In the Money vs. Out of the Money: An Overview
Traders define options as "in the money" (ITM) or "out of the money" (OTM) by the strike price's position relative to the market value of the underlying stock, commonly called its moneyness.
An ITMoption is one with a strike price that has already been surpassed by the current stock price. An OTMoption has a strike price that the underlying security has yet to reach, meaning the option has nointrinsic value.
Key Takeaways
- In options trading, the difference between "in the money" (ITM) and "out of the money" (OTM) is a matter of the strike price's position relative to the market value of the underlying stock, called its moneyness.
- ITM options have intrinsic value and are priced higher thanOTM options in the same chain, and they can be immediately exercised.
- OTM are almost always less costly, making them more desirable to traders with smaller amounts of capital.
- OTM options are more commonly traded for strategies such as covered calls or protective puts.
In the Money
ITM options have their uses. For example, a trader may want to hedge or partially hedge their position. They may also want to buy an option that has some intrinsic value rather than just time value.
Because ITM options have intrinsic value and are priced higher thanOTM options in the same chain, theprice moves (%) are relatively smaller. It is possible for ITM options to have large price moves but, compared to OTM options, the percentage moves are smaller.
Certain strategies call for ITM options, while others call for OTM options, and sometimes both. One is not better than another; it comes down to what works best for the strategy in question.
Calls
A call option gives the option buyer the right to buy shares at the strike price when and if it is beneficial to do so. An in the money call option, therefore, is one that has a strike price lower than the current stock price.
For example, a call option with a strike price of $132.50 would be considered ITM if the underlying stock is valued at $135 per share because the strike price has already been exceeded. A call option with a strike price above $135 would be considered OTM because the stock has not yet reached this level.
In this case, the option would have $2.50 worth of intrinsic value, but the option may cost $5 to buy. It costs $5 because there is $2.50 of intrinsic value and the rest of the option cost, called the premium, is composed of time value. You pay more for time valuethe further the option is from expiry because of the greater probability the underlying stock price will move before expiry, which provides an opportunity to the option buyer and risk to the option writer which they need to be compensated for.
Puts
Put options are purchased by traders who believe the stock price will go down.
ITM put options, therefore, are those that have strike prices above the current stock price. A put option with a strike price of $75 is considered in the money if the underlying stock is valued at $72 because the stock price has already moved below the strike. That same put option would be out of the money if the underlying stock is trading at $80.
Generally, the price of a put option increases the farther away from expiry it is, because of the time value.
Out of the Money
In the money or out of the money options each have their pros and cons. One is not better than the other. Rather,the variousstrike pricesin an options chain accommodate all types oftradersand option strategies.
When it comes to buying options that are ITM or OTM, the choice depends on your outlook for theunderlying security, financial situation, and what you are trying to achieve.
OTM options are less expensive than ITM options, which in turn makes them more desirable to traderswith limited capital.
Some of the uses for OTM options include buying the options if you expect a big move in the stock. Since OTM options have no instrinsic value, they have a lower up-front cost than ITM options. If a stock currently trades at $100, you can buy an OTM call option with a strike of $102.50 if you think the stock can reasonably rise well above $102.50.
OTM options often experience larger percent gains/losses than ITM options. Since the OTM options have a lower price, a small change in their price can translate intolarge percent returns and volatility.
It is not uncommon to see the price of an OTMcall optionbounce from $0.10 to $0.15 during a single trading day, which is equivalent to a 50 percent price change.
What Is Options Trading?
Options are contracts that give their holders the right to buy or sell a number of shares of an asset if it reaches a predetermined price within a set time period. Options are derivatives. That is, the contract represents a number of shares of a stock, a bond, or even a currency but does not convey ownership of an asset.
What Is the Purpose of Options Trading?
Options trading is a bet on the future direction of an asset's price. The options trader thinks that a stock or other asset will rise or fall in value in the near future. By arranging an options contract, the trader who guesses correctly has the right to buy (if it's a call option) or sell (if it's a put option) a number of shares of that asset as long as the contract is in effect.
Can Anyone Trade Options?
Theoretically, anyone can trade options. Most brokers require that prospective options traders fill out a form testifying that they have the financial resources and the basic knowledge required to trade options. There are higher levels of tests to pass before an investor can engage in the more esoteric varieties of options trading.
The Bottom Line
In the money options have an intrinsic value. That is, the strike price that is agreed upon has already been surpassed by the current market price of the asset.
An out of money option has a strike price that the underlying security has yet to reach. That makes this type of option cheaper to obtain but riskier as an investment.
