A lot has been written regarding the use of various stock and index option strategies. However, there is one area that seems to have gotten a little slighted by writers and authorities alike. The Deep-in-the-money option. We have all used or heard about, buying the out of the money call, buying the option slightly in the money, buying the at the money option and even selling or buying out of the money or way out of the money options. However, when was the last time anyone talked about a deep-in-the-money option and its use to you? Hmmm! What I thought! They don't. Even though the deep-in-the-money option is discussed relatively little, it has tremendous potential for use in both bear and bull market scenarios.
The Deep-in-the-money Call option.
When one examines a deep in the money call option a very interesting surprise awaits you. The in the call option usually carries very little time value and a lot of intrinsic value. (The value or amount the option is in the money.) Well the importance of this fact is most apparent when you anticipate the emergence of a bear market or technical correction of a market for any sustained period of time. It is especially interesting when the deep in the money call is called into play and used in conjunction with the long put option. Let's take a look and see how.
Normally, when one sells a call option it is done in a covered call situation, where one is selling an option to generate income through the collection of premiums from call option sales. These options are usually at the money, slightly out of the money, or slightly, at best, in the money.
However, if you look at the deep in the money option you will find it is the perfect partner to be used with the long put option. When anticipating a bear market scenario. Heres why.
When selling a deep-in-the-money call option you can protect as much of the value of the stock as you would like from a market decline. Unlike an out of the money option which is just used for generating income, the deep in the money option gives you protection to the downside to the level of whatever strike price you decide to sell. (See figure 1-1 below)
FIGURE 1-1: The comparison of Premium received from various strike prices the deeper in the money you go.
Now it is clear to see that selling the 50 or 40 call option is not going to give you nearly the protection that the 30 or 20 Call option will give you in the way of protection, simply because the 50 and 40 call option does not generate as much premium as the 20 or 30 call option. And even though you risk your stock being called away at a much lower price, in fact at an extremely much lower price, look what the deep in the money call has given you. Cash!! And Protection! Just as an example the XYX 20 Call gives you $3,200 in cash and protection down to $20 a share. In addition, you can take $2.25 or $225 of the cash you took in and purchase a XYZ 50 Put and now not only do you have downside protection to $20 for your stock, but you can turn around and sell the put for what ever the amount the put ends up in the money. In the case of the XYZ $20 Call, if the stock dropped to $25 you have several profitable alternatives when you use the deep in the money call (Selling the XYZ $20 call and Buying the XYZ $50 Put)
Scenario #1: If the stock drops to $25 you can buy back the option for around $500 allowing you to keep the stock which is now down to the price of $25 from $50, however you still kept over $2,700 in call premium from the XYZ $20 call option you sold. Secondly, you can sell the XYZ $50 put you purchased at $2.25 or $225 for roughly $2,500, netting you an additional $2,275 in addition to the $2700 you kept for the call premium, giving you a net cash position of $4,975. In addition to the $4,975 you still own 100 shares of XYZ at $25.
Scenario #2: You can let them take your stock at $20, keeping $3,250 and the $2,000 you get for your XYZ stock when they exercise you at $20 a share and then you can sell the XYZ $50 put option you purchased for $225 for $2500 or a $2,250 profit. This would give you a total of:
$2,000 for the 100 Long XYZ shares that were exercised from you
Either way, not only do you protect your position and equity, but also you actually make a profit. But it is only achieved with the majority of the assistance from the deep in the money call.
FIGURE 2-2: Comparing the use of the Deep-in-the-money options in conjunction with the Put purchase vs. The Put Purchase alone to hedge in anticipation of a bear market vs. No action at all.
Notice that the sale of the deep-in-the money call provided us with two essential parts of the strategy. The protection of cash to offset any loss in the value of XYZ and the cash to purchase the Protective at the money $50 Put, so that if the bear market scenario came to pass, the account would not only be protected, but would actually show a net profit.