When trading options, it’s important to understand the difference between in the money vs. out of the money. In simple terms, this is a way to measure an option’s intrinsic value, relative to the underlying asset’s current price. Knowing the difference between the two and when an option is in the money or out of the money matters when deciding whether or not to exercise options. Specifically, it can determine whether you’re able to turn a profit when trading options. If you’re just getting started with options trading or consider it, consult with a financial advisor to avoid pitfalls and spot real opportunities.
To understand the phrases “in the money” and “out of the money,” it first helps to know a little more about options. An option is essentially a contract that gives investors the right to buy or sell a security. You’re not required to do so; that’s why it’s called an option.
There are two basic types of options: puts and calls. A put option gives you the right to sell a stock for its strike price at any time before expiration. A call option is the opposite; it gives you the right to buy a stock at its strike price at any time before expiration.
The strike price is the price at which an option can be exercised, i.e. bought or sold. This is not necessarily the same as the price of the underlying asset. In fact, the value of an options contract can change based on the price of the asset it’s attached to.
This is where in the money vs. out of the money comes into play. These terms are used to define or measure an option’s intrinsic value at any given time. Intrinsic value means the difference between the option’s strike price and the asset’s current value.
In the Money, Explained
In simple terms, an option is in the money if it has intrinsic value. But how this is measured depends on whether you’re talking about a call option or a put option.
Again, put options give you the right to sell an asset at a predetermined price on or before a preset expiration date. A put option is in the money when the underlying security’s price is lower than the strike price, thus implying intrinsic value. If you were to exercise the option and sell, the higher strike price would work in your favor for generating a profit.
With call options, you’re in the money when the underlying asset’s current price is higher than the strike price. So if you were to exercise an option on these terms, you’d be buying the underlying asset for less than what it’s worth. In that scenario, being in the money on a call option means you can buy the stock at a discount, with the potential to sell at a profit.
Whether you’re trading call or put options, the size of the gap between the underlying asset’s value and the strike price is what determines intrinsic value and whether you’re in the money. The key is having your guess about whether a stock’s price will rise or fall in a particular time frame pay off.
In the Money Example
Assume that you have a call option for an energy stock that has a strike price of $10. The stock is trading $12 a share, which automatically means you’re in the money since the underlying price is above the strike price. The more the stock’s price increases, the better for you if you choose to exercise the option. For example, if the stock’s price were to jump to $50 you could still exercise the option to buy it at $10 per share before the option expires. The higher the price, in this example, the more intrinsic value the option has.
Now, assume that you have a put option for the same stock with the same strike price of $10. In this scenario, the further the underlying asset’s current price falls below the strike price, the better. That’s because it translates to greater intrinsic value. If you were to exercise the option, you’d benefit from being able to sell at the higher strike price.
Out of the Money, Explained
When an option is out of the money, it has no intrinsic value. Again, whether an option is out of the money can depend on whether it’s a call or put option. With call options, the contract is out of the money if the underlying asset’s current price is below the strike price. In that situation, it wouldn’t make much sense to exercise the option because the price you’d pay for the underlying asset, i.e. the strike price, is above what the asset is actually trading for.
In the case of put options, a contract is out of the money if the underlying security’s current price is higher than the strike price. If you were to exercise a put option that’s out of the money, you’d be selling it for less than its current value.
Out of the Money Example
Out of the money more or less works in reverse. So, say that you have a call option with a strike price of $10 and the underlying stock is trading for $8. The option is out of the money because of the higher strike price and the more the stock’s actual price falls, the more out of the money it becomes.
Now, assume you have a put option at $10 and the underlying stock is trading for $12 a share. Again, you’re out of the money because if you exercised the option you’d sell for less than what the stock is trading for on the open market. And the higher the price goes, the further you go out of the money.
If in the money vs. out of the money still seems complicated, remember that it’s all about determining intrinsic value for options. Options that are in the money have intrinsic value while those that are out of the money do not, since exercising them wouldn’t result in a profit.
In the Money vs. Out of the Money: Which Is Better?
Whether an option is in the money or out of the money doesn’t necessarily make it better than the other. It ultimately depends on your goals as an investor and what you’re trying to achieve. For example, if you have call options that are in the money then you could make money off the deal if the strike price stays below the market price. The reverse would be true if you’re holding put options that are in the money.
It’s also important to note that out of the money options have lower premiums, meaning they’re less expensive to trade. So if you’re conscious about cost as an investor, that’s something else to factor in when deciding whether to pursue in the money or out the money options in your portfolio.
When measuring an option’s value, intrinsic value is just one thing to consider. You also have to keep time value in mind. Time value means how much time there is remaining before an option expires. The longer this window, the more time value an option has since the odds of it becoming in the money increase.
What all this means is that even if an option is out of the money, with zero intrinsic value, it could still have time value. Taking note of this type of scenario can help you decide whether it makes sense to buy out of the money options.
Finally, you should also know that there’s a third path option values can take. When the option’s strike price is equal to the price of the underlying asset, it’s considered to be at the money. So if you were to exercise a call or put option at the money, you’d get no profit from it. Hence, the option would have no intrinsic value.
The Bottom Line
Options trading can have high profit potential but it’s important to understand how in the money vs. out of the money contracts work. Compared to traditional stock trading, options trading can also be riskier so that’s equally important to remember as you weigh whether this alternative investment strategy is a good fit for your risk profile.
Tips for Investing
- Consider talking to a financial advisor about options trading and whether in the money or out of the money strategies are right for you. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s financial advisor matching tool makes it easy to connect with professional advisors in your local area. It takes just a few minutes to get your personalized recommendations online. If you’re ready, get started now.
- One of the most useful tools investors have is an investment calculator, which helps portfolios maintain the desired balance among asset classes.
Photo credit: ©iStock.com/da-kuk, ©iStock.com/PashaIgnatov, ©iStock.com/Maksim Rumiantsev
Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. Shes worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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