There are three ways based on strike prices to buy and sell options with varying degrees. An option can be at-the-money (ATM), in-the-money (ITM) or out-of-the-money (OTM). But what makes an option ATM, ITM or OTM? Below we will answer that very question and show a few examples that should make the concept a little easier to fully understand.
For the sake of this explanation, we will use JPMorgan Chase (JPM), which at the time of this writing was trading right around $149.
An at-the-money option is a call or a put option that has a strike price about equal to the underlying price. The ATM options (the 149-strike put or call in JPM’s case) have only time value (a factor that decreases as the option’s expiration date approaches, also referred to as time decay). These options are greatly influenced by the underlying stock’s volatility and the passage of time. In addition, ATM options generally have a delta of about 0.50 as seen below. One of the definitions of option delta is the percentage of expiring ITM. In this instance, they have about a 50% chance of expiring ITM, which makes sense based on the stock being currently ATM.
An option that is in-the-money has intrinsic value. A call option is ITM if the strike price is below the underlying stock’s current trading price. In the case of JPM, ITM options include the 148-strike call and every strike below that. Put options that are ITM for JPM include 150 and above. ITM puts are above the current price of the underlying. One will notice that option positions that are deeper ITM have higher premiums. In fact, the further in-the-money, the deeper the premium.
If an option expires ITM, it will be automatically exercised or assigned. For example, if a trader owned a JPM 148 call and the stock closed at $150 at expiration, the call would be automatically exercised, resulting in a purchase of 100 shares of JPM at $148 a share. In addition, ITM options generally have a delta greater than 0.50 as seen below. They have more than a 50% chance of expiring ITM.
An option that is out-of-the-money has no intrinsic value. A call option is OTM if the strike price is above the underlying stock’s current trading price. In the case of JPM, OTM options include the 150-strike call and every strike above that. Put options that are OTM for JPM include 148 and above. Put options are OTM if the strike price is lower than the underlying price.
Since the OTM option has no intrinsic value, it holds only time value. OTM options are cheaper than ITM options because they have a greater likelihood of expiring worthless. OTM options generally have a delta less than 0.50 as seen below. They have less than a 50% chance of expiring ITM. OTM options expire worthless at expiration. Many option traders will sell OTM options with the odds on their side to expire worthless.
Let’s take a look at a quick example of each below: ATM, ITM and OTM options.
Let’s assume you were bullish on a stock that was currently trading at $179.23. You could buy an ATM long call with a strike price of 180 (rounded up from 179.23) for 5.60 (ask price) with a positive delta of 0.49 as seen below. The option would have almost a 50/50 chance of expiring ITM at expiration based on delta. In addition, the option would make about 0.49 (or $49 in real terms) for every dollar the stock moved higher all other factors held equal. The option would then be just ITM if the stock price moved above the strike price.
As an option trader, you could also buy a call option that is ITM to start the position too (as well as OTM). You could buy an ITM long call with a strike price of 175 for 8.35 (ask price) with a positive delta of 0.62 as seen below. The option would have better than a 50% chance of expiring ITM at expiration. In addition, the option would make about 0.62 (or $62 in real terms) for every dollar the stock moved higher all other factors held equal and the delta would get larger. The tradeoff here is the cost and risk. You get a bigger delta and better odds, but you also pay a bigger premium.
Another way to potentially profit from your bullish outlook is to sell an OTM put option. You could sell an OTM put option with a strike price of 172.5 for a credit of 3.45 (bid price) with a positive delta of 0.32 as seen below. The option would have more than a 50% chance of expiring worthless, which in this case would be favorable. Option sellers get to keep the premium if the option expires worthless. The profit is limited to the credit received, unlike a long call, which has unlimited profit potential. The trade-off here is the odds are on the option seller’s side with the delta less than 0.50.
As always, everything about options is a risk/reward and probability trade-off. Depending on what option is bought or sold and if the option is ATM ITM or OTM is a big part of the trade-off.
Senior Options Instructor
Market Taker Mentoring, Inc.