced Risk: Compared to at-the-money (ATM) and out-of-the-money (OTM) options, DITM options are less risky because of their higher intrinsic value, making them less susceptible to time decay and volatility.
Examples and Applications
- Example 1: Suppose the current price of a stock is $150. A call option with a strike price of $100 is considered deep in the money. Should the stock’s market price rise further, this call option’s intrinsic value will increase proportionately.
- Example 2: Conversely, if the stock price is the same $150, a put option with a strike price of $200 would be deep in the money, gaining intrinsic value as the stock price decreases.
Historical Context
The concept of options trading dates back to ancient Greece, but the modern options market was greatly developed with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. Over the years, the use of DITM options has evolved with increased financial sophistication and the introduction of more complex trading strategies.
Important Considerations
- Liquidity: DITM options can sometimes be less liquid compared to ATM options, affecting the ease of entering and exiting positions.
- Theta Decay: Although DITM options are less affected by time decay compared to OTM options, they still lose value as they approach expiration.
- Bid-Ask Spread: The spread can be wider for DITM options, influencing transaction costs.
Related Terms
- At the Money (ATM): An option with a strike price equal (or close) to the current market price.
- Out of the Money (OTM): An option with no intrinsic value – for call options, the strike price is above the market price, and for put options, below.
- Leverage: Using borrowed funds or financial instruments to amplify potential returns.
FAQs
Why would an investor choose to buy deep in the money options?
How do DITM options affect the options’ Greeks?
References
- Black, F., & Scholes, M. (1973). The Pricing of Options and Corporate Liabilities. Journal of Political Economy, 81(3), 637-654.
- Hull, J. C. (2018). Options, Futures, and Other Derivatives. Pearson Education.
Summary
Deep In The Money options offer a strategic tool for traders and investors seeking to maximize leverage while mitigating risk. Understanding their intrinsic and extrinsic values, as well as their application in various trading scenarios, is essential for making informed investment decisions.
