In the Money Options vs. Out of the Money Options
In the money options are options contracts where the current price of the asset is trading above the strike price of the option. The premium (price of the contract) paid by an option buyer for an options contract comes from things like volatility of the asset, time to expiration of the contract, and intrinsic value. Many investors prefer in the money options because the option price includes intrinsic value.
The intrinsic value of the option is the difference between the price of the security and the strike price. When an options contract is in the money, then an investor can easily calculate the intrinsic value. In that case, the investor knows one piece of the of the premium.
The other pieces of the premium of the options contract are things like time to expiration and the volatility of the asset. How much of each of these pieces an investor should add to the premium can be hard to determine. Pro investors sometimes use models like Black-Scholes to calculate the value of the contract.
In The Money vs. Out of The Money Options
Many options investors believe that buying in the money options is a safer way in invest in stocks. Investors believe this because losses are limited to the premium paid. For example, if you buy a call option on a stock and the stock plummets below the strike price, the option expires worthless. On the bright side, instead of taking huge losses had you bought the stock, you’ve only lost the option premium.
On the other hand, if the stock were to skyrocket, your gains would be lower compared to owning the stock. When you buy an in the money call option, your gains are equal to the return on the stock minus the premium that you paid.
Also, options investors may think of out of the money options as more speculative. Unlike in the money options, the premium paid for out of the money options has zero intrinsic value. The options premium comes from the other items like time to expiration and volatility. Those items are much harder for the average investor to calculate.
Profits and Losses of In The Money
As mentioned before, in the money call options will perform similarly to the asset. An investor’s profit is lower than owning the asset. The limited profit is due to the premium paid. Keep in mind, the premium is also determined by time to expiration and volatility.
Although time to expiration can be hard to determine exactly, investors should know that its value goes down over time. The value decreases because, as time passes, there is less chance for the asset to move up or down. Because options contracts are short-term, time to expiration is an important part of the premium of the options contract.
Similarly, volatility plays a role in the premium of an options contract because of its short-term nature. Volatility is a calculation of the past ups and downs of the asset. The higher the volatility the higher the premium and vice versa.
Profits and Losses of Out of The Money Options
The premium for an out of the money option is lower than a similar in the money option. The premium of an out of the money option is lower because its value is limited to time to expiration and volatility. A lower premium means that an investor’s downside is further protected. Greater protection happens because your cash investment is much lower for exposure to the same amount of assets compared to a similar in the money contract.
At the same time, the upside to an out of the money option is much higher. For example, if the asset goes up beyond the strike price of a call option, it becomes in the money. At that point, the option will gain intrinsic value. The addition of intrinsic value can boost the premium big time.
Out of the money options typically require a big increase in the security to pass the strike price. Therefore, large gains don’t happen very often.
Out of the money options can also gain value in another way. If the asset raises, but does not pass the strike price, the out of the money option can increase. In this case the option buyer may be able to close out the position in with a small profit.
Deep In The Money Options
A deep in the money option is one where the current price of the asset is significantly above the strike price for a call option. For a deep in the money put option the price of the is significantly below the strike price.
When estimating the value of the premium for deep in the money options, the intrinsic value could make up almost all of the value. If this is the case, then the premium should go up and down almost exactly in tandem with the asset. Investors use the term Delta to describe the correlation between the asset and the option premium.
Remember every options contract represents 100 shares of the security. Therefore, deep in the money options investors can get similar investment returns to the asset with less cash.
One of the biggest concerns for any options investors is the short-term nature of the contracts. Options contracts can expire anywhere from a few days to a few months. There are a few options that can expire around a year.
The asset of options contracts can cover many assets including stocks, indexes, or commodities. Options investing requires estimating short-term movements in these assets, which can be a hard task to repeat.
Always remember that the price of any of the assets can swing violently. Any short-term wild swing could harm your investment return.
About BJ Cook
BJ Cook is a long-time stock nerd. He has held several roles in the equity research world and earned the right to use the CFA designation in 2014. When he’s not writing for Investment U, you can find him searching for new investment ideas. Outside the investment community, BJ is a die-hard Cubs fan.