Have you ever found yourself in a financial jargon jungle, trying to figure out what phrases like “in the money” and “out of the money” mean in options trading? No need to scratch your head any longer. Let’s put on our explorer hats and start this thrilling expedition through the options trading wilderness.
What Are Options?
First off, let’s understand what options are. Think of an option like a special ticket. It gives you the right (but not the obligation) to buy or sell an asset (like a stock) at a specific price (the “strike price”) before a certain date (the “expiration date”). There are two types of options – calls and puts. A call option lets you buy the asset, while a put option lets you sell it.
The Intriguing World of In the Money vs. Out of the Money
Now, onto the exciting part: “in the money” and “out of the money.” These terms relate to the current market price of the underlying asset compared to the option’s strike price.
In the Money Options
When an option is “in the money,” it means you could exercise it for an immediate profit. For a call option, this happens when the market price is above the strike price. So if you have a call option to buy a stock at $50, and the stock is trading at $60, you’re in the money!
Out of the Money Options
On the other hand, if your option wouldn’t make any dough if exercised right now, it’s “out of the money.” In our example above, if the stock is trading at $40, your call option is out of the money.
Why In the Money vs. Out of the Money Matters
The state of your option – in the money or out of the money – can influence your trading strategy.
- In the Money: These options cost more because they already have intrinsic value (the difference between the strike price and market price). But they also offer a greater chance of making a profit.
- Out of the Money: These options are cheaper, so they’re a low-cost way to control a large amount of stock. They could deliver significant profits if the stock price moves in the right direction.
Crunching Numbers: A Real-World Example
Let’s use our trusty crystal ball to see how this plays out in real life. Suppose you buy a call option with a strike price of $100 for a stock currently trading at $105. This option is in the money, and the intrinsic value is $5.
Now, let’s imagine you buy another call option for the same stock, but this time, the strike price is $110. This option is out of the money since the stock price is less than the strike price. While it doesn’t have any intrinsic value, it could still provide you with potential profits if the stock price rises above $110 before the option expires.
In the Money vs. Out of the Money: A Deeper Dive
While we’ve already brushed the surface of these two vital terms, it’s time to delve a little deeper. After all, understanding these phrases is like getting a map for your journey in the world of options trading. So, buckle up and let’s venture deeper into this exciting terrain.
The Case of In the Money
Let’s say, you own a call option on Company XYZ with a strike price of $25, and the market price is currently $30. This means you have the right to buy Company XYZ’s stock at $25, while the market is trading it at $30. If you exercised your right, you’d make an immediate profit of $5 per share (minus any premium you paid for the option). This makes your option ‘in the money’.
But it’s not only about the immediate profit. Being ‘in the money’ also gives an option intrinsic value. In this example, the intrinsic value would be $5. This is the actual, tangible value that the option would have if you exercised it right away. That’s some good news for your wallet, right?
Now, let’s turn the tables a bit. Imagine you’re holding a put option (the right to sell) on Company XYZ with a strike price of $30, but the market price is $25. You can sell at a higher price than the market price, putting you in the driver’s seat. This option is also ‘in the money’.
Out of the Money Explained
Now, let’s imagine you own a call option on Company ABC with a strike price of $50. However, Company ABC’s stock is currently trading at $45 in the market. If you were to exercise your call option, you’d be buying the stock at a higher price than it’s currently trading for. Not the best scenario, right? Hence, your option is said to be ‘out of the money’.
Similarly, if you own a put option on Company ABC with a strike price of $40, while the market price is $45, your option would be ‘out of the money’. You’d be selling the stock for less than the current market price, which isn’t profitable.
Grasping the Concept with a Chart
Let’s illustrate this with a table to get a clearer picture:
|Option Type||In the Money||Out of the Money|
|Call Option||Market Price > Strike Price||Market Price < Strike Price|
|Put Option||Market Price < Strike Price||Market Price > Strike Price|
The Role of Time Value
The journey of options trading doesn’t end with just understanding ‘in the money’ and ‘out of the money’. There’s another essential concept – the time value. This is the value that the market places on the potential for an option to become ‘in the money’ before it expires. The longer the time, the higher the time value, as there’s more chance of the stock price moving to a profitable position.
For ‘out of the money’ options, the entire premium represents the time value. As there’s no intrinsic value, the price you pay for the option is based purely on the gamble that it may become ‘in the money’ before expiration. For ‘in the money’ options, the premium is the sum of the intrinsic value and the time value.
Getting your head around ‘in the money’ vs. ‘out of the money’ options is like learning the ABCs of options trading. It’s an essential part of your toolkit as you navigate your way through this exciting market. With the map of knowledge in your hands, you’re well on your way to becoming a skilled explorer in the world of options trading. Happy journeying!
Frequently Asked Questions (FAQs)
Is it better to buy in the money or out of the money?
The choice between buying in the money (ITM) or out of the money (OTM) options depends on your investment goals, risk tolerance, and market expectations. ITM options are more expensive than OTM options but have a higher delta, meaning their price is more likely to move in-step with the underlying asset. OTM options are cheaper, but they require the underlying asset to move more before they become profitable. If you believe the asset will make a significant move, OTM options can provide a greater return on investment.
What is in the money at the money and out of the money?
In the money (ITM) means that an option has intrinsic value – a call option with a strike price lower than the market price, or a put option with a strike price higher than the market price. Out of the money (OTM) means an option has no intrinsic value – a call option with a strike price higher than the market price, or a put option with a strike price lower than the market price. At the money (ATM) means the strike price and market price are the same.
What does it mean when you are out of the money?
When you are “out of the money,” it means that if you were to exercise your option right now, it wouldn’t be profitable. This is because, for a call option, the market price of the asset is lower than your strike price. For a put option, the market price is higher than your strike price.
What is ITM vs ATM vs OTM?
ITM, ATM, and OTM are acronyms for in the money, at the money, and out of the money, respectively. They represent where the strike price of an option is in relation to the current market price of the underlying asset.
How do you know if you are in or out of the money?
You can determine if you are in or out of the money by comparing the option’s strike price to the current market price of the underlying asset. If your call option’s strike price is less than the market price, or if your put option’s strike price is more than the market price, you are in the money. The opposite is true for being out of the money.
What is the advantage of out of the money?
OTM options are cheaper to buy than ITM options. This makes them attractive to speculators betting on a big price move in the underlying asset, as they can potentially provide a larger relative return if the price moves in the right direction.
Is out of the money option bad?
Not necessarily. While OTM options carry a higher risk of expiring worthless, they are cheaper and can provide a larger relative return if the underlying asset’s price moves favorably.
Is it better to keep money in the bank or buy property?
This depends on your financial goals, risk tolerance, and market conditions. Property can offer both rental income and value appreciation, but it also comes with costs and responsibilities. Keeping money in the bank is safer but typically offers lower returns.
When should I buy ITM or OTM options?
You should buy ITM options when you expect a moderate move in the underlying asset’s price, and you are willing to pay more for a higher chance of a profitable trade. You should buy OTM options when you expect a significant move in the underlying asset’s price and are willing to risk the option expiring worthless.
What is an example of out of the money?
For a call option to be OTM, the strike price would need to be higher than the current market price of the underlying asset. For example, if you own a call option for Company X with a strike price of $110, and Company X’s stock is currently trading at $100, your call option is OTM.
Should you buy in the money options?
ITM options have a higher probability of staying profitable compared to OTM options, but they are more expensive. Buying ITM options can be a good choice if you want to limit potential losses and expect a moderate price move in the underlying asset.
What happens when you buy option out of the money?
When you buy an OTM option, you are betting that the price of the underlying asset will move in the direction you predict. If it doesn’t, your option will expire worthless. If the asset’s price does move in the desired direction and surpasses the strike price, your OTM option will become ITM.
Does in-the-money include premium?
Being “in the money” doesn’t include the premium paid for the option. It simply means the option has intrinsic value. However, for an option holder to profit at expiration, the option’s intrinsic value must be greater than the premium paid.
What happens when an option goes in-the-money?
When an option goes in-the-money, it means it has intrinsic value and could be exercised profitably. For call options, this happens when the asset’s market price is higher than the strike price. For put options, it’s when the asset’s market price is lower than the strike price.
Why do people buy ITM options?
People buy ITM options because they have a higher probability of staying profitable compared to OTM options. They are less risky but are also more expensive due to their intrinsic value.
Do all ITM options get exercised?
Not all ITM options get exercised. Some traders might choose to sell their ITM options before expiration to avoid the costs and responsibilities of owning the underlying asset. Others might let their options expire worthless if the transaction costs of exercising outweigh the benefits.