If you're thinking about using options for your investment portfolio, an important concept to understand is the distinction between in the money (ITM) vs. out of the money (OTM) options.
ITM are options that are profitable right now. OTM options are bought to try to earn a higher return later. But options are not for every investor. Find out more about how these investing strategies work and if they make sense for your portfolio.
The Short Version
- ITM options are profitable if exercised right now. OTM options are not.
- Traders buy OTM options in the hope that the option gets closer to or become ITM.
- OTM options are considered more aggressive than ITM options because they can potentially offer higher returns. At the same time, OTM options can easily lose their value.
- Whether you buy ITM options or OTM options depends on your financial goals and risk tolerance.
What Are In the Money vs. Out of the Money Options?
Before we begin, if you're not familiar with stock options and related terms, please read our Options Primer.
The difference between ITM and OTM options is whether they have intrinsic value. “Intrinsic value” means if you exercise your option immediately, you can make a profit. In order to determine intrinsic value, we need to understand both the option's strike price — the price at which you can buy (in the case of a call option) or sell (with a put option) the underlying stock — and the current market price of a stock, known as the spot price.
For example, a call option for ABC stock with a strike price of $20 will be ITM if the stock price of ABC is above $20. It's out of the money if the stock price of ABC is below $20. As a general rule of thumb, the more ITM the option is, the higher the cost of the option. This cost is known as the option premium.
This article focuses on options relating to U.S. stocks as opposed to options relating to equities. “Stock” generally refers to shares in public companies. “Equity” can refer to stock for either public or private companies.
What Is “In the Money”?
Let's go into further detail on the concept of an ITM option. As mentioned earlier, options that are in the money have intrinsic value because they are profitable if exercised immediately. Specifically, if you have a call option with a strike price of $20 (allowing you to buy the stock for $20) and the stock is trading at $25, your option is in the money with an intrinsic value of $5 ($25 – $20).
There are typically two ways you can end up owning an option that is in the money. You can buy an option that is already in the money (hoping that it becomes deeper in the money) or buy an option that is out of the money that eventually becomes in the money.
So why doesn't everyone buy an option that is already in the money? The reason is the deeper an option is in the money, the higher the cost (premium). Additionally, an option that is in the money doesn't offer the same potential upside as an option that is out of the money.
Let's use an example to illustrate an in the money option.
ITM Option Example
Say that ABC stock is currently trading at $19 a share. After rigorous analysis, you decide it's overvalued. In order to short the stock, you purchase an ITM put option. This gives you the right to sell the stock at a certain strike price.
You purchase a put option at a strike price of $21 that will expire in two months. This strike price is ITM with an intrinsic value of $2 because you can sell the stock $2 higher than what it is currently trading at ($21 – 19). You make this trade because you believe that the underlying stock's current market price of $19 will decrease.
Let's say the premium for this option is $2.50. Stock options in the U.S. are usually for 100 shares per contract, so this option contract will cost $250. For simplicity's sake, we will assume there is no commission in this example.
At expiration, the price per share of ABC drops to $17. The intrinsic value for this option is now $4 ($21 – $17). But instead of exercising the option, you can simply sell the option and pocket the profits. Your profit per share will be $1.50 ($4.00 – $2.50), for a total of $150 ($1.50 x 100).
Pros and Cons of In the Money
What Is “Out of the Money”?
OTM options have no intrinsic value. In other words, if you exercise the option immediately, it is not profitable. For example, if you exercise a call option with a strike price of $25 (allowing you to buy the stock for $25) and the stock is trading at $20, you pay $5 more than the going price of the stock.
When you buy an OTM option, you hope the underlying asset price moves so that the option becomes closer in the money or actually in the money.
The farther out of the money an option is, the less likely it is to become in the money at expiration. And that's why the option costs less. While buying an option that is far out of the money can seem like a gamble, if it becomes ITM, the profit can be huge.
OTM Option Example
Let's use the former example of ABC stock that is trading at $19 a share. But this time we are in a different universe where your research shows that ABC's price per share is going to increase.
You purchase an OTM call option at a strike price of $20 that will expire in two months. The premium for this option is $0.50, or $50 per contract. Remember that a call option gives you the right (but not the obligation) to buy the stock at the strike price. Since ABC stock is currently trading at $19, you cannot make a profit buying the stock at $20. Thus, this option is currently out of the money.
In this alternate universe, you are again correct. ABC leaps to $21 per share at expiration. You now sell your option for a premium of $1.00, yielding a profit of $0.50 per share ($1.00 – $0.50), or $50 per contract. You doubled your initial investment of $50.
Pros and Cons of Out of the Money
Which Is Better, In the Money or Out of the Money?
At expiration, it is always better for an option to be in the money because it will have value. If an option expires out of the money, it is worthless. However, whether you initially buy an ITM or OTM option depends on your risk profile and financial goals.
If you're willing to take risks and are confident in the magnitude in which the underlying stock will move, an OTM option can potentially yield larger profits. In both of our examples above, the stock price moved $2, but the ITM option made a $150 profit on a $250 investment (60% profit), while the OTM option made a $50 profit on an $50 investment (100% profit). But keep in mind that if the underlying stock moved only $1, the OTM option would have been worthless at expiration while the ITM option would still have been profitable.
For more insight into how to do analysis on your investments, check out our guide on Technical vs Fundamental Analysis.
Can You Really Make Money in Options Trading?
While it is certainly possible to make money trading options, only a very small percentage of traders can make a steady income because the market is unpredictable and options are by nature volatile. However, there are option trading strategies that can provide a steady income. An example would be selling covered calls (selling call options for stocks you own), but this strategy requires owning the underlying stock.
Even though options are generally considered high risk, investors still use options because they can provide asymmetrical returns. According to Michael Lewis's book, The Big Short, New York-based investment firm Cornwall Capital used options to grow their initial capital of $110,000 to over $12 million.
Find out more >>> Best Options Trading Platforms
Options can be a great opportunity for traders to exercise greater leverage than they otherwise could by purchasing shares of stock outright. The concept of ITM and OTM options is crucial to understand if you want to successfully trade options and use options proficiently for your investment portfolio.
Disclaimer: The content presented is for informational purposes only and does not constitute financial, investment, tax, legal, or professional advice. If any securities were mentioned in the content, the author may hold positions in the mentioned securities. The content is provided ‘as is’ without any representations or warranties, express or implied.