When it comes to your finances, there is a big difference between being in the money and being out of the money. We will discuss these differences in this article.
Meaning Of “In-the-Money”
In-the-money (“ITM”) options are contracts that have strike prices below the underlying stock price for call options, or strike prices above the underlying stock price for put options. Intrinsic value is the amount by which an option is in the money.
It is calculated by subtracting the strike price from the underlying asset price for call options, or by subtracting the underlying asset price from the strike price for put options.
For an option to have intrinsic value, the strike price must be lower than the underlying asset price for call options, or the strike price must be higher than the underlying asset price for put options. If an option is not in the money, it has no intrinsic value.
Meaning Of “Out-Of-The-Money”
Out-of-the-money (“OTM”) is a term used in derivatives trading where the market value of the derivative is not the obligation. It is also known as being "out of the market." This means that the price of the underlying asset, such as a stock or commodity, is not high enough to make a profit from buying and selling it.
The time value of money is also a factor in out-of-the-money prices. When an investor buys an OTM option, they are paying for the chance that the underlying asset will increase in value before the option expires. This is because options have a limited time frame in which they can be exercised.
If the market price doesn't rise above the strike price before expiration, then the option will expire worthlessly. While OTM options are less expensive than their in-the-money counterparts, they also carry more risk. This is because there is no guarantee that the market price will rise above the strike price before the expiration.
In-The-Money And Out-Of-The-Money Call Options
An in-the-money call option is a contract that gives the holder the right to buy an underlying asset at a strike price that is lower than the current market price. For example, if ABC stock is trading at $50 per share, and you have an in-the-money call option with a strike price of $45 per share, you have the right to buy 100 shares of ABC stock for $4500. To make money on this trade, you would need ABC stock to rise above $45 per share before the option expires.
Out-of-the-money call options are the opposite; they give the holder the right to buy an underlying asset at a strike price that is higher than the current market price. So, using our previous example, if you had an out-of-the-money call option with a strike price of $55 per share, you would need ABC stock to rise above $55 per share before the option expires to make money on the trade. In general, in-the-money call options are more expensive than out-of-the-money call options because they have a higher chance of expiring in the money.
In-The-Money And Out-Of-The-Money Put Options
With put options, you earn the right to sell the security at your chosen price. For example, if you had a put option on a stock rather than a call option.
A put option is only worthwhile if the strike price is higher than what the stock is currently worth in the market. This is because you'd be able to sell your shares for more than you could on the stock exchange. This gives the put option intrinsic value, which means you would likely exercise the option to sell.
A put option is unprofitable when the strike price is below the current stock market value. If you sold the stock, you would make less money than if you exchanged it on the stock market. Chances are, you wouldn't want to do that.
In-The-Money Vs. Out-Of-The-Money: Which Is Better?
In-the-money and out-of-the-money both have their own sets of pros and cons, and which one is best for you depends on your goals as a trader.
In general, in-the-money options will cost more than out-of-the-money options, but they also tend to be more stable and have a higher chance of expiring in the money. Out-of-the-money options are less expensive, but they're also more volatile and have a lower chance of expiring in the money.
So, which is better? It depends on your trading strategies and goals. If you're a risk-averse trader who is looking for stability, then in-the-money options may be a better choice. On the other hand, if you're willing to take on more risk for the chance of a higher reward, then out-of-the-money options may be a better fit. Ultimately, it's up to you to decide which type of option is best for your trading style.
Risk For Buyers And Sellers
In general, an in-the-money option is seen as a safer investment for buyers and a riskier one for sellers when compared to an out-of-the-money option.
If you buy an option, the worst that can happen is you'll lose what you paid for the contract. If this scenario plays out, the individual will have to forfeit the option's premium. When an investor buys an option that is already "in the money," this usually means there's a greater chance the option will stay in the money, which could result in either making a profit or at least getting some of what was spent on buying the option back.
If the option buyer exercises their contract when it is in the money, then the options seller is forced to complete a purchase or sale of a security at below-market prices. If a contract is profitable from the start, there's a bigger likelihood the contract buyer will choose to exercise it later on. The opposite is evident for out-of-the-money options. Buyers are generally viewed as accepting more risk than sellers.
Final Thoughts
If you’re not entirely sure whether an option is in the money or out of the money, the best way to find out is by using a calculator or consulting with a financial coach. By understanding the difference between these two types of options, you can better assess which ones are right for your investment portfolio. Do you have any experience investing in options? What approach do you take when choosing between in-the-money and out-of-the-money options?
If you have additional questions, set up a call with a Money Coach at Bolder today.
