Show notes
Hey everyone. This is Kirk here again from optionalpha.com and welcome back to the daily call. Today, we are going to be talking about getting a basic understanding of a deep in the money call option strategy. There's a lot of jargon in there and so, we want to break this down for you guys if you're getting started with options or if you're new to options trading. The term "deep in the money" basically refers generally to option contracts which are more than $10 in many cases in the money, meaning they have intrinsic value or a lot of baked in intrinsic value right now. For call options, this would be strike prices that are at least $10 lower than where the stock is trading right now. For put options, that would be strike prices that are at least $10 higher than where the stock is trading right now. In either case, the idea here is that options that are far in the money have this deep intrinsic or high intrinsic value because they're so far in the money that if they were to be exercised right now, they do have value to exercise and get rid of the stock or buy the stock and dump it in the market.
Now, the call option strategy side of this is this idea that you are much better off to buy deep in the money call options than you are to outright, buy long stock in an underlying security. Now, on the general premise, I agree with the general analysis in most cases that it is much better for you to synthetically go long a stock using options than it is to go long the underlying stock itself. I feel like in most cases, stock can be insanely inefficient and can cost a lot of capital and can tie up a lot of capital in your account. And so, I want to use an example here today just to prove this point. Now, again, there's a lot of moving pieces here. There's no one way to do it. There's many contract months, there's how deep in the money do you go, how far out do you go in expiration, etcetera. I want to try to touch on as many of these as we can in the daily call and just to kind of again, get the discussion going and the dialogue going on this. But generally, I agree with the premise that you are much better off to synthetically go long a stock than you are to buy the actual underlying shares.
Let's take an example of Netflix. Netflix is a popular one. Right now, it's trading around 340. And so, to buy stock in Netflix, if you were to buy 100 shares of Netflix, it will cost you $34,000. Now, for most people, that would tie up all of their account and then some. They probably don't even have enough money to do that. But if you have enough money to actually buy Netflix which is a big hurdle in and of itself, it would tie up $34,000 to buy 100 shares. And so, one of the ways that you can trade Netflix and go long Netflix synthetically using options is to potentially buy a deep in the money call option. Now, here's where you start to have some analysis and you have to do this. It's nothing that we've done before, so it's up to you to determine how far out you want to go in expiration time. But you can buy deep in the money calls for 30 days out, 60, 90, 120 and in some cases, you can buy them very far out. With Netflix, we're looking at the January 2019 contracts which are over 250 days out from expiration.
Let's say you're really bullish on Netflix for whatever reason and you want to get a long position, long exposure and you're willing to hold that position for a long time. January 2019 contracts, so many, many, many months of holding these contracts. If you were to buy the 270 strike call options, again, which are more than $10 in the money, so they're very deep in the money as it's commonly referred to, the 270 strike call options when the stock is trading at around 340 would cost you $8,800. You could replicate a position in Netflix for about $8,800. Now, this is obviously significantly lower than the $34,000 it would cost to actually buy the stock. That's why options become so efficient because you can leverage option contracts and replicate a stock-like position without having to outlay all the money.
Now, here's where you'll also have to make decisions on how deep do you go in the money. In this case, you want to use Delta as your approximate for how many shares that option contract will replicate or will basically mimic. In this case, the 270 call options have a Delta of 80 and so, what that means is that that call option is going to replicate about the profit and loss of 80 contracts as the stock is moving. If Netflix goes up by $1, you should assume that you're going to make about 80% of that move, really. You're only going to participate in 80% of that move versus if you had say 100 shares, you'd participate in a $100 move. With a Delta of 80, if Netflix goes up by $1, you're only going to get $80. You want to use Delta to be your approximate representation of how many shares that deep in the money contract is really trying to mimic.
Just to give you guys another opinion on this or another look at this, the 225 call options which are now even further in the money cost about $12,000, so still significantly lower than buying Netflix outright. But those call options now have a Delta of 90, so they're going to replicate a 90 share type position in Netflix. It's going to mimic Netflix like you will have 90 shares in your account or like you're trading 90 shares of stock. As you can see, the further you go in the money, it costs more money, obviously. As you go in the money, it cost more money, but you also start to replicate more and more of the stock position. Ultimately, like I said, it's up to you to decide how you want to do this if you're super bullish on Netflix and if you want to use this type of strategy.
For full disclosure, I don't use this ever. I do not ever go into a position where I'm super bullish on anything. I prefer to just trade options the way that we teach at Option Alpha and how we trade around the market in a 30 to 60-day time period. I think it's much more effective to do that. But again, if you have some underlying major bullish assumption and you don't want to buy the stock or you can't afford to buy the stock, I think some sort of deep in the money call option strategy is a good alternative. I don't think it's the best strategy to use compared to other things, but if you're dead set on doing this, if you have it set in your mind that you want to go long a stock, then this is a good way to do it using options synthetically. It's much cheaper and offers a little bit more pinpoint accuracy as to how far you think it might go and how long you want to hold the contracts, etcetera. Hopefully this helps out. I know it's a little bit longer than our usual daily calls. But as always, if you guys have any questions, let me know and until next time, happy trading.
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