A call option gives you the right but not the obligation to buy the underlying security, while a put option gives you the right, but not the obligation, to sell the underlying security.You can buy and sell options that are “in the money” or “out of the money.” Each strategy has pros and cons.
What’s the Difference Between In-the-Money and Out-of-the-Money Options?
One reason that options have value is the possibility that changes in prices could make exercising them profitable (time value). However, intrinsic value describes the actual value of exercising the option at a specific point in time.
In-the-Money and Out-of-the Money Call Options
If you, for example, own a call option on a stock, that option is in the money when the strike price is below the stock’s market price. Remember, a call option gives you the right to buy the underlying security. So when the strike price is below the stock’s price in the market, you are able to buy the stock at a price lower than what you would have paid if you bought it on the stock exchange. This signifies that the option has some intrinsic value, and you would likely exercise the option. If the strike price was greater than the stock’s price in the market, the call option would be out of the money. In that case, you wouldn’t exercise the option because the stock would be available for purchase on the stock exchange at a lower price. To determine the intrinsic value of an option, you need to determine the potential profit of exercising it. Options typically involve 100 shares per contract. The formula for calculating the intrinsic value of a call option is: (Current share price - Strike price) x 100 = Intrinsic value So, if you own a call for XYZ with a strike of $50 and XYZ is trading at $45, that gives it an intrinsic value of $500.
In-the-Money and Out-of-the-Money Put Options
Put options give you the right to sell the security at a particular price. Consider in the example above that you had a put option instead of a call option on a stock. A put option would be in the money when the strike price is higher than the stock’s price in the market, because you’d be able to sell the stock at a price greater than what you would be able to sell on the stock exchange. This gives the put option intrinsic value, and you would likely exercise the option to sell. A put option is out of the money when the strike price is below the stock’s price in the market. In that case, exercising the option would mean selling the stock and would fetch you less compared to a sale on the exchange, and you would likely not do that. The formula for the intrinsic value of a put option is: (Strike price - Current share price) x 100 = Intrinsic value
Costs
When you buy an options contract, the price per share you pay to buy that contract is called the options premium. Option premiums are generally impacted by factors such as the price of the underlying asset, the strike price, the time remaining for the contract to expire, and the implied volatility of the underlying asset. While the intrinsic value of an option gives you a sense of whether to exercise an option and what to expect in general, it does not give you a complete picture of the profits you would stand to make. Your actual profit will depend on the premium you paid to execute the contract and transaction costs involved.
Risk for Buyers and Sellers
In general, in-the-money options are viewed as a less risky proposition for buyers and a riskier proposition for sellers compared to out-of-the-money options. The risk for the buyer of an option is that the contract will never become worth more than they paid for it. If this happens, they lose out on the premium paid for the option. If they buy an option that is already in the money, there is typically a higher chance the option remains in the money, allowing them to profit or at least recoup a portion of what they spent on buying the option. The risk for the seller of an option is that the buyer will exercise the contract when it is in the money, forcing the options seller to complete a purchase or sale of a security at worse-than-market prices. If a contract starts in the money, there’s a higher chance the contract buyer will eventually choose to exercise it. The inverse is true for out-of-the-money options. Buyers are seen as taking on a higher risk than sellers.
Time Value
One of the most important things determining the value of an options contract is time value or time decay. The closer an option is to expiration, the less premium the market is willing to pay for it. The more time there is before an option expires, the higher its time value will be. That’s because there’s more time during which the underlying security’s price can change, causing the option to go from out of the money to in the money. What this means is that both in-the-money and out-of-the-money options will tend to lose value as time passes.
At-the-Money Options
“In the money” and “out of the money” are phrases that describe when an option has positive or negative intrinsic value, respectively. In other words, they’re used when the strike price of an option and the market price for a security are different. If the strike price for an option and market value of the underlying security are the same, the intrinsic value of the contract is $0. These are called at-the-money options. Exercising the option would have the same effect as buying or selling the security on the market. You’d get or receive the same price per share.
The Bottom Line
“In the money” and “out of the money” are phrases used to describe the intrinsic value of an option. As an options buyer, you want the contracts to be in the money (have intrinsic value). As a seller, you want options to expire without being exercised, so you want the contract you sell to be out of the money. Options are derivatives and in general, carry greater risk than buying the actual underlying security. Keep in mind that options, especially selling some kinds of options, can leave you susceptible to unlimited losses. You can use the concept of in the money and out of the money to manage your risk.
