What is Deep in The Money (DTM)?

Introduction

If the striking price of an option is lower than the current market price of the underlying asset for a call option, or higher than the current market price of the underlying asset for a put option, then the option is considered to have intrinsic value on account of the fact that it is in the money. "Deep in the Money" (DTM) is the term that is used to describe the option when the value of the option reaches a significant level. At the point where an option is deep in the money, its value is almost entirely based on its intrinsic characteristics, with only a little amount of time value.

For an option to be considered deep in the money, it must have a delta that is either at or very close to 100. This is another distinguishing feature of such an option. The opposite of an option that is deep in the money is an option that is deep out of the money. Both of these options can be contrasted further. An option such as this has no worth in and of itself, and it has a very low value in terms of time. Additionally, it would have a delta that is.

What is DTM

When an option's strike price is one strike below the highest available strike price and its expiration is less than 90 days away, the option is considered to be "deep in the money" according to the U.S. tax authority, the Internal Revenue Service. Or, an option with a strike price lower than two strikes from the highest available stock price and more than 90 days till expiration.

When an option is in the money by $10 or more, traders usually consider it deep in the money. This is true for put and call options alike, and it's possible for either kind to be highly in the money. This signifies that the strike price of a put option is at least $10 higher than the underlying asset's current market price, and that the strike price of a call option is at least $10 lower than the underlying asset's current price.

In cases when the options are associated with stocks that are trading at lower prices, say $20 or less, the threshold for the option to be deemed deep in the money could be $5 or even lower. The option price moves in a nearly 1:1 ratio with the underlying asset when an option is deep in the money like this, with a very high delta level nearing 100.

Extreme intrinsic value is one of the most prominent features of deep in the money options. You can deduct the option's strike price from the underlying asset's current market value to get the value of a call option. A put option's value is determined by adding the strike price to the underlying asset's current market value. An option's delta increases closer to 100 the further it goes into the money. When the delta hits 100, it indicates that each point movement in the underlying asset's price is matched by a point movement in the option's price.

Deep in the money options are a great strategy for long-term investors because of this feature. This is particularly valid when contrasting deep in the money choices with both out-of-the-money and in-the-money options. Investing in a deep in the money option bears similarities to buying the underlying asset since their prices fluctuate almost exactly in tandem with each other. On the other hand, the option offers advantages such smaller capital requirements, leverage, higher potential profits, and reduced risk.

Trading Strategy for DTM

The derivative has some value even though a deep out of the money option appears to be worthless. Time value is included in all options, both in and out of the money. Time value quantifies the advantage of owning an option with time till maturity and at least a slight probability that the underlying's price will move in the direction of the intended strike.

Consequently, some investors are willing to pay a tiny sum for the remaining time value even though a deep out of the money call or put has no intrinsic worth. But as the option approaches its expiration date, this time value drops.

In comparison to comparable options that have strike prices that are closer to the price of the underlying asset, deep out of the money options have a relatively low cost, which is the most evident characteristic of these options. In the event that the option moves into the money before it expires, there is a significant possibility that the payoff will be substantial.

However, there is also a significant danger that the options may expire worthless. This latter scenario has the potential to result in a significant percentage reward. The modest sum that was paid for the option has the potential to multiply many times over. The possibility of achieving one hundred percent gains is actually on the lower end of the spectrum.

Because only a few of the options need to be successful in order to generate a gain for the portfolio as a whole, it is tempting to buy options that are deep out of the money on a large number of assets all at once. The expenses, however, are compounded by fees, and some experts consider these kinds of options to be gambling because they have a big potential payoff but a very low probability of being successful.

Considerations for DTM

Deep in the money options provide a trader with the potential to earn nearly as much from the actual price fluctuations of the underlying asset as holders or short sellers of the actual asset. This is due to the fact that option premiums are substantially lower than the actual price of the underlying asset. Deep in the money options, on the other hand, come with lesser capital outlay and risk, but this does not mean that they are risk-free. It is essential to keep this in mind.

The trader still requires the underlying asset to move in the desired direction during the given time frame of the option in order to generate a profit. This is because an option has a lifespan that is limited by its expiration date, which is not true for the underlying assets when it comes to the underlying assets.

It is always possible that the underlying asset would move in the opposite direction to the one that the trader intends. This would result in the option being less profitable, and it might even bring the option to be profitable, or even out of the money, in extreme situations. In the event that this occurs, the intrinsic value of the option may completely vanish, leaving behind only the option premium, which will decrease as a result of time decay.

In the majority of instances, a trader will attempt to close out any option that is deep in the money early, but, according to the rules, this is only permitted with American options. In Europe, their counterparts can only be exercised once they have reached their expiration date. A trader is able to clean up their positions and take advantage of the most attractive pay-outs (in the case of deep in the money calls) or interest rates (in the case of deep in the money puts) by executing the deep in the money option early. This allows the trader to maximise their profits.

As a result of the fact that having a put that is deep in the money is essentially the same as shorting the underlying asset, but without the credit of the short proceeds that can generate interest, this is the case. In a similar fashion, possessing a call option that is deep in the money is essentially the same as owning the underlying asset; however, the option holder does not benefit from collecting any dividends that are paid out by the underlying asset.

DTM Example

Imagine that you buy a September call option on a stock that has a strike price of $85 on June 1, 2020. Assume that you buy the option. The strike prices of the September call options on the stock that day were $75, $85, $100, $125, and $150. The closing price of the stock on that day was $125, and the strike prices, respectively, were $75, $85, $100, and $150.

The call option with a strike price of $85 (two strikes below $125) is regarded to be a deep in the money option according to the standards of the Internal Revenue Service (IRS). This is because the period of the option is greater than ninety days. If we were to take the time to compute the deltas for these alternatives, we would most certainly discover that they are in the high nineties.

Pros and Cons of DTM

Conclusion

In order for an option to be considered "deep in the money," it must have a strike price that is either much higher or lower than the current market price of the underlying asset. Additionally, the option must consist almost entirely of its intrinsic value.

Options that are deep in the money have a delta that is one hundred or close to one hundred, which indicates that their price fluctuates in a manner that is virtually identical to the price fluctuations of the underlying asset.