What it means
A call option gives the right to buy shares at a fixed price, the strike, before a set date. A deep in-the-money option has a strike well below the current share price, so it already has a large intrinsic value (the gap between the share price and the strike).
Such an option tends to move almost one for one with the shares. The strategy works by buying that option instead of the shares.
For example, an investor who wants exposure to 1,000 shares priced at $100 would need $100,000, but could buy options that behave similarly for perhaps a third of that sum. The cash saved can be held in treasury bills or used elsewhere in the portfolio.
The main attraction is capital efficiency and a lower maximum loss. The most the buyer can lose is the premium paid, which is less than the cost of the shares.
The main drawbacks are that the option has an expiry date, it pays no dividends and it contains time value that falls to zero by expiry. Choice of option matters.
Investors normally choose an expiry at least a year away, so time value decays slowly, and a strike far below the current price, so the option has a high delta (the amount the option price moves for each dollar move in the share). Wide trading spreads on options can also add to cost, so liquid contracts are preferred.
This is a tool for experienced investors who understand options, because mistakes can be costly. It is also not a free lunch: if the shares fall sharply, the percentage loss on the option can be larger than the percentage loss on the shares.
Position size should reflect that.
In practice
Real-world examples.
Example
A portfolio manager likes a large retailer but wants to keep cash available for other opportunities. She buys options with 18 months to expiry and a strike far below the market price. The position uses about a third of the cash that owning the shares would require.
Example
A retired investor considers replacing a $200,000 holding in a technology company with options to reduce the amount at risk. His adviser points out that the options expire and pay no dividends, and that he could lose the whole premium. He decides the strategy does not suit his goal of steady income.
Example
A hedge fund uses the strategy to gain exposure to a stock around an earnings announcement. It buys deep in-the-money options so that its loss is capped at the premium if the results disappoint. After the announcement, it sells the options and keeps the profit.
Formula
Calculation
Cash saved = cost of buying the shares - premium paid for the options
An investor wants exposure to 1,000 shares priced at $100, which would cost 1,000 x 100 = $100,000. Instead, he buys 10 call contracts (each covering 100 shares) with a strike of $70, at a premium of $32 per share. Premium cost = 10 x 100 x 32 = $32,000, so cash saved = 100,000 - 32,000 = $68,000. If the shares rise to $110, and time value stays at $2, the option is worth 40 + 2 = $42, a gain of (42 - 32) x 1,000 = $10,000, the same dollar gain as owning the shares, but 31.25% on $32,000 against 10% on $100,000. If shares fall to $90, the option is worth 20 + 2 = $22, a loss of $10,000.Case study
Seen in the real world.
Birchwood Partners is an illustrative, fictional investment club with $150,000 to invest in a single company trading at $75. Buying 2,000 shares would use the entire sum, leaving nothing for other ideas.
The club's treasurer instead buys 20 call contracts with a $50 strike and 14 months to expiry at $27 each, a total premium of 20 x 100 x 27 = $54,000. The remaining $96,000 is held in short-term government securities.
Over the following year, the company's shares move sideways, and the options lose their time value, falling to $25 each, a loss of $4,000, but the $96,000 earns interest. The illustrative lesson is that the strategy frees cash and limits risk, but a flat share price still costs money because time value erodes.
Watch out
Common mistakes.
- Treating the options as identical to the shares, when they expire, pay no dividends and lose time value each day.
- Choosing an option with a short expiry to save money, when it decays quickly and may expire before the investment idea works.
- Using the cash saved to take on extra risk elsewhere, which can leave the total portfolio more exposed than if the shares had been bought.
Questions
People also ask.
Why use options instead of shares?
The main reasons are lower cash outlay and a capped maximum loss, which free money for other uses, but these come with expiry and time value costs.
What is a deep in-the-money option?
It is an option whose strike price is far below the current share price, so most of its value is intrinsic and it moves almost in step with the shares.
What happens at expiry?
The investor can exercise the option to buy the shares, sell it before expiry, or roll it into a later one, but if it is not used it may expire worthless.
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