Options: “In-the-Money”, “At-the-Money” and “Out-of-the-Money”
The relationship between an option’s strike price and the current asset price (spot price) determines its moneyness:
- In the Money (ITM)
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For a call option, the spot price is above the strike price. For a put option, the spot price is below the strike price. This means the option has intrinsic value.
- At the Money (ATM)
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The spot price is equal to the strike price for both call and put options. This means the option has no intrinsic value but may have time value.
- Out of the Money (OTM)
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For a call option, the spot price is below the strike price. For a put option, the spot price is above the strike price. This means the option has no intrinsic value.
Moneyness is not a quality ranking. It is a description of where the strike sits relative to spot, and it determines how much of the premium you are paying for intrinsic value (which you own outright) versus extrinsic value (which decays to zero).
In-the-Money (ITM) Options An option is considered in-the-money if exercising it would result in a positive cash flow. For call options, this means the stock price is above the strike price. For put options, the stock price is below the strike price.
Example: Suppose you hold a call option with a strike price of $50, and the current stock price is $60. This option is ITM because you can buy the stock at $50 and immediately sell it at $60, netting a $10 profit per share (minus the premium paid).
ITM options have intrinsic value. For call options, it’s calculated as . For put options, it’s . Since ITM options have intrinsic value, they are less risky compared to OTM options. They provide a cushion against the premium paid. ITM options typically have higher premiums due to their intrinsic value. This can be beneficial for sellers (writers) who collect the premium.
The reason follows from delta, not from any empirical study: an in-the-money option has a delta approaching one (delta — the option’s price change per $1 move in the stock — is defined properly in the Greeks section below), so it tracks the stock closely and behaves less like a lottery ticket. The flip side is that you have paid for that intrinsic value in cash, so a deep ITM call risks far more dollars per contract than an out-of-the-money one. “Safer” here means lower variance per dollar of exposure, not less money at risk.
Out-of-the-Money (OTM) Options An option is considered out-of-the-money if exercising it would result in a negative cash flow. For call options, this means the stock price is below the strike price. For put options, the spot price is above the strike price.
Example: Suppose you hold a call option with a strike price of $50, and the current stock price is $40. This option is OTM because buying the stock at $50 would be more expensive than the current market price of $40.
OTM options are often used for speculative purposes. They are cheaper but carry higher risk. If the stock price moves favorably, the returns can be substantial.
OTM options provide leverage. A small investment can control a large number of shares, potentially leading to significant gains if the stock price moves in the desired direction. OTM options have lower premiums because they have no intrinsic value. This makes them attractive for buyers who are looking for high-risk, high-reward opportunities.
OTM options are more volatile and have a lower probability of being exercised.
- Portfolio Hedging
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Hedge with out-of-the-money puts, struck at the level below which the loss becomes intolerable, as every hedging section later in this chapter does. An in-the-money put protects dollar for dollar, but you prepay its intrinsic value in cash for exposure you already have; the cheap part of a hedge is the tail, and that is what an OTM strike buys.
- Speculative Plays
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Use OTM options for speculative plays. If you anticipate a significant price movement, OTM call options can offer high returns with a smaller initial investment.
- Income Generation
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Write out-of-the-money calls against stock you own — covered call writing, treated at length in section “Covered Call Strategy”. Writing in-the-money calls for the fatter premium is a common beginner error: the strike is already below spot, so in the flat or mildly bullish market you were forecasting you will be assigned and will have sold your stock. If you want to sell the stock, sell it; do not disguise the sale as income.
The choice between ITM and OTM is a choice about what you are buying. ITM premium is mostly intrinsic value — you are paying cash for exposure you already could have had by buying the stock, plus a small option on top. OTM premium is entirely extrinsic — you are buying nothing but the possibility, and it decays to zero on a schedule.