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I understand that OTM options with low deltas are not that attractive, hence liquidity is less. But how about deep ITM options, why is the liquidity not there? Deep ITM options are a cheap way to achieve same risk required profile as holding the underlying, so how come there are no buyers for these options?

As a side note, if I am long a deep ITM option and I am sitting on a profit, then in absence of liquidity, my alternative is to exercise the option, and then close out the resulting underlying position,correct? Apart from bid-ask costs and trade commissions, are there any other catches with this profit taking method?

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There is less liquidity because they are less volatile. Option traders aren't exactly risk averse (read: are degenerate gamblers) and the other market participants that use options don't have much use for deep in the money options.

Also, just trade more liquid assets and equities if you want liquid options.

At-the-money options, and at-the-money options strategies have hundreds and thousand percent payoffs on relatively mundane price changes in the underlying asset.

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One reason might be the 100% margin requirement on long options. Suppose I want to go long AAPL. I could get a deep ITM call or buy shares.

$12,700 for 100 shares, with it's 25% margin requirement is like around $3200 locked up cash. Combine with a deep OTM Jan 2017 $70 strike put for $188, would give a $3400 margin requirement to enter the trade.

or I could be in the JAN 2017 $70 strike for nearer $5800, but with a 100% margin requirement due to being a long call.

So (3400/5800) = 59% increase in margin requirement for Deep ITM calls.

Plus long term the shares will pay dividends, while a LEAP CALL does not.

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  • Ok,but liquidity for ditm options is scarce for near months too, not just LEAPS
    – Victor123
    Commented Mar 25, 2015 at 3:46
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    @Victor123 - one thing neither of us mentioned is that quarterly months might trade up to 9 months in advance and have more volume/liquidity than off months, which only trade for maybe two-three months. Shorter term weeklys and off months are only used by swing traders with under 60 days til expiration. Odds are if you don't see liquidity in the option you are researching, it is because there is an easier cheaper way to accomplish the same delta.
    – Knuckle-Dragger
    Commented Mar 25, 2015 at 4:36

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