How to Win at Trading Options
For option traders, a key question is what strike price to pick. The choice can be the difference between a winning and a losing trade.
You can choose an in-the-money (ITM) or an out-of-the-money (OTM) option contract. Let’s examine the difference. Even seasoned investors need a review of the basics from time to time.
An ITM call option has a strike price below the market price, and an OTM call option has a strike price above the market price. Conversely, an ITM put option has a strike price higher than the market price, and an OTM put option has a strike price lower than the market price.
For example, if XYZ is trading at $15.50, an XYZ call option with a strike price of $14 is ITM, and a call option with a strike price of $17 is OTM. Conversely an XYZ put option with a strike price of $17 is ITM and a put option with a strike price of $14 is OTM.
Another way you can think about ITM vs. OTM is that you would exercise an ITM option because you can either buy (call) or sell (put) XYZ at a more favorable price than you could get on the market. On the other hand, it would make no sense to exercise an OTM option. In the above example, if you can buy XYZ on the market at $15.50, why would you exercise the option to buy XYZ at $17?
Intrinsic Value and Time Value
Another way to say this is that an ITM option has intrinsic value, which means the option has value if it were to be exercised now. The intrinsic value is calculated as the difference between the market price and the strike price. So in the XYZ example, the ITM call option has intrinsic value of $1.50 ($15.50 – $14).
As you may have guessed, an OTM option has no intrinsic value since it won’t be exercised.
Note that the value of an option is comprised of intrinsic value and time value. This means that when you buy an OTM option, you are paying strictly for time value, which decreases over time. The fall in time value accelerates as the expiration date approaches until at expiration the time value falls to zero. Since an OTM option doesn’t have intrinsic value, when time value also falls to zero, the OTM option’s overall value is also zero at expiration. It expires worthless.
If you ever come across the term “theta,” that’s the measure of time decay, i.e. how quickly the time value declines. An option’s theta is expressed as a negative number and it shows how much an option’s time value can be expected to fall each day if everything else is held constant.
ITM vs. OTM
When you start with an OTM option, you need the underlying stock to move enough to be ITM in order for it to have value at expiration. (Of course, in practice, you could sell an option before expiration, so if the stock price moves in your favor enough, you could still sell an OTM option at a profit.)
When you start with an ITM option, as long as the stock does not move against you enough to become OTM, at expiration the option will still have intrinsic value and it won’t expire worthless. Thus, buying an ITM option is considered to be more conservative. Keep in mind, though, that it’s entirely possible to still lose money on an ITM option if the stock price moves unfavorably against you.
The other disadvantage is that an ITM option costs more, so you will need to spend more per contract. Indeed, for options of the same stock and same expiration date, the more ITM the option is, the higher its price will be. And the more OTM an option is, the lower its price will be.
When you start with a high-priced option, it’s tougher to make huge gains in percentage terms. For example, if you bought an OTM option for $1, to achieve a 50% return it just needs to gain $0.50. But if you bought an ITM option for $5, to make the same 50% you would need it to increase by $2.50.
No One-Size-Fits-All Approach
Whether an ITM or OTM makes most sense for you depends on your risk tolerance, how aggressive you want to be, and what you are trying to do with the trade (make as much money as possible, hedge, etc.).
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