In finance, deep in the money indicates that the strike price of an option substantially deviates from the stock price of the underlying asset in a favorable way. For a call option that is deep in the money, the strike price is considerably lower than the stock price. On the other hand, for a put option that is deep in the money, the strike price is significantly higher than the market price of the stock. In both of these situations, the option holder stands to gain a substantial profit if the option is exercised. In order to form a deep in the money scenario, the strike price must differ from the market price by at least one strike price value in the right direction, depending on the option type.
For example, stock for Company X currently sells for $50 US Dollars (USD) per share. A call option agreement with a strike price of $25 USD and a put option agreement with a strike price of $75 USD would both be deep in the money. If the call holder exercises his option, he profits from the purchase of Company X stock valued at $50 USD per share for only $25 USD per share. The put holder also profits from his option, selling his shares at $75 USD per share when the current value is only $50 USD per share. Options that are deep in the money possess intrinsic value, which is the disparity between the strike price and the current market price, often prompting option holders consequently to sell the option for its intrinsic value.
The hedge ratio, also known as the delta, is a business ratio that compares the variations in the market price of a stock to the matching changes in the intrinsic value of an option. As options shift deeper into the money, the hedge ratio approaches a value of 1.0 for a call option and –1.0 for a put option. This means that for every $1 USD the market price of a stock increases, the call option value also increases $1 USD. For a put option, the exact opposite is true, with every $1 USD increase in the underlying stock price being matched by a $1 USD decrease in the put option value.
Options may also move deep out of the money. In such a case, a call option has a strike price that is at least one strike price amount higher than the current market price of its underlying stock. Conversely, a put option that is deep out of the money has a strike price that is at least one strike price amount lower than the current market price of its underlying stock. Although such an option has no intrinsic value, it still has a time value based on its maturity date.
Many investors tout the advantages of investing in deep in the money call or put options. In many ways, it is similar to making investments in the stocks themselves. The benefits of option investments relative to stock investments, however, include leverage, limited risk, and lower capital requirements. Another benefit is the greater potential for profit associated with deep in the money options.