In the world of options trading, understanding the terms 'In the Money' (ITM) and 'Out of the Money' (OTM) is crucial. These terms describe the intrinsic value of an options contract in relation to the current market price of the underlying asset.
What are Options?
Before we delve into the details of ITM and OTM, it's important to have a brief understanding of options. An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. There are two types of options - calls and puts. A call gives the holder the right to buy an asset at a certain price, while a put gives the holder the right to sell an asset at a certain price.
In the Money (ITM)
In the money means that an options contract has intrinsic value. For a call option, this happens when the current market price of the underlying asset is higher than the strike price of the option. Conversely, for a put option, an option is in the money when the market price of the underlying asset is lower than the strike price.
Example of ITM Call Option: Consider a call option for Apple Inc (AAPL) with a strike price of $150, expiring in one month. If the current market price of AAPL is $160, then this option is considered 'in the money' because you have the right to buy AAPL at $150, which is $10 lower than the current market price. This price difference, known as the intrinsic value, can be immediately realized if you were to exercise the option.
Example of ITM Put Option: Consider a put option for AAPL with a strike price of $150, expiring in one month. If the current market price of AAPL is $140, then this option is 'in the money' because you can sell AAPL at $150, which is $10 higher than the current market price. Again, this price difference is the intrinsic value of the option.
Out of the Money (OTM)
Conversely, an option is considered 'out of the money' when it does not have intrinsic value. For a call option, this happens when the current market price of the underlying asset is lower than the strike price. For a put option, an option is out of the money when the market price of the underlying asset is higher than the strike price.
Example of OTM Call Option: Consider a call option for AAPL with a strike price of $150, expiring in one month. If the current market price of AAPL is $140, then this option is considered 'out of the money' because you would not want to exercise the right to buy AAPL at $150 when you can buy it on the open market for $140.
Example of OTM Put Option: Consider a put option for AAPL with a strike price of $150, expiring in one month. If the current market price of AAPL is $160, then this option is 'out of the money' because you would not want to exercise your right to sell AAPL at $150 when you can sell it on the open market for $160.
Why are ITM and OTM Important?
ITM and OTM determine whether it's profitable to exercise an option. They also greatly influence the premium of the options. Typically, ITM options are more expensive because they have intrinsic value, while OTM options are cheaper because they contain only time value. Traders use these terms to assess the risk and reward scenario in options trading. Buying OTM options might be cheaper but has a lower probability of profit, while buying ITM options, though expensive, has a higher probability of profit.
In-the-Money or Out-of-the-Money: Which to Choose?
The decision to buy ITM or OTM options depends on the trader's market outlook, risk tolerance, and investment strategy. If a trader is highly confident that the price of the underlying asset will move significantly, they might choose OTM options. These options are cheaper, and if the price of the underlying asset does move significantly, the payoff can be quite substantial. However, the risk of the option expiring worthless (if the price doesn't move as anticipated) is also higher. On the other hand, if a trader wants to reduce risk or is looking for a higher probability of profit, they may choose ITM options. These options are more expensive, but they also have intrinsic value and a higher delta (which means they'll move more closely with the price of the underlying asset).
Understanding the concepts of 'in the money' and 'out of the money' is fundamental to successful options trading. These terms describe whether an options contract has intrinsic value or not, and they can greatly influence the cost of an option and the decision whether or not to exercise it. It's important to remember that options trading involves significant risk and is not suitable for all investors. It requires a deep understanding of financial markets, and investors should always conduct thorough research or seek advice from a qualified professional before engaging in options trading.
Overall, while ITM and OTM provide insights into the intrinsic value of an option and potential profitability, they're just one piece of the puzzle. Factors such as the volatility of the underlying asset, the time until expiration, and the investor's risk tolerance and market outlook should also be taken into account when trading options.
Although Out of the Money options are cheaper and may seem more attractive due to their lower cost, data suggests that over 75% of all options held until expiration end up worthless, meaning they were OTM when they expired. This highlights the increased risk that comes with OTM options and underscores the importance of a well-thought-out trading strategy. It's essential to consider both the potential rewards and the associated risks when dealing with options trading.
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