An out-of-the-money option (OTM) is one where the strike price is unfavorable in relation to the current market price of the underlying asset. In OTM call options, the strike price is higher than the market price. For put options, the strike price is lower. OTM options have no inherent value since there is no benefit in exercising the Option and buying or selling the asset at the set strike price. However, OTM options are cheaper to purchase than ITM options.
In-the-money options have strike prices that are advantageous versus the current trading price. ITM calls have strike prices below the market price, while ITM puts strike prices higher than the market value. ITM options have a built-in value equal to the difference between the strike price and market price. An investor will be able to exercise an ITM option to buy or sell the underlying asset at a discount or premium to market value.
Due to their higher intrinsic value, ITM options have much higher premiums than OTM options. But higher premiums also mean higher profit potential. OTM options have lower premiums but sometimes expire worthless if the underlying price fails to reach the strike price.
What is the Out of The Money (OTM) Option?
An out-of-the-money (OTM) option is a call or put option that would result in no profit if it were exercised immediately. An OTM call option has a strike price that is higher than the current market price of the underlying asset. An OTM put option has a strike price that is lower than the current market price of the underlying asset.
The intrinsic value of an OTM option is zero since there is currently no difference between the strike price and market price that would lead to a potential profit. However, OTM options still retain time value, which is the portion of an option’s premium that accounts for the possibility of the Option becoming profitable prior to expiration due to movements in the underlying asset price.
For example, consider a call option with a strike price of Rs. 50 on a stock that is currently trading at Rs. 48 per share. This call option is OTM by Rs. 2. The call option holder would be able to purchase the shares at Rs. 50, which is Rs. 2 more than the current market price if it were executed right away. This would result in no profit. However, if the stock price rises to Rs. 52 before the call option expires, it now has an intrinsic value of Rs. 2 per share since the holder could exercise and immediately make a Rs. 2 profit per share. The time value represents the potential for this type of favorable price movement while the Option remains valid.
OTM options have a lower premium cost compared to in-the-money (ITM) options or at-the-money (ATM) options. This is because the probability of OTM options resulting in a payout is lower, hence there is less time value priced into the premium. However, for some trading strategies, the lower cost is beneficial. For example, a call option buyer sometimes chooses an OTM call option over an ITM call if they expect a large upside movement in the underlying asset price but want to reduce the premium cost.
Trading OTM options involves six important factors. OTM options are more sensitive to changes in implied volatility. Higher implied volatility increases the time value of options in general, which has an outsized impact on increasing the value of OTM options.
OTM options are subject to time decay as expiration approaches. The time value erodes as expiration gets nearer, which hurts OTM options more, given their full premium consists of time value only.
OTM options make sense when expecting a bigger move in the underlying asset price. The cheaper premium cost allows exposure with less upfront capital.
They are riskier than ITM or ATM options given the lower probability of ending up profitable. The underlying asset price needs to move favorably by more than with other option types to generate a return.
OTM options are more likely to expire worthless. Since they require a larger move in the underlying, the odds of that occurring by expiration are lower.
They are used to hedge or speculate on a directional outlook. For example, buying an OTM call to benefit from an expected upward move or buying an OTM put to profit if the price declines.
Certain strategies, like the long strangle, rely on OTM options. This involves buying an OTM call and OTM put to profit from a large price movement in either direction.
How does the Out of The Money (OTM) Option work?
An out-of-the-money (OTM) option would work by not generating a profit if exercised immediately due to the current market price of the underlying asset relative to the Option’s strike price. The key to understanding how OTM options work lies in the concepts of intrinsic value and time value.
Intrinsic value refers to any built-in profit an option has based on the difference between the strike price and the market price of the underlying. For example, with a stock trading at Rs. 50 and a call option with a Rs. 48 strike price, the intrinsic value is Rs. 2 per share since the holder buys at Rs. 48 and immediately sells at Rs. 50.
An OTM option, by definition, has no intrinsic value. With a call option, the strike price is higher than the market price. With a put option, the strike price is lower. In both cases, there is no profit to be made by exercising the Option and initiating the associated trade in the underlying.
However, even though an OTM option has no intrinsic value, it sometimes still has a time value. Time value represents the chance that the Option becomes profitable prior to expiration. It accounts for uncertainties in factors like volatility, time until expiry, interest rates, etc.
For example, say a stock is at Rs. 48 and there is a call option with a Rs. 50 strike expiring in 3 months. This OTM call cannot be exercised for a profit right now. However, over the next 3 months, if the stock rallies to Rs. 52, the call option now has an intrinsic value of Rs. 2 per share and is exercised or sold at a profit.
An investor pays a premium to buy an option, which represents the time value and any intrinsic value. For an OTM option, the entire premium is time value, given the lack of built-in profit. The goal is for the underlying price to move such that the option transitions from having no intrinsic value to having intrinsic value before it expires.
As expiration approaches, the time value erodes. This time decay accelerates in the final month before expiry. Therefore, the underlying price needs to move favorably relatively quickly after purchase for an OTM option buyer to generate a profit. Otherwise, they risk the Option expiring worthless if it remains OTM.
Sellers of OTM options take the opposite view. They earn the premium upfront and benefit from time decay as it pulls the option price lower. Profitability arises if the Option expires OTM, allowing the seller to keep the full premium. The seller incurs losses if the Option converts to ITM.
OTM options are used by both hedgers and speculators, depending on their goals and forecast for the market. Speculators buy OTM calls if expecting an upside move in the underlying or OTM puts if expecting a decline. The cheaper premium cost allows exposure with less capital.
Hedgers buy OTM puts to protect a long stock position against downside risk if they view the puts as relatively inexpensive for the protection provided. Sellers sometimes generate income by selling covered OTM calls against a long stock position, profiting from the premium earned if the calls expire OTM.
What happens if the Option is Out of The Money?
An option expires worthless and has no value if it is out of the money. A call option is OTM when the strike price is higher than the market price of the underlying asset. A put option is OTM when the strike price is lower than the market price of the underlying.
With an OTM option, there is no difference between the strike price and the current market price that would allow the option holder to exercise for an immediate profit. However, the Option sometimes still has extrinsic value, specifically time value. Time value represents the possibility of the Option becoming profitable prior to expiration if the underlying asset price moves favorably.
As an OTM option heads closer to expiration, the time value decays at an accelerating rate. Time value erosion is not linear. It speeds up exponentially in the last 30-60 days before expiration as the probability of remaining OTM increases. An OTM option sometimes loses value very quickly with this acceleration in time decay.
For an option buyer, this is risky if the underlying does not move as expected. The purchased Option expires worthless due to evaporation of time value. For an option seller, accelerating time decay is beneficial as it pulls the option price lower.
Ideally, for an OTM option buyer, the underlying price will move advantageously while the Option is still valid, transitioning it from OTM to ITM. For example, if an OTM call option has a Rs. 50 strike price and the underlying rallies from Rs. 48 to Rs. 52, that Option is now Rs. 2 in the Money. It has intrinsic value and is exercised profitably prior to expiration.
The faster this transition happens after purchase, the better for the buyer. Time decay has less chance to erode the new intrinsic value. The intrinsic value gained might not be greater than the temporal value lost if the transition occurs near the point of expiration. The option seller faces losses in this transition scenario. What was previously an expiring worthless OTM option now has intrinsic value they must pay out if exercised.
What are the benefits of Out-of-the-money (OTM) Options?
Investing in out-of-the-money (OTM) options has seven main benefits, which include lower premium cost, higher profit potential, speculation with lower capital, etc.
1.Lower Premium Cost
The main advantage of OTM options is they come with a lower premium cost compared to at-the-money (ATM) or in-the-money (ITM) options. Since OTM options have a lower chance of finishing in the money at expiration, you pay less upfront to establish the position. The lower premium spent allows you to gain greater leverage on your trading capital potentially.
2. Higher Profit Potential
Despite the lower probability of expiring ITM, OTM options provide larger profits if the forecasted move in the underlying occurs before expiration. The farther out of the money the strike price, the more potential profit if the price moves into the money. This leveraged payoff compensates for the higher risk of buying OTM options.
3. Speculation with Lower Capital
OTM options offer a way to speculate on upside or downside moves in the underlying asset while tying up only a small amount of capital. Buying OTM calls or puts controls on a large number of shares for the cost of the premium. This leveraged exposure allows speculating on big price moves with less capital.
4. Less Impact from Time Decay
Time value decay accelerates as options get closer to expiration. OTM options have a lower sensitivity to time decay compared to ATM or ITM options since most of the option premium consists of time value anyway. Positions have more time to become profitable before time decay starts eroding.
5. Increase Income from Overwriting
Selling OTM calls against stock positions brings in premium income from options decaying over time. Since the calls are OTM, you get to keep the premium as long as shares remain below the short call strike at expiration. This generates extra income from positions you already own.
6. Define Risk in Spreads
Spreads combine buying and selling options to define risk. OTM options are used as the long or short legs in spreads. The maximum loss is limited to the net debit or credit taken when opening the spread position. The OTM short options expiring worthless delivers the maximum gain.
7. Lower Margin Requirements
OTM options have less chance of going to ITM, so brokers require less margin to hold them. Buying OTM calls or opening OTM credit spreads ties up less margin equity, allowing you to put on more contracts for a given account balance.
The main benefits of trading OTM options are lower premium costs, higher reward potential, lower capital requirements, less time decay, increased income from overwriting, defined risk spreads, and reduced margin requirements. OTM options allow trading strategies with higher leverage and greater efficiency.
What are the Downsides of Out of the Money (OTM) Options?
The possible downsides and risks of trading out-of-the-money (OTM) options include a higher risk of expiring worthless, uncertainty of probability, time decay impact, etc.
1.Higher Risk of Expiring Worthless
The main downside of OTM options is the high probability of expiring worthless if the underlying asset price does not move enough prior to expiration. Since OTM options rely entirely on time value, they are more likely to expire with no payout as time decay accelerates. Options traders take on a higher risk of losing the entire premium paid for OTM options.
2. Uncertainty of Profitability
It is very uncertain whether an OTM option will actually end up profitable by expiration. A significant move in the underlying is required, which is difficult to predict reliably. There are no guarantees the asset price will trend favorably or by how much. Transitioning from OTM to ITM depends heavily on market conditions.
3. Time Decay Impact
Time value erodes as expiration approaches, at an accelerating rate in the final weeks. This time decay has a more detrimental impact on OTM options since they depend totally on time value. The time window is much smaller to transition into profitability before the time value diminishes. Monitoring time decay effects requires active management.
4. Potentially Overpaying
While OTM options have lower nominal premiums, investors could still overpay relative to the probability of payout. The odds of remaining OTM are higher, so the price paid might not reflect fair value. Ensuring the price reflects realistic chances of positive returns requires careful evaluation.
5. Opportunity Cost
Capital spent purchasing OTM options that ultimately expire worthless represents a lost opportunity cost. The funds could have been utilized elsewhere with a higher probability of generating positive returns. Investors need to allocate capital to potentially more profitable trades.
6. Unhedged Tail Risk
OTM put options offer a less expensive downside hedge, but they do not cover tail risks. For example, buying 10% OTM still leaves substantial room for larger declines before protection kicks in. The protection has gaps relative to more ATM hedging alternatives.
7. Loss Magnification
While profits are magnified, so too are losses. The leveraged nature of OTM options produces larger percentage losses if the trade goes against the buyer. The loss is confined to the premium paid, but this represents a significant portion of capital at risk.
8. Complex Strategies
Certain advanced strategies using OTM options require experience and active management to ensure proper execution. For example, ratio spreads involve balancing OTM and ITM legs. The dynamics involved make them inappropriate for novice options traders.
9. Wide Bid/Ask Spreads
Options with wider bid-ask spreads have higher effective costs of trading in and out. OTM options tend to have wider spreads due to lower volume and open interest. Higher frictional costs detract from profitability.
10. Miscategorized Moves
Transitioning from OTM to ITM requires sizable underlying movement, but it sometimes does not align with a trader’s directional assumption. For example, an OTM put might transition to ITM due to a volatility spike rather than a directional move lower.
While OTM options offer unique opportunities, their higher risk requires a thorough evaluation of the probabilities and costs involved before deploying them in an options trading strategy. Traders should analyze both the potential upsides and downsides carefully.
What is In The Money (ITM) Option?
An in-the-money (ITM) option is an option with a strike price that is favorable compared to the current market price of the underlying asset. An in-the-money (ITM) option is an option that has intrinsic value. This means there is a difference between the Option’s strike price and the current market price of the underlying asset that would allow the option holder to exercise the Option for a profit immediately.
Meanwhile, a put option is ITM when the strike price is above the market price of the underlying. A put option that has a strike price of 55 and a stock price of 50 is also in the Money by Rs. 5. The put holder exercises and sells the stock for Rs. 55 while only paying Rs. 50 to obtain it, netting Rs. 5 of intrinsic value per share.
In both cases, ITM means the strike price allows the option holder to capture an immediate difference compared to the market price. This built-in profit is what comprises the Option’s intrinsic value. It exists regardless of any other factors, like time left until expiry.
An ITM option will always have both intrinsic value and time value. Time value represents the potential for the Option to gain more intrinsic value prior to expiration if the underlying price moves further in a favorable direction. Time value accounts for uncertainties in factors like volatility, time decay, and interest rates.
Since ITM options already have inherent profit built in, they exhibit less time value erosion as expiration approaches relative to at-the-money or out-of-the-money options. The intrinsic value component does not decay as time value does.
How does In The Money (ITM) Option work?
An in-the-money (ITM) option has intrinsic value since the strike price is favorable compared to the market price of the underlying asset, which works by allowing the option holder to exercise the Option for a profit. This means the strike price of the Option provides an immediate financial benefit relative to the current market price of the underlying asset. Understanding how intrinsic value works is key to understanding how ITM options function.
Intrinsic value represents built-in profit for an option based on the difference between its strike price and the market price. For call options, the strike price is below the market, which allows the holder to buy the asset below its current value. For put options, the strike is above the market, allowing the holder to sell the asset above its current value.
The intrinsic value thus creates an immediate payoff for the ITM option holder. By exercising, they capture a built-in profit equal to the difference between strike and market price. Even if an ITM option lacks any time value, exercising yields this guaranteed arbitrage.
Having intrinsic value differentiates ITM options from out-of-the-money (OTM) options, which have no inherent profit benefit. It also distinguishes them from the Money (ATM) options whose strike directly equals the market price.
In addition to intrinsic value, ITM options also possess time value – the portion of an option’s premium not explained by intrinsic value. Time value represents the potential for the ITM option to gain even greater intrinsic value prior to expiry if the underlying price keeps moving favorably.
The balance between intrinsic and time value depends on how deep ITM the Option already is and the time left until expiry. Deep ITM options exhibit more intrinsic and less time value. They act more like the underlying itself with minimal leverage. Options barely ITM closer to expiry see time value dominate.
ITM options cost more than OTM or ATM options since the premium must price in guaranteed current intrinsic value plus remaining time value. As expiration nears, ITM options lose time value slowly at first, then accelerate into expiry. Intrinsic value holds steady, barring major underlying moves.
What happens if the Option is in the money?
An option has inherent value and is exercised by the option holder to purchase or sell the underlying asset at a favorable price if it is in the money at expiry. The Option has intrinsic value when it is in the Money (ITM). A call option is ITM when the strike price is below the market price of the underlying asset. Meanwhile, a put option is ITM when the strike price is above the market price of the underlying.
The intrinsic value represents a built-in profit the option holder captures by exercising the Option. The holder of an ITM option exercises the Option to lock in the intrinsic value as a guaranteed profit. For a call option, they exercise to buy shares below market value. For a put, they exercise to sell shares above market. Exercising an ITM option before expiration allows capturing the arbitrage between the strike price and market price.
What are the Benefits of In The Money (ITM) Options?
The main benefits of ITM options are higher odds of finishing profitable, retained intrinsic value, faster breakeven, reduced time decay, downside/upside protection, profit from continued directional moves, and the ability to exercise early before expiration.
1.Higher Probability of Profit
The key advantage of ITM options is they have a greater probability of finishing in the money at expiration since they already have intrinsic value. While ITM options cost more, you are paying for a higher chance of earning a profit on the positions.
2. Intrinsic Value Protection
ITM options protect against time decay because changes in implied volatility do not impact the intrinsic value. Even if IV drops, the Option retains its built-in intrinsic value as long as the stock price holds on the profitable side of the strike price.
3. Earlier Breakeven
ITM options break even earlier than out-of-the-money (OTM) options. Breakeven for calls is the strike price plus the premium paid. For puts, it is the strike price minus the premium. The intrinsic value component helps reach breakeven faster.
4. Less Impact from Time Decay
Time value decay accelerates in the last 30 days until expiration. However, ITM options are less sensitive to time decay early in the cycle since most of the premium consists of protective intrinsic value rather than time value.
5. Downside Protection
ITM calls to protect against downside moves in the underlying stock past the call strike price. The purchased call locks in the right to buy shares at the lower strike even if the stock declines below that level before expiration.
6. Upside Protection
ITM puts to protect against upside moves above the put strike price. The put owner locks in the right to sell shares at the higher strike even if the stock climbs above that level before expiration.
7. Profit from Continued Directional Moves
ITM options benefit from continued directional moves in the profitable direction. For calls, the underlying stock price rising further adds to intrinsic value. For puts, a falling stock price increases intrinsic value.
8. Early Exercise Potential
Unlike OTM options, which rarely get exercised early, ITM options are exercised at any point to lock in intrinsic value profits rather than waiting for expiration. This provides greater flexibility.
What are the Downsides of In The Money (ITM) Options?
The seven primary downsides and dangers of trading in the Money (ITM) options are higher premium cost, lower leverage, caps profit potential, etc.
1.Higher Premium Cost
The biggest drawback of ITM options is they come with a higher premium cost. You are paying extra for the built-in intrinsic value component that adds to the price of the Option. Out-of-the-money options cost less upfront.
2. Lower Leverage
The higher premium reduces the leverage provided by ITM options. Your potential return is lowered compared to an out-of-the-money option, costing much less but reaching the same level of profit at expiration if the underlying moves favorably.
3. Caps Profit Potential
Holding ITM call options caps profits above the strike price. Any stock gains higher than the call strike is a lost opportunity since the call owner has the right to buy shares only at the lower strike price. The same applies to ITM puts.
4. Acceleration of Time Decay
While ITM options have less time to decay initially, they accelerate rapidly during the last 30 days until expiration as the window narrows for the Option to finish ITM. Time value evaporates quickly right as intrinsic value is peaking.
5. Assignment on Short Calls or Puts
Selling covered calls or cash-secured puts uses ITM options to collect higher premiums. But short ITM options have higher odds of being assigned early if the trader needs to pay more attention to managing before expiration.
6. Implied Volatility Changes
While intrinsic value is protected, ITM options still have exposure to implied volatility changes in regard to their remaining time value. Volatility fluctuations impact ITM options, too.
7. Narrower Bid/Ask Spreads
As very liquid instruments, ITM options have tight bid/ask spreads. However, the high volume results in volatile option prices. It makes entries and exits more difficult to execute favorably.
The major drawbacks of trading ITM options are higher premium costs, lower leverage, profit capping on long positions, accelerated time decay late in cycles, assignment risks when shorting, implied volatility exposure on time value, and thin markets with volatile option prices.
Which is better, OTM and ITM Options?
There is yet to be a definitive answer on whether OTM or ITM options are better overall. Each type has advantages and disadvantages based on factors like objectives, market conditions, risk tolerance, and time to expiration.
ITM options have higher premium costs but also higher probabilities of finishing in the money by expiration. OTM options are cheaper but have lower probabilities of profit. Traders must weigh the tradeoffs.
OTM options offer greater leverage due to the lower premium cost. A smaller investment controls a larger number of contracts. This introduces more risk but also allows larger percentage returns if the underlying moves favorably. ITM options provide less leverage but have inherently higher odds of being profitable.
How does the strike price determine whether an option is OTM or ITM?
The strike price’s relation to the current market price of the underlying asset determines if an option is OTM (strike unfavorable to market price) or ITM (strike favorable to market price). The strike price of an option represents the fixed price at which the option holder buys or sells the underlying asset if they exercise the Option.
Comparing the strike price to the current market price of the underlying is what determines if an option has intrinsic value and is considered in the Money (ITM) or if it lacks intrinsic value and is out of the Money (OTM).
For call options, the strike price sets the purchase price for buying the underlying if exercised. The call option is ITM when the strike is below the market price because the holder exercises and immediately buys shares below market value. This creates intrinsic value equal to the difference between market price and strike.
What role does intrinsic value play in classifying an option as OTM or ITM?
The presence or lack of intrinsic value plays an important role as it determines whether an option is classified as ITM or OTM. Intrinsic value is the built-in profit an option would have if exercised immediately due to a favorable spread between the strike price and the current market price of the underlying asset.
Out of the Money means the option strike price is unfavorable relative to the market price of the underlying asset. OTM calls have strike prices above the current market price. OTM puts strike prices below the market price. This unfavorable positioning means OTM options have no intrinsic value. Exercising an OTM call or put would result in no immediate profit since acquiring or selling the asset would occur at the less favorable strike price.
Since OTM options have no intrinsic value, their premium consists only of time value. Time value represents the chance the Option becomes profitable before expiration due to movement in the underlying asset price. An OTM call or put only becomes profitable if the underlying price moves enough for the Option to cross the breakeven point and transition to having intrinsic value. OTM options have value solely from time value until they become ITM.
What to buy, OTM or ITM Options?
There is no definitive answer on buying out-of-the-money (OTM) or in-the-money (ITM) options. The optimal choice depends on your market outlook, risk tolerance, and trading strategy. Your directional outlook on the underlying asset should help determine whether OTM or ITM options make more sense to buy.
OTM options provide more upside leverage if you expect a larger move. The lower premium cost leaves more room for the Option to increase in value. But if you anticipate a smaller directional move, ITM options have a higher likelihood of earning a profit. Paying an extra premium provides more downside protection.
For volatile assets with wide price swings, OTM options capture extended upside. For range-bound assets, ITM options take advantage of smaller moves. Your appetite for risk also helps you decide between OTM and ITM. ITM options limit potential losses if you are more risk-averse. You increase the odds of at least breaking even by paying higher premiums.
When to buy OTM and ITM Options?
The decision between buying OTM and ITM options depends on factors like your market outlook, risk tolerance, timeframe, and capital available. By assessing these dynamics, you will be able to determine when each option type is suitable. In the following situations, think about purchasing OTM options.
You expect a large directional move in the underlying asset price. OTM options offer greater leverage to benefit from major swings. The further the OTM, the more pronounced the move required.
Volatility is low or expected to rise. Higher volatility increases the value of OTM options significantly. Buying them when volatility is depressed is advantageous.
You have a long time until expiration. More time allows the underlying to move into profitable territory for OTM options. Nearer-term trades favour ITM.
You want greater leverage for less capital outlay. The cheap premiums of OTM options allow you to trade more contracts.
You have a high-risk tolerance. OTM options have higher probabilities of expiring worthless.
In the following situations, think about purchasing ITM options.
You expect a moderate upside or downside rather than a huge swing. ITM options accrue gains with smaller moves in the underlying.
Volatility is high or expected to decline. ITM options hold value better than OTM if volatility reverts lower.
You want a higher probability of profit. ITM options have built-in intrinsic value, giving a greater chance of finishing in the money.
You have a short expiration time frame. ITM options suffer less from time decay, given their intrinsic value cushion.
You have a lower risk appetite. ITM provides more certainty of a payout compared to OTM.
You don’t need to pay a higher premium. ITM options cost more but have higher odds of paying out.
Balance your outlook, timeframe, risk tolerance, and capital constraints. For large moves, OTM makes sense. For modest moves, consider ITM. Assess probabilities and leverage to fit your objectives.
Which is more profitable, OTM or ITM Options?
There is no definitive answer on whether OTM or ITM options are inherently more profitable. Each type carries different risk-reward profiles that suit different strategies and market environments. Traders must examine the tradeoffs involved.
On the one hand, OTM options require larger directional moves in the underlying asset to turn profitable before expiration. This introduces more risk, given the lower probability of the necessary price swing occurring. However, the cheap premiums provide greater leverage, allowing for exponential returns if the move does materialize.
ITM options have high probabilities of finishing with intrinsic value based on their built-in cushion. But the higher premium paid caps the maximum return. Each dollar of intrinsic value has to first cover the higher premium cost before accruing gains. Returns tend to be higher in absolute dollar terms but lower in percentage terms.
Generally, OTM options are more profitable percentage-wise if the trades turn favorable before expiration. ITM options are often more profitable in terms of absolute dollar gains, given the higher likelihood of finishing in the money.
Profitability is influenced by a variety of other factors, though. OTM options have more time to transition to ITM on longer-term trades. The nearer term favors ITM. Rising volatility boosts OTM more than ITM. Declining volatility hurts OTM. ITM is safer, but OTM offers exponential upside. OTM profits from sizable swings, ITM from modest moves. Overpaying for either Option reduces profits.
Is it better to sell OTM Options compared to ITM Options?
No, it is generally not better to sell out-of-the-money (OTM) options compared to in-the-money (ITM) options. There are tradeoffs to consider between the two when selling options. On the one hand, OTM options come with higher premiums due to the lower probability of the options finishing in the money at expiration.
As a seller, you collect a larger premium income from selling OTM options. You keep the entire premium if they expire worthless as intended. However, the farther OTM an option is, the greater the likelihood of assignment if the market swings against you. Deep OTM options require less of a move to transition to ITM. While you collect more premiums upfront, selling them, the risk of losing money from assignments also rises.
What is an example of OTM Options?
Imagine an investor who believes that stock XYZ is currently trading at Rs. 50 per share is going to rise over the next 6 months. They want to capitalize on this outlook but need more capital to invest. The investor decides to purchase out-of-the-money call options on the stock.
Specifically, the investor buys 10 of the XYZ January 50 call options with a strike price of Rs. 55 for a premium cost of Rs. 1 per contract.
Since the market price of XYZ stock is Rs. 50, while the call option strike price is Rs. 55, the calls are considered out of the money. The Rs. 55 strike represents the breakeven level where the calls transition from having no intrinsic value to having intrinsic value if XYZ trades above that price.
As OTM calls, they currently have no built-in profit potential because there is no benefit to exercising them when the market remains below the strike. Exercising would allow buying shares at Rs. 55 when they are at times bought on the open market for the lower price of Rs. 50. Rather, these OTM calls are leveraged bets that the price will rise above Rs. 55 by the January expiration date in 6 months. They rely purely on time value and the investor’s speculation of how high the stock might climb.
Being OTM allows the investor to purchase 10 call option contracts for only Rs. 10 total (Rs. 1 x 10 contracts). This achieves exposure to 1,000 shares of XYZ stock with just Rs. 10 of capital.
The calls become Rs. 5 in the money and most likely increase in value to about Rs. 4 or Rs. 5 based on time value if XYZ increases to Rs. 60 by January. This would allow the investor to capture a large return on their small initial investment.
However, if XYZ remains below Rs. 55 and the calls stay OTM, they will expire worthless in January. The investor loses their full Rs. 10 investment. The higher leverage comes with a higher risk of losing the entire capital outlay.
In this example, the cheaper premium, high leverage potential, and large prospective return if XYZ rallies significantly exemplify the dynamics and risk-reward tradeoff of purchasing out-of-the-money call options. The investor is speculating on the upside with limited dollars at stake.
What is an example of ITM Options?
Imagine an investor who owns 100 shares of stock ABC, currently trading at Rs. 50 per share. The investor is bullish on ABC and wants to generate additional income from their existing long stock position. They decide to sell covered calls on the stock.
Specifically, the investor sells 1 ABC June 45 call option contract with a strike price of Rs. 45 for a premium of Rs. 8 per contract.
Since the market price of the ABC stock is Rs. 50, while the call option strike price is Rs. 45, the call is considered in the money. There is Rs. 5 of intrinsic value built into the call option based on the Rs. 5 difference between the strike and market price.
The investor sells shares to the call holder at Rs. 45 when they are worth Rs. 50 on the open market, if exercised. This intrinsic value exists regardless of the time left until expiry or other factors.
By selling the ITM call, the investor collects the premium as income. However, they cap their potential upside on the stock to only the strike price of Rs. 45 if assigned on the call option before expiry.
The investor selected an ITM call strike below the market price to maximize the Option’s premium income. OTM or ATM calls would provide lower premiums but allow participating in gains above Rs. 45 if ABC continues rising.
With the ITM call, if ABC drops below Rs. 45, the call premium protects the downside. The investor is assigned to the call but maintains the Rs. 8 per share income if ABC climbs beyond Rs. 45. Their return is lower in a major rally but protected on the downside.
By selling an in-the-money call option, the investor is able to generate recurring income from their long stock holdings through the options market. The ITM strike balances risk versus return, given the market outlook.
This example demonstrates using ITM options to execute strategies like covered call writing. The probability of assignment is higher, but the investor utilizes the intrinsic value to collect income and hedge risks.
Share
Previous Article
No Comments Yet