Why would you buy deep in the money call options?

Buying shares of a company is pretty straight forward. You look up the ticker or name of the company, place an order, and receive said shares. The only things you really need to be concerned about is what company, how many shares, and if it’s trading at a reasonable price.

When it comes to stock options, there is much more thought needed to go into your game plan. Adding to the previous list, you also need to be concerned with what strike price, expiration date, and even likelihood of the contract going in the money or not. However, if you have strong conviction about the movement of a stock, in this case to the upside, you could purchase in the money calls or out of the money calls. The use of leverage to multiply your returns is much more than just holding plain ol’ stocks; that’s the appeal of options right? But the certainty of these contracts you buy that are in and or out of the money being in the money at expiration is not 100%. Though these contracts are much cheaper, you can’t take full advantage of the intrinsic value with these contracts. They’re either only valued extrinsically (out the money) or a mix (in the money; remember that the delta is .50). By utilizing deep in the money call options, you are taking advantage of the upside potential through its intrinsic value from a shorter time frame, have protection from downside, and cost cheaper than its stock equivalent. Deep in the money call options also eliminates the anxiety associated with worrying about whether or not your contracts will be in the money.

Let’s use a real example to demonstrate these points:

I will be using the Robinhood desktop website because of it’s friendly UI with $SPY as the ticker.

As of March 3, 2022, the price of $SPY at cash close was $435.73. As a refresher, contracts that are considered to be deep in the money are at least 10% below the price of the underlying. Therefore: $435.73 * 0.90 = $391.50. I will also be using LEAPs as the contract expiration, in this case December 30, 2022. This gives us about 9 months til expiration, or 303 days. Also because these later dated contracts are priced in increments of $5, I will be using the $390 strike.

Remember that each contract is the equivalent of 100 shares of the underlying.

If you were to purchase 100 shares of $SPY at $435.73, that would cost you $43,573. However, by utilizing the $390c 12/30, instead of forking out a eye boggling $43.5k, this contract will cost $6,646. That’s a staggering difference of $36,927! If you were to use the same amount of capital from those 100 shares of $SPY for $390c 12/30, you could get 6 contracts. 6 contracts multiplied by 100 gives you the exposure equivalent of 600 shares, 500 more than shares for the same amount. To summarize this section:

• 100 shares of $SPY at $435.73 = $43,573
• 1 contract of $390c 12/30 @ $66.46 = $6,646
  • Difference of $36,927 for same exposure
• Or with the same amount of capital:
  • 6 contracts of $390c 12/30 @ $6,646 per contract = $39,876
  • 5x the exposure while still having some money to spare

So this means at every dollar increase, the 100 share will gain $100 while the $390c 12/30 contract will have a gain of $100 (more or less depending on delta). This is only if the underlying goes up in value. On the other hand, if the underlying goes down in value, it will lose $100 per dollar loss while the contracts will lose about $100 (again, depends on delta).

There are disadvantages to using option contracts than shares of course. The biggest one being that option contracts are time restricted, and the closer to the expiration date the more extrinsic value is lost due to theta. But with deep in the money calls, that shouldn’t be too much of a concern. There’s also the disadvantage of not getting dividends. Currently, $SPY has a dividend yield of 1.33% which comes out to be $579.52 annually with 100 shares. Lastly, no matter what time frame your contracts are, realizing gains from options will always be taxed as short term capital gains.

Option contracts act like stocks but they aren’t stocks. They can be a replacement assuming that you will hold onto this position for a couple months. Usually, when individuals purchase option contracts they do not really have the intention of exercising them, but remember if shares are ultimately what you would want, you can do so if desired.