Options are financial contracts that give their holders the right to buy or sell an underlying asset at a specific price within a certain timeframe. In options trading, two terms that are frequently used are In The Money (ITM) and Out Of The Money (OTM). These terms describe the relationship between the current price of the underlying asset and the strike price of the option. In this blog post, we will discuss the difference between ITM and OTM options and how they are used in options trading.
ITM Options
An option is considered to be ITM if its strike price is favorable to the current market price of the underlying asset. For example, if the current market price of a stock is $50 and the strike price of a call option is $45, then the option is ITM. This is because the holder of the option has the right to buy the stock at a price lower than its current market price.
In the case of a put option, it is ITM when the strike price is higher than the current market price of the underlying asset. For example, if the current market price of a stock is $50 and the strike price of a put option is $55, then the option is ITM. This is because the holder of the option has the right to sell the stock at a price higher than its current market price.
OTM Options
An option is considered to be OTM if its strike price is not favorable to the current market price of the underlying asset. For example, if the current market price of a stock is $50 and the strike price of a call option is $55, then the option is OTM. This is because the holder of the option would have to pay more than the current market price to buy the stock.
In the case of a put option, it is OTM when the strike price is lower than the current market price of the underlying asset. For example, if the current market price of a stock is $50 and the strike price of a put option is $45, then the option is OTM. This is because the holder of the option would have to sell the stock at a price lower than its current market price.
ITM vs OTM Options
The primary difference between ITM and OTM options is their intrinsic value. ITM options have intrinsic value because they can be exercised for a profit, whereas OTM options have no intrinsic value and are worthless at expiration.
Another difference between ITM and OTM options is their premium. ITM options have higher premiums than OTM options because they have intrinsic value. The premium is the price that the option buyer pays to the option seller for the right to buy or sell the underlying asset.
Examples
Let’s look at an example of how ITM and OTM options work in practice.
Suppose the current market price of XYZ stock is $100. A call option with a strike price of $90 is ITM because the holder of the option can buy the stock at a price lower than its current market price. The option premium for this option might be $15.
On the other hand, a call option with a strike price of $110 is OTM because the holder of the option would have to pay more than the current market price to buy the stock. The option premium for this option might be only $1 or $2.
Conclusion
In conclusion, understanding the difference between ITM and OTM options is essential for options traders to make informed investment decisions. ITM options have intrinsic value and can be exercised for a profit, while OTM options have no intrinsic value and are worthless at expiration. When trading options, it is important to consider factors such as the current market price of the underlying asset, the strike price of the option, and the option premium. By incorporating these factors into their investment strategies, options traders can increase their chances of success in the market.