A deep in the money call is when you write an option where the strike price, is much less than the current share price. The generally accepted definition is 10% below the current share price. You may be asking why anyone would sell a call option on a stock that would require them to sell the stock at less than the current price? The answer is in the premium.
- Company A is trading for $20 a share
- Investor sells a call option at $18 per share
- A premium is received of $2.50 for the option.
- If exercised the investor receives $18 for the stock + the upfront premium of $2.50 = $20.50 in total.
- Break even price for investor of $17.50
The attraction that the deep in the money call is that you have extra protection built into your trade. For you to lose on your position the share price would have to decline beyond the 10%+ gap to the strike price. As you can see form the above example the break even price for the investor also accounts for the premium received. This provides an extra cushion for the investor.
We all know that stocks can and do lose 10% of their value in short periods of time, but outside of commodities stocks it is a rare occurrence.
The main purpose of this strategy is to bank more reliable cash flow than what is on offer with in the money (ITM), at the money (ATM), or out of the money calls (OTM). Some regular daily fluctuations will not affect your profit at all, and you are not relying on any capital growth to hit your strike price and bank you profit like you would be with OTM calls.
If you are selecting stocks that have a stable history and are trending upwards over time then it can be a reliable strategy that can net you better yields than holding cash. You will not be earning the same kind of return you could with an ATM or OTM call option though. So if you get bored easily with stable numbers then this strategy may not be for you.
Writing a deep in the money call can also net you some extra profits on a stock that you were planning to sell anyway. The extra upfront premium can top off your exit with a few extra points for very little effort. As long as you are not in a hurry to off load the stock as you will have to wait for the option to be exercised to take full advantage.
With much of the risk from the trade removed by going deep in the money, you will have to continually do your research to find opportunities that will meet your return requirements.
This is a great way for those who are new to trading and want to take on lower risk until they feel more comfortable making trades. It is also suitable for those who are seeking cash flow while protecting their capital.