The concept of an option being in-the-money (ITM) or out-of-the-money (OTM) depends on the relationship between the option's strike price and the market value of the underlying asset, as well as whether the option is a call or a put. This relationship defines ITM and OTM differently for call and put options.
In this guide, we will explore what determines whether an option is ITM or OTM, highlight the key differences between these two states, and delve into their implications for trading strategies.
KEY DIFFERENCES
In-The-Money (ITM): An option is in-the-money when it has intrinsic value, meaning the strike price is favorable compared to the current market price of the underlying asset.
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Call option: Underlying asset is higher than the strike price.
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Put option: Underlying asset is less than the strike price.
Out-The-Money (OTM): An option is out-the-money when it does not have intrinsic value, meaning the strike price is not favorable compared to the current market price of the underlying asset.
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Call option: Underlying asset is lower than the strike price.
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Put option: Underlying asset is higher than the strike price.
At-The-Money (ATM): An option is at-the-money when it does not have any intrinsic value but does have extrinsic value, meaning the strike price is equal to the market price of the underlying asset and the option’s premium consists entirely of its time value.
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Call & Put option: Underlying asset is equal to the strike price.
CALCULATION
Intrinsic Value Options:
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Call Options Intrinsic Value Calculation: Intrinsic value = Current Stock Price - Strike Price
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Put Options Intrinsic Value Calculation: Intrinsic value = Strike price - Current Stock Price
Extrinsic Value Options:
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Call & Put Options Extrinsic Value: Extrinsic value value = Total Premium - Intrinsic Value
ITM OR OTM? WHICH IS BETTER?
Why would an investor choose an ITM option over an OTM option, or vice versa?
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ITM Options: typically have a higher probability of profit, lower risk, lower profit and come at a higher premium.
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OTM Options: typically have a lower probability of profit, higher risk, higher profit and come at a lower premium.
ITM AND OTM OPTION STRATEGIES
What are the strategies involving ITM and OTM options?
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ITM Options: might be used in conservative strategies, like covered calls or protective puts.
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OTM Options: are often used in speculative strategies, like buying calls or puts to leverage potential large price movements with limited capital.
TIME DECAY IMPACT
Time Decay (theta) is a measure of how the value of an option decreases as time progresses because options have a finite life and their value diminishes as they approach expiration.
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ITM options: are less affected by time decay since they already have intrinsic value.
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OTM options: more significantly as they rely heavily on time value. As expiration approaches, the value of OTM options can decrease rapidly.
VOLATILITY IMPACT
Volatility (sigma) can increase the value of both ITM and OTM options, but the impact is usually more pronounced on OTM options because they are more sensitive to changes in the underlying asset's price.
LIQUIDITY DIFFERENCES
How does liquidity differ between ITM and OTM options?
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ITM Options: typically have higher liquidity due to their higher intrinsic value, making them more attractive to traders.
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OTM Options: might have lower liquidity, which can lead to wider bid-ask spreads.
IMPLIED AND HISTORICAL VOLATILITY
What role do implied volatility and historical volatility play in pricing ITM and OTM options?
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Historical volatility measures the past price fluctuations of an asset, providing an empirical assessment of its variability over a specific period.
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Implied volatility, on the other hand, is forward looking and reflects the market's expectations of future price fluctuations and is derived from current option prices.
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Implied volatility reflects market expectations of future volatility and significantly impacts OTM options' pricing due to their higher sensitivity.
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Historical volatility provides context but has less direct impact on pricing compared to implied volatility.
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DIVIDEND CONSIDERATIONS
Dividends can affect the price of the underlying stock, which in turn affects the value of both ITM and OTM options.
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They reduce the value of the underlying asset since they represent a cash outflow to the shareholder.
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ITM call options might be exercised early to capture the dividend, whereas OTM options are less likely to be impacted directly.
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To wrap things up, getting a handle on the differences between ITM and OTM options can really help you navigate the twists and turns of the options market. ITM options, with their higher odds of profit and lower risk, are great for more cautious strategies, even though they come with a heftier price tag. On the flip side, OTM options are the go-to for those looking to take bigger risks for potentially larger rewards, thanks to their lower cost. By understanding how time decay, volatility, and dividends play into the value of these options, you'll be better equipped to make smart trading choices. We trust this guide has given you a solid grasp of these concepts. Thanks for spending your time with us!
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Our commitment to accuracy means we constantly review and update our articles to reflect the latest developments and trends in options trading. We strive to present unbiased information, allowing our readers to make informed decisions based on solid evidence. Discover more about our rigorous standards and our dedication to excellence on our website.
- Edge, Merrill. “Understanding Option Pricing: Intrinsic and Time Value.” Merrill Edge, 31 July 2020, www.merrilledge.com/investment-products/options/options-pricing-valuation.
- “Out-of-the-Money and In-the-Money Vertical Spreads.” Schwab Brokerage, www.schwab.com/learn/story/out-money-and-money-vertical-spreads.
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