Trading options contracts involves many unique concepts and terminology that investors need to understand. Among the most important is understanding whether an option is “in the money” or “out of the money.”
Knowing the difference between being “in the money” (ITM) and “out of the money” (OTM) allows the holder of a contract to know whether they’ll enjoy a profit from their option. The terms refer to the relationship between the options strike price and the market value of the underlying asset.
“In the money” refers to options that have profit potential if exercised today, while “out of the money” refers to those that do not. In the rare case that the market price of an underlying security reaches the strike price of an option exactly at the time of expiry, this would be called an “at the money option.”
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What Does “In the Money” Mean?
In the money (ITM) describes a contract that would be profitable if its owner were to choose to exercise the option today. If this is the case, the option is said to have intrinsic value.
A call option would be in the money if the strike price is lower than the current market price of the underlying security. An investor holding such a contract could exercise the option to buy the security at a discount and sell it for a profit right away.
Put options, which are a way to short a stock, would be in the money if the strike price is higher than the current market price of the underlying security. A contract of this nature allows the holder to sell the security at a higher price than it currently trades for and pocket the difference.
In either case, an in the money contract has intrinsic value, so the options trader can exercise the option and make money doing so.
Example of In the Money
For example, say an investor owns a call option with a strike price of $15 on a stock currently trading at $16 per share. This option would be in the money because its owner could exercise the option to realize a profit. The contract gives the holder the right to buy 100 shares of the stock at $15, even though the market price is currently $16.
The contract holder could take shares acquired through the contract for a total of $1,500 and sell them for $1,600, realizing a profit of $100 minus the premium paid for the contract and any associated trading fees or commissions.
While call options give the holder the right to buy a security, put options give holders the right to sell. For example, say an investor owns a put option with a strike price of $10 on a stock that is trading at $9 per share. This would be an in the money option. The holder could sell 100 shares of stock at a price of $10 for a total of $1,000, even though it only costs $900 to buy those same shares. The contract holder would realize that difference of $100 as profit, minus the premium and any fees.
What Does “Out of the Money” Mean?
Out of the money (OTM) is the opposite of being in the money. OTM contracts do not have intrinsic value. If an option is out of the money at the time of expiration, the contract will expire worthless.
Options are out of the money when the relation of their strike prices to the current market price of their securities are opposite that of in the money options.
For calls, an option with a strike price higher than the current price of the underlying security would be out of the money. Exercising such an option would result in an investor buying a security for a price higher than its current market value.
For puts, an option with a strike price lower than the current price of its security would be out of the money. Exercising such an option would cause an investor to sell a security at a price lower than its current market value.
In either case, contracts are out of the money because they don’t have intrinsic value – anyone exercising those contracts would lose money.
Example of Out of the Money
For example, say an investor buys a call option with a strike price of $15 on a stock currently trading at $13. This option would be out of the money. An investor might buy an option like this in the hopes that the stock will rise above the strike price before expiration, in which case a profit could be realized.
Another example would be an investor buying a put option with a strike price of $7 on a stock currently trading at $10. This would also be an out of the money option. An investor might buy this kind of option with the belief that the stock will fall below the strike price before expiration.
What’s the Difference Between In the Money and Out of the Money?
The premium of an options contract involves two different factors: intrinsic value and extrinsic value. Options that have intrinsic value at the time they are written to have a strike price that is profitable relative to the current market price. In other words, such options are already in the money when written.
But not all options are written ITM. Those without intrinsic value rely instead on their extrinsic value. This value comes from speculative bets that investors make over a period of time. For this reason, assets with higher volatility often have their options contracts written out of the money, as investors expect there to be bigger price swings. Conversely, assets considered to be less volatile often have their options written in the money.
Options written out of the money are ideal for speculators because such contracts come with less expensive premiums and are often created for more volatile assets.
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Should I Buy ITM or OTM Options?
The answer to this question depends on an investor’s goals and risk tolerance. Options that are further out of the money can be more rewarding, but come with greater risk, uncertainty, and volatility. Whether an option is in or out of the money (and how far they’re out of the money), and the amount of time before the expiry of the option impacts the premium for that option, with riskier options typically costing more.
Whether to buy ITM or OTM options also depends on how confident an investor feels about the future of the underlying security. If a trader feels fairly certain that a particular stock will trade at a much higher price three months from now, then they might not hesitate to buy a call option with a very high strike price, making it out of the money.
Conversely, if an investor thinks a stock will fall in price, they can buy a put option with a very low strike price, which would also make the option out of the money.
Beginners and those with lower risk tolerance may prefer buying options that are only somewhat out of the money or those that are in the money. These options usually have lower premiums, meaning they cost less to buy. There are also generally greater odds that the contract will wind up in the money before expiration, as it will take a less dramatic move to make that happen.
Investors can also choose to combine multiple options legs into a spread strategy that attempts to take advantage of both possibilities.
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Options contracts don’t have to be exercised to realize a profit. Sometimes investors buy contracts with the intent of selling them on the open market soon after they become in the money for quick gains. In either case, it’s important to consider if an option is in the money or out of the money when buying or writing options contracts, as well as when deciding when to execute them.
While SoFi does not offer options trading at this time, it does provide a great way to for investors to get started. By opening a brokerage account on the SoFi Invest investment platform, you can build a portfolio of stocks, exchange-traded funds, and cryptocurrencies.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.