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To be or not to be…in-the-money? That is the question.
This simple inquiry can incite passionate discussion when posed to those trading in the options marketplace. Comparing an option that is 'in-the-money' (ITM) with one that is 'out-of-the-money' (OTM) is somewhat like comparing a granny smith apple with a red delicious apple. Both are apples, but when you bite into them, you realize that there are some very distinct differences. Some of us prefer sweet, others prefer sour. There isn't necessarily a right or wrong answer, it's a matter of taste.
Selecting the strike price for our long call or put trade is similar in that there is not necessarily a right or wrong choice, but there are distinct differences between ITM and OTM. We need to understand these differences in order to make an appropriate choice.
Options are in-the-money when the price of the underlying security is above/below the strike price; such that if exercised, the resulting stock position would have positive value. For example, if we consider a stock trading at $50 per share, a call option with a strike price of $40 would be in-the-money by $10. An out-of-the-money call option would be any strike price that is above the underlying security price.
This $10 is called intrinsic value, and is the value the option would be priced at expiration, given the stock and strike prices listed ($50 -$40). Intrinsic value changes tick for tick with the movement of the security, and is not affected by anything else. Any premium amount above the intrinsic value is referred to as time or extrinsic value. This extrinsic value is impacted by various things…time decay, implied volatility, interest rates, American/European style exercise, etc. Extrinsic value disappears by expiration day. So, in simple terms, the ITM options have intrinsic value and the OTM options do not.
| In-the-money options are more expensive per contract because they have intrinsic value. They are also more conservative in that there is some amount of "real" value to them that cannot simply evaporate over time. They have a cushion of value, as long as the option remains ITM at expiration.
Out-of-the-money options are less expensive per contract than their ITM counterparts, but cheaper doesn't mean less risky. The entire premium on an OTM option is extrinsic (time) value, which makes them more aggressive to trade. If the stock does nothing or goes against our trade, we can lose the entire premium. In other words, if an option is OTM at expiration, it will expire worthless.
To illustrate this, let's compare the two scenarios in a back test. We will buy an ITM and an OTM option, spending roughly the same dollar amount on both trades. For our example we will look at Apple (AAPL - Analyst Report) long calls purchased 4/2/09 and sold 5/4/09. Both entry and exit are based on closing prices. We will exclude commissions. (Remember, this is just for illustrative purposes, no recommendations should be inferred).
The stock moved from $112.71 to $132.07 during the month we were in this trade. As you can see, the OTM 130 call cost $143 less than the ITM 95 call, but generated an additional $1000 in profit. So, why would anyone want to go ITM? Spending more to make less may seem a bit counter productive…but let's see what happens if we hold the above trades to expiration.
When we carry the trade forward to expiration, the stock had moved back to $122.42. This meant that the May 95 call option was still in-the-money by $27.42 and we were able to exit our trade at a price of $27.38 per contract. We still made $755 on the trade. On the other hand, the May 130 call option was out-of-the-money at expiration. It expired worthless. Therefore, we lost not only the potential profit, but our entire investment on that trade.
So, back to the magical question…To be or not to be…in-the-money? The answer, as with most anything in options trading, depends on many things. Individual risk tolerance levels, trading style, time horizon, investment objective and even personality will need to be considered when making a choice in your personal trading. Some of us prefer our apples sweet and others enjoy the zing of sour. Those of us who prefer to be more aggressive and speculative with our trades might prefer the out-of-the-money scenario. If we are more conservative, an in-the-money option might be a more appropriate choice.
This article provides a glimpse into just a couple of the many decisions to be made when selecting an option strike price. Implied volatility, time decay, size of move in the stock, etc. are other things that will have a material impact on this decision. Be sure to address them as well. Happy trading!
You can learn more about different types of option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
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