Finance

In The Money vs Out Of The Money Options

In The Money vs Out Of The Money Options

In options trading, the difference between “in the money” (ITM) and “out of the money” (OTM) is called moneyness which basically states the difference between the strike price’s position relative to the market value of the underlying stock. When the strike price surpasses the current stock price, it is said to be ITM. A trader will use this when he wants to hedge his position, and percentage moves are smaller comparatively. An OTM option is one that has a strike price that the underlying security has yet to reach, which also means that the option has no intrinsic value. They are less expensive than ITM and also have larger percentage gains/losses.

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What do they indicate?

During a call option, an ITM call option takes place when Strike Price < Stock Price. OTM call option is when Strike Price > Stock Price. Exercising this will lead to profit for the option holder.

During the put option, an option is describing ITM when Strike Price > Stock Price. It usually carries some intrinsic value and time value. A put option is OTM when Strike Price < Stock Price. Option holder must not exercise this option.

Calculation:

Intrinsic value: It is the amount by which the strike price of an option is In The Money.

  • For Call Option, =(Stock Price- Strike Price)
  • For Put Option, =(Put Strike Price- Stock Price)
  • ATM and OTM options don’t have any intrinsic value.

Time Value: The Time value is also referred to as the Extrinsic value, which means the excess amount over and above an option’s intrinsic value. It decreases to zero over time as the option moves closer to expiration, this is known as Time decay. Options premium depends on time to expiration. Options that would expire after a longer duration of time would be more expensive as compared to those expiring in the current month as the former would have more time value left, increasing the probability of trade going in your favor.

Option Premium= Time Value + Intrinsic Value

  • For ITM, intrinsic value and time value both are YES.
  • For OTM, intrinsic value is NO and time value is YES.
  • ATM is the same as OTM.

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Examples:

  • If the share price of ABC.Ltd is Rs.100 in the cash market; a call option with a strike price of Rs.80 is In The Money Option, whereas put option with a strike price of Rs.120 is Out Of The Money option.
  • If the share price of XYZ.Ltd is Rs.100 in the cash market; a put option with a strike price of Rs.120 is In The Money Option, whereas a put option with a strike price of Rs.80 is Out Of The Money option.

Benefits for traders:

ITM options are more conservative due to higher deltas – the measure of how much an option’s price will change based on the movement of an underlying stock. Since intrinsic and time value both are included the impact is reduced. This means that even if the underlying value of stock remains static till a contract’s expiration, the trader can sell to close an ITM option and still collect the remaining intrinsic value, thus avoiding a total loss on the trade. OTM has a lower cost to buy, at the same time it can give the trader serious leverage if the underlying stock moves in his favor.

Risk Involved:

ITM contracts, are more expensive to enter and while the payoffs on an in-the-money trade can be high, the trader could ultimately suffer a bigger loss if the underlying stock moves in an unpredicted way.

OTM contracts have lower deltas, hence reducing the chances of the trade expiring ITM is slimmer. These contracts are more susceptible to time decay, which means that if the underlying stock does not see a dramatic swing in the trader’s favor, a 100% loss is likely to occur.

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Final Thoughts:

The choice between In The Money vs Out Of The Money Options is a matter of preference, bearing in mind that your choice may change with each trading opportunity. When you’re expecting a sudden rise in the underlying stock, it might make more sense to purchase out-of-the-money options. On the other hand, if you expect a relatively modest rise over a longer period of time, you may prefer to trade in-the-money options.

Author: Mahek Medh

About the Author: Currently, I am in my second-year bachelor’s program and over the period of time I have realized that I enjoy learning about numbers and money, and I find topics of Finance to very interesting thus this is the domain and space where I wish to etch my long term career.

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