The relationship between an option’s strike price and the current asset price (spot price) determines its moneyness:
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.
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.
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.
Understanding these concepts helps in assessing the potential profitability and risk of options trading.
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.
Studies, such as those by Black and Scholes (1973), have shown that ITM options are less volatile and have a higher probability of being exercised, making them a safer bet for conservative investors.
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 stock 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. However, they can offer high returns in bullish or bearish markets when used properly.
Use ITM options to hedge your portfolio. For example, buying ITM put options can protect against downside risk in a bearish market.
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.
Write ITM call options on stocks you own to generate additional income through premiums. This strategy, known as covered call writing, can enhance returns in a flat or mildly bullish market.
Understanding ITM and OTM options is essential for strategic financial planning. ITM options offer lower risk and higher premiums, suitable for conservative strategies. OTM options provide leverage and potential high returns, ideal for speculative plays. Use these tools wisely to grow and protect your wealth.