In the money vs. out of the money: what is the difference?
Discover the differences between in the money and out of the money options and how to make the best choices for your investment portfolio.
Summary
In the money and out of the money options are traded relative to their current asset prices and values.
Both ITM and OTM options can be profitable under certain specific circumstances.
OTM options offer benefits like lower premium costs and less time decay impacts, while ITM options provide benefits like higher profit probability and a faster break-even rate.
Find a financial advisor who can assist you in navigating the complexities of ITM and OTM options trading.
What is options trading, and why is it important?
Trading options involve trading assets relative to their current prices and values.
When trading options, it is essential to understand terms like ‘in the money’ (ITM) and ‘out of the money’ (OTM) to measure the intrinsic value of an option based on the price of its underlying asset.
Knowing the differences between ITM and OTM and when an option is considered in the money or out of the money is a valuable tool for deciding whether or not to exercise certain options based on the profits you will be able to obtain.
What is ”in the money” (ITM)?
An option that is in the money is one with intrinsic value.
However, this measurement will depend on whether you are referring to a put option or a call option. Put trading options allow you to sell assets at predetermined prices before a pre-set expiry date. These options are in the money when the price of their underlying securities is lower than the strike prices. If you sell, the high strike price would benefit you by producing a profit.
Call options are ITM when their underlying assets’ current prices are higher than their strike prices. If you exercised an option in this scenario, you buy the underlying asset for a lower price than it is worth. This implies the potential to sell the asset at a profit.
When trading put options or call options, the discrepancy between the underlying assets’ values and their strike prices will determine their intrinsic values and whether they are ITM.
For example, consider a call option for a business stock with a strike price of $20. The stock is trading at $25 per share, which means you are in the money, as the strike price is lower than the underlying price. If you have a put option for the same stock with a $20 strike price, the more you benefit from a higher intrinsic value when the underlying asset’s price falls below the strike price.
What is “out of the money” (OTM)?
An option that is out of the money or OTM has no intrinsic value.
Again, this is determined by whether it is a put option or a call option. In terms of call options, the option is out of the money if the asset’s underlying price is below its strike price. If you were to exercise this option according to your options trading strategies, the price you would pay for the underlying asset is higher than what the asset trades for, making it unprofitable.
Put options are considered out of the money if their underlying assets’ current prices are higher than their strike prices. If you exercised an OTM put option, you would sell it for a lower price than its current value and make a loss.
For instance, if you have a call option with a $20 strike price and the underlying stock trades at $15, the option is OTM because the more the stock’s price falls compared to its high strike price, the more OTM it will become.
Even if you had a put option at $20 and the underlying stock is being traded at $22 per share, you would still be OTM, as you would sell the option for less than what the stock is being traded for on the open market.
What are the benefits and risks of ITM options?
There are benefits and risks associated with ITM options:
Benefits
A higher probability of profit and lower decay impact compared to OTM options.
Protection against time decay, as changes in volatility do not impact their intrinsic values.
ITM options break even at a faster rate than OTM options.
ITM options offer both downside and upside protection.
Unlike OTM options, which usually do not get exercised early, ITM options can be exercised at any point to lock in their intrinsic value profits rather than waiting for expiry. This provides greater flexibility.
Risks
Higher premium costs due to their built in intrinsic values.
The price of these options can reduce their leverage, lowering your returns.
ITM call and put options can cap your potential profits above the strike price. If a stock gains higher than its call strike, owners can only buy shares at the lower strike price.
These options may decay less initially, but they decay rapidly during the 30 days before expiry.
ITM options have protected intrinsic values but are still exposed to implied volatility fluctuations regarding their remaining time values.
What are the benefits and risks of OTM options?
OTM options have many benefits and risks to consider before trading.
Benefits
Lower premium costs than ITM options.
Higher profit potential as long as the forecasted underlying asset move takes place before expiry.
OTM options provide a way to speculate on downside, or upside moves in underlying assets while requiring only small sums of capital.
Less time decay impacts than ITM options.
Selling OTM call options against stock positions can bring in high levels of income from decaying options, helping you generate more income from your positions.
OTM options have a lower risk of going to ITM.
Risks
There is a higher risk of expiring worthless if their underlying prices do not move before expiry.
There is a higher risk to traders of losing the full paid premium.
These options offer uncertain profitability, as a significant underlying move is needed to produce a profit.
OTM options’ values erode over time, meaning that the time window for profitability is shorter before expiry.
Investors still risk overpaying for OTM options relative to the probability of profit.
Out of the money vs. in the money: which is better for me?
Your best choice will depend on your personal investment and trading goals. For instance, if you have ITM call options, you could profit from the deal if the strike price remains below market price, while the opposite would be true for ITM put options.
It’s important to consider that out of the money options carry lower premiums and may be less costly to trade. If you are a cost-conscious investor, this is another factor to take into account, as is time. The longer your time value window, the more time value an option will have since the odds of it moving ITM will be higher.
In essence, even if an option is OTM and does not carry intrinsic value, it may still have time value, which means that it could be worth buying out of the money options in this scenario. Values can even take a third route; when their strike prices are equal to their underlying asset prices, they are considered ITM and would have no intrinsic value.
Get expert financial advice
“In the money” and “out of the money” options have unique benefits, risks, and potential profit profiles. Trading options can be complex to navigate, which is why it is recommended that you work with an experienced financial advisor to build your portfolio.
Let us connect you with an expert financial advisor who can explain your options and help you make the right selection.
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