Not those types of calls.
We are talking about options…those kinds of calls…and specifically…deep in the money calls.
But very few people truly have a good understanding of what a call is and specifically the best way to use them as stock replacement for fractions of the cost.
We will spend the rest of the article explaining what calls are then speaking about deep in the money calls and exactly how to use them.
What Is a Call Option?
For starters, what is a call?
A call represents 100 shares of stock (so does a put).
Let’s look at an example.
We are looking at the at the money calls in Facebook that expire in the March 17 expiration cycle which happens to be 21 days from now. If we buy a call and specifically the $136 call we are saying
We expect/hope Facebook will go higher from here and hopefully in 21 days be over $136. For this, we agree to buy 100 shares of Facebook if Facebook is over $136 when this call expires in 21 days.
If Facebook is over $136 21 days from now, the call will be in the money as the stock price will be above the price of our call strike. When we bought this call we agreed to buy 100 shares of Facebook at the predetermined priced of $136 per share if the option were to expire in the money.
Well for starters, before this trade becomes profitable for us at expiration, Facebook must actually be over $136 + $1.97 = $137.97. Why is this? Because we paid a debit for the call thus the stock has to be above our strike plus the price we paid for the call or in this case $1.97.
This is all just an example of buying a standard call and the prices we must get to before we can make money. Very straight forward.
So What Are These Deep In The Money Calls All About?
Above we mentioned that a call was deemed in the money when the stock price was above the strike price.
Deep in the money calls simply mean those calls with strike prices are furthest in the money.
Let’s look at another example.
On the left side of this image, we are pointing one of our arrows to the $123 call. Facebook is currently trading at $135.44 which would make the $123 call over $12 in the money. This is an example of a deep in the money call.
But besides knowing that it is $12 in the money, how else can we know it is deep in the money? We can look no further than an options delta which is its stock equivalent. A 96 delta call has the synthetic equivalent of 96 shares of stock. Don’t believe me? Look here.
Here we can see we are buying 96 shares of Facebook which gives us 96 deltas. How much will this cost? $135.44 * 96 = $13,002.24.
Same thing. We bought that $123 deep in the money call and came away with 96 deltas. How much did this cost? $1,255. About 1/10th of the cost for the synthetic equivalent of 96 shares of stock. In both cases, if Facebook were to go up $1, both the 96 shares and the $123 deep in the money calls would be worth $96 more.
Advantages to Deep in the Money Calls
Well, we just showed how buying deep in the money calls costs about 1/10th of the price of buying the stock and we get the same profits on a $1 up move. But there is something else that makes deep in the money calls so interesting.
On the left, we have our call but on the right, we have the corresponding put for the same strike price. Because the calls are deep in the money, the total value or the price we paid ($12.55) is the intrinsic value of the call. But what is the extrinsic value of that call? It would be the price of the corresponding out of the money put. Or in this case, about $0.12.
But what does this mean? Well, for deep in the money calls we have to look to the put side to see how much premium is going to be taken out of our call. This is the extrinsic value that is removed from our deep in the money call or in this case $0.12. If Facebook does not move at all and expires at the exact same price it is today, the value of our call with be only $0.12 less than it is today. This makes deep in the money calls a great asset and a nice tool for stock replacement because you are giving up very little premium and extrinsic value to wield almost 100 shares of stock for only 1/10th of the cost.
Deep in the money calls are those that are furthest in the money. These calls have the highest delta. Delta is our synthetic stock equivalent. With deep in the money calls we are able to wield almost 100 shares of stock for small fractions of the price and give up very little premium and extrinsic value for doing so.