A call option, or call, is a derivative contract that gives the holder the right to buy a security at a set price at or before a certain date. If this price is lower than the cost of buying the security on the open market, the owner of the call can pocket the difference as profit. Although options trading can be profitable, it is also more complicated than ordinary stock trading. Below, we consider some of the benefits of buying options that are in the money.
Key Takeaways
- A call option is in the money (ITM) when the underlying security's current market price is higher than the call option's strike price.
- Being in the money gives a call option intrinsic value.
- Generally, the more out of the money an option is, the lower its market price will be.
- Once a call option goes into the money, it is possible to exercise the option to buy a security for less than the current market price.
- As a practical matter, options are rarely exercised before expiration because doing so destroys their remaining extrinsic value.
When Is a Call Option in the Money?
A call option is in the money (ITM) when the underlying security's current market price is higher than the call option's strike price. The call option is in the money because the call option buyer has the right to buy the stock below its current trading price. When an option gives the buyer the right to buy the underlying security below the current market price, then that right has intrinsic value. The intrinsic value of a call option equals the difference between the underlying security's current market price and the strike price.
An option is In the Money (ITM) if the strike price is better than the market price. This means that the owner will make a profit by exercising the option.
An option is Out of the Money (OTM) if the market price is better than the strike price. There is no advantage to exercising these options until they move into the money.
A call option gives the buyer or holder the right, but not the obligation, to buy the underlying security at a predetermined strike price on or before the expiration date. "In the money" describes the moneyness of an option. Moneyness explains the relationship between a financial derivative's strike price and the underlying security's price. A call option is called "out of the money" if the strike price is higher than the price of the underlying security.
Generally, the more ITM an option is, the more it will cost to buy. Conversely, out-of-the-money options cost less, and they are cheaper the further away they are from being in the money. However, there are other factors that affect an option's price, such as volatility and time to expiration.
A Simple Example
For instance, suppose a trader buys one call option on ABC with a strike price of $35 with an expiration date one month from today. If ABC's stock trades above $35, the call option is in the money. Suppose ABC's stock is trading at $38 the day before the call option expires. Then the call option is in the money by $3 ($38 - $35). The trader can exercise the call option and buy 100 shares of ABC for $35 and sell the shares for $38 in the open market. The trader will have a profit of $300 (100 x ($38-$35)).
Advantages of In the Money Call Options
When a call option goes into the money, the value of the option increases for many investors. Out-of-the-money (OTM) call options are highly speculative because they only have extrinsic value.
Once a call option goes into the money, it is possible to exercise the option to buy a security for less than the current market price. That makes it possible to make money off the option regardless of current options market conditions, which can be crucial.
Parts of the options market can be illiquid at times. Calls on thinly traded stocks and calls that are far out of the money may be difficult to sell at the prices implied by the Black Scholes model. That is why it is so beneficial for a call to go into the money. In fact, at-the-money (ATM) options are usually the most liquid and frequently traded in part because they capture the transformation of out-of-the-money options into in-the-money options.
As a practical matter, options are rarely exercised before expiration because doing so destroys their remaining extrinsic value. The main exception is very deep in the money options, where the extrinsic value makes up a tiny fraction of the total value. Exercising call options becomes more practical as expiration approaches and time decay increases dramatically.
Disadvantages of in the Money Options
While in the money options are more likely to turn a profit, out-of-the-money options are much cheaper to buy. This makes OTM options an attractive play for speculators willing to bet that the underlying security is likely to see major price gains. The more out of the money an option is, the cheaper it is to buy.
A Game for Professionals
On the whole, the game of options going into the money and being exercised is best left to professionals. Someone must eventually exercise all options, yet it usually doesn't make sense to do so until near the expiration day. That means frantic trading on triple witching days when many options and futures contracts expire.
Small investors should usually plan on selling their options long before expiration rather than exercising them.
Most individual investors lack the knowledge, self-discipline, and even the money to actually exercise call options. Of these, the lack of money is the most serious problem. Suppose an investor purchases a call option that is 13% out of the money and expires in one year for 3% of the value of the underlying stock. If the stock goes up by 22% during that year, the value of the investment will have tripled (22 - 13 = 9, which is three times the original 3). That sounds good, but there is a potential hitch.
Suppose the investor put $3,000 of $100,000 into the call option described above. If the rest was in cash earning 0%, the 3% risked is now 9%, for a total gain of 6%. What the investor really has at this point is the right to buy stocks worth $122,000 for $113,000. Unfortunately, the investor only has $97,000 in cash. That is not enough to exercise the call option, so a trip to the market makers is necessary.
Why Would You Buy a Call Option Out of the Money?
Out-of-the-money call options are a speculative play by investors who believe that the underlying stock price is likely to increase before expiration. Perhaps they believe the firm will release positive news, or there are rumors of an acquisition. Many investors buy out-of-the-money call options before a company's earnings call or other major announcements, hoping for positive news that will push the price upwards. A famous example happened during the 2021 GameStop short squeeze when retail speculators correctly predicted that the stock price would rise.
What Does It Mean If a Call Option Is Out of the Money?
A call option is out of the money if the price of the underlying security is lower than the option's strike price. There is no advantage to exercising an out-of-the-money option, since it is cheaper to buy the underlying security on the market. For that reason, an option is worthless if it is still out-of-the-money when it expires.
Is It Better to Buy Call Options in the Money?
Options cost more if they are in the money, but they are also safer. Out-of-the-money options require a larger price movement to become profitable, and they are more likely to expire worthless. This makes out-of-the-money options a riskier bet, even though they are cheaper. It is up to each investor to decide how much risk they are willing to take.
