Options can have different statuses – in the money, out of the money, or at the money. These statuses, known as “moneyness,” depend on the relationship between the option’s strike price and the price of the underlying stock. This relationship can change over time as the stock price fluctuates.
Let’s explore what in-the-money and out-of-the-money options are and how they differ.
Understanding In-the-Money Options
An option is considered in the money (ITM) if it would have value if it expired at that moment. For call options, the stock price must be above the strike price, while for put options, the stock price must be below the strike price.
Being in the money is not dependent on whether the trader owns or has sold the option. It also does not determine the profitability of the trade. The status can change from in the money to out of the money as the stock price fluctuates.
Benefits and disadvantages of in-the-money options are:
- ITM options have lower volatility, larger premiums, and lower probability of total loss.
- However, they also come with greater potential loss, lower percentage upside, and higher cost.
Examples of In-the-Money Options
For instance, if Stock X is priced at $21 a share, call options with a $20 strike price are in the money. Conversely, call options with higher strike prices are out of the money.
Similarly, put options with a $20 strike price on Stock Y, priced at $19 a share, would be in the money.
Understanding Out-of-the-Money Options
An option is considered out of the money (OTM) if it would be worthless if it expired at that moment. Call options are OTM if the stock price is below the strike price, while put options are OTM if the stock price is above the strike price.
Out-of-the-money options have lower costs but higher volatility. They also have a greater probability of loss.
Examples of Out-of-the-Money Options
For example, call options with a $20 strike price on Stock X, priced at $19 a share, would be out of the money.
Put options with a $20 strike price on Stock Y, priced at $21 a share, would also be out of the money.
Understanding At-the-Money Options
An option is at the money (ATM) when the stock price is exactly at the option’s strike price. It is a rare moment, and the option will likely soon become in the money or out of the money.
If an option closes expiration at the money, it typically expires worthless.
Key Differences between ITM and OTM Options
- ITM options are less volatile and have intrinsic value, while OTM options are entirely time value.
- ITM options have a lower probability of total loss compared to OTM options.
Conclusion
Whether an option is in the money or out of the money depends on the relationship between the strike price and the stock price. These statuses can change based on market movements. Understanding these concepts is crucial for options traders.