Quite often you will hear the terms "in-the-money", "at-the-money" and "out-of-the-money" or ITM, ATM and OTM. These terms all refer to an options current Intrinsic Value.
The strike price of an option compared to the current stock price is what determines the option's Intrinsic Value and hence determines whether the option is in, at or out of the money. If a call option's strike price is less than the current market price of the underlying asset it is said to be in-the-money - as the option buyer can exercise and make an instant profit.
Consequently, if a calls strike price is higher than the current underlying asset it is said to be out-of-the-money because it has no Intrinsic Value. Confused? Take a look at these quick formulas;
In-the-Money = Strike price less than underlying price
At-the-Money = Strike price is the same as the underlying price
Out-of-the-Money = Strike price is greater than the underlying price
In-the-Money = Strike price is greater than the underlying price
At-the-Money = Strike price is the same as the underlying price
Out-of-the-Money = Strike price is less than the underlying price
Comments (6)
Peter
July 14th, 2011 at 6:00pm
Oh man, I apologize for that! You're right, if you stay in the trade and the stock stays there you will collect the premium of $8 per contract. If the market goes down then you will lose money. You will start losing money if the stock starts going below $127.
Selling the 125's will gain you an extra $1 per contract net but without the downside protection.
Jim
July 14th, 2011 at 11:17am
Hi Peter,
Thanks for getting back to me. your help is greatly appreciated.
You said the trade I asked about was not a good one because it was so close to expiration. What if I'm just looking to collect the premium? My thinking was that because it was so close the possibility of SPY dropping below the strike was negligible and iwould expire worthless.
Also, if it is the premium I'm interested in for right now does it make sense for me to say the heck with the spread and just sell the 125's for .09?
Thanks again
Jim
Peter
July 14th, 2011 at 2:18am
Hi Jim,
If you are short a put option and the holder exercises, you do not have to do anything - your broker will close out your option position and assign you a position in the stock at the value of the strike price.
For put options, you should first look at the payoff profiles below;
Buy Put Option
Sell Put Option
If you are long a put option you want the market to go down and if short a put option you want the market to either remain at the current level or go up.
The strategy you mention is called a put spread. Given the prices you list, you will receive a credit of $8 to put this trade on ((0.09 - 0.17) * 100)).
The maximum you can gain from this position is going to be the credit you recieved i.e. $8. The maximum loss is going to be $292 (((127 - 124) - 0.08) * 100).
Correct - at expiration if the underlying is trading above 127 both options expire worthless and you keep the $8 premium received.
This trade is not a good one so close to the expiration date given that the stock is trading at $131.50 with 2 days remaining - the stock needs to trade to 124 (+6%)before you can start making any money.
I hope this helps...let me know if anything is not clear.
Jim
July 13th, 2011 at 8:44am
Hi Peter,
I am in the process of trying to learn options. I seem to be getting stuck with long and short puts and I'm hoping you can help.
If I sell a naked put that gets exercised, what is the process...do I just enter a buy to close market order? And regardless... with uncovered puts, whether buying or selling, you still want the stock price to go down and, either way if the strike price is higher than the stock price that Put is ITM, is that right?
Also, can you tell me where the greatest danger (other than the stock taking a sudden nosedive) lies in the following scenario:
SPY currently trading at $131.50
July 11 Puts (2 days to expiration)
BID ASK
124 .07 .09
125 .09 .11
126 .12 .15
127 .17 .20
Buy 10 July15 124 Puts
Sell 10 July15 127 Puts
Assuming on expiration day at 3:00PM if the stock is above 127, both options should expire worthless right?
Thanks in advance for your help
Peter
May 15th, 2011 at 8:18am
Hi Wayne, it depends on the style of the option. If the option is American it can be exercised prior to the expiration date, however, if the option is European it can only be exercised on the expiration date. Most exchange traded options on listed stocks are American.
But this doesn't mean that you can just exercise the option and make a profit by selling the stock as it depends on the price you paid for the option and the price that you sell the stock for.
Let's say you're looking at buying an ITM call option on MSFT with MSFT trading at $25. You look at the $24 call option. Now, the price of this option in the market will never be less than $1, so you will probably end up paying something like $1.10 for the option. If you go and exercise the option, sure, you will be assigned the stock at a price of $24 and then sell the stock for $25 for a $1 profit.
However, you've paid $1.10 for the option, so you have to deduct that from your profit, which in this case leaves a loss of -$0.10.
Let me know if it is still unclear.
Wayne
May 14th, 2011 at 9:16am
I haven't seen any action on this board in a few months but I'll pose my question anyway:
Why would you not buy "in the money" call options, exercise the option, sell the underlying asset, and keep the profit? Is there something that says you have to wait until the expiration date to exercise the option?
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