The Main Differences of In the Money and Out of the Money Options

When it comes to options trading, knowing whether you’re “in the money” (ITM) or “out of the money” (OTM) is crucial. It tells you if you’ll make a profit on your option contract. These terms define the relationship between the option’s strike price and the market value of the underlying asset.

“In the money” means the option has profit potential if exercised right now, while “out of the money” means it does not. Sometimes, the market price of an underlying security hits the option’s strike price exactly at expiration, which is known as an “at the money” option.

Understanding “In the Money”

Being “in the money” (ITM) means your option contract would be profitable if you decided to exercise it immediately. This type of option has intrinsic value, which is why it’s appealing to many traders.

If you’re holding a call option, you’re “(ITM)” when the strike price is lower than the current market price of the underlying security. For example, if you have a call option with a strike price of $15, and the stock is currently trading at $16, you could buy the stock at $15 and sell it at the market price of $16, pocketing the difference.

On the other hand, put options, which are typically used when betting that a stock’s price will drop, are “in the money” if the strike price is higher than the current market price. This means you could sell the stock at a higher strike price than what it’s currently worth on the market.

Example

Imagine you have a call option with a strike price of $15, and the stock is trading at $16. You’re “in the money” because you could exercise the option to buy shares at $15 and then sell them at $16, earning a $1 profit per share, minus any premiums or fees.

Alternatively, if you own a put option with a strike price of $10, and the stock is trading at $9, you’re also “in the money.” This allows you to sell the stock at $10 when it’s only worth $9, securing a profit of $1 per share, again minus any associated costs.

Understanding “Out of the Money”

“Out of the money” (OTM) is the opposite of being “in the money.” OTM options have no intrinsic value, and if they expire this way, they become worthless.

For call options, if the strike price is higher than the current market price, the option is “out of the money.” Exercising it means buying the security for more than it’s worth. For put options, if the strike price is lower than the market price, it’s also “out of the money,” as selling the security would result in a loss.

Example

Suppose you buy a call option with a strike price of $15, but the stock is trading at $13. This option is “out of the money” because exercising it would mean buying the stock at $15 when you could get it for $13 on the open market.

Similarly, a put option with a strike price of $7, while the stock is trading at $10, would also be “out of the money.” Exercising this option would involve selling the stock for $7 when it’s worth $10, which doesn’t make financial sense.

The Key Difference Between ITM and OTM

An options contract’s value includes two main components: intrinsic value and extrinsic value. “In the money” options possess intrinsic value because their strike prices are favorable compared to the market price. On the other hand, “out of the money” options depend on extrinsic value, which market volatility and speculation influence.

“Out of the money,” options are often cheaper and attract speculators who anticipate significant price swings. In contrast, options for less volatile assets are typically “in the money” because these contracts offer more stability.

How these terms impact your potential profits and strategy

Choosing the right options depends on what you want as an investor and how much risk you’re willing to take. Going for options that are further “OTM” can lead to bigger rewards but also come with more risk, uncertainty, and volatility. Whether an option is “ITM or OTM,” how far it is from being profitable, and the time left until the option expires all affect its premium. Riskier options typically have higher costs.

Deciding between ITM or OTM options also hinges on your confidence in the future of the underlying stock. If you’re pretty sure that a stock will jump significantly in three months, you might go for a call option with a high strike price, making it “out of the money.”

On the flip side, if you believe a stock’s price will drop, you could buy a put option with a low strike price, which would also be “out of the money.”

If you’re new to trading or have a lower risk tolerance, you might prefer options that are only slightly “ITM or OTM.” These options usually have lower premiums, so they cost less upfront. There’s also a better chance that these contracts will end up profitable before they expire, as they require less of a price move to make money.

Some investors like to mix things up by combining different options into a spread strategy, aiming to benefit from multiple market scenarios.