Options trading is all about choosing the right strategy. Should an investor go for an“in the money” (ITM) or “out of the money” (OTM) trade, which is represented by the strike price position relative to where the stock is currently trading. The difference between an “in the money” and “out of the money” option is a question of profiting or losing the capital invested.
An in the money option is one that provides revenue to the holders by exercising the contract. On the other hand, an out of the money option is a contract that is rendered worthless for the contract holder at expiry.
If the stock price, manages to fall precisely at the same rate as the strike at expiry, this option would be considered as an at the money (ATM) option.
Understanding ITM and OTM
Financial derivatives are competitive securities; the potential benefits of an investor are in choosing the right strategy to predict the direction the price of an asset is going to take. In derivatives, the profits of an investor are directly proportional to the losses of his counterpart. For example, if an option contract expires in the money, the holder will receive a revenue equal to the money lost by the writer. In the same manner, for an out of the money option, the money lost by the holder will be the same as the reward received by the writer.
Calls
In the case of calls, an in the money call option contract is one that has a strike price lower than the market value of the underlying asset. Allowing the holder to buy the asset cheaper than market value and sell it immediately for a profit. Conversely, an option would be considered OTM if the stock price doesn’t surpass the strike price; in this case, the contract wouldn’t provide any value to the option buyers.
Let’s recap, for call contracts:
- In the Money: stock price > strike price
- At the Money: stock price = strike price
- Out of the Money: stock price < strike price
Puts
Put contracts are purchased by traders who believe the price of an asset is going to depreciate, as a safer alternative to short-selling. When it comes to puts, an ITM option is one that has a strike prices above the stock price hence allowing the option holder to sell an asset over retail price. OTM puts have strike prices over the market value of the underlying asset, therefore worthless for the put holder.
In summary, for puts:
- In the Money: stock price < strike price
- At the Money: stock price = strike price
- Out of the Money stock price > strike price
ITM and OTM Issued Options
The premium of an option contract has two components, intrinsic and extrinsic value. Options released with intrinsic value are contracts that, at the time of their release, have a strike price with an advantageous margin to the current market price. That is to say; they already are in the money when written. Not all option contracts have intrinsic value when emitted, options without intrinsic value rely on their extrinsic value, which is the value of time, the speculative value. It is for this reason that assets with low volatility rates are usually written ITM. In contrast, more volatile assets are commonly issued OTM as they are expected to have more significant price moves.
Options written OTM are the preferred choice of speculators as they have lower premium prices and usually have more volatile assets. ITM and OTM issued options are both feasible option strategies that can be profitable from the holders and the writer’s perspective. One approach is not better than the other; it all depends on what the investor necessities are and what he is trying to achieve. Besides ITM and OTM, written options usually are combined into spread strategies that can take advantage of the benefits that both approaches have to offer.
How to Trade with Confidence
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