OTM vs. ITM: What Does “In-The-Money” Mean?
Investors that have been getting into options trading have surely seen terminology relating to in-the-money. In fact, there are various “money-ness” terms in the options market. There’s also out-the-money and at-the-money. So what do all of these terms mean?
Put simply, the ITM, OTM or ATM term refers to where the option’s strike price is trading at in accordance to the underlying security’s current price. An option can go between all three terms leading up to expiration, as the security price fluctuates while the strike price remains constant.
In elementary terms, an option is in-the-money (or ITM) when the stock price trades above the call option’s stock price or below the put option’s strike price. In technical terms, if expiration were today, the option would be exercised, as there is no time value left but intrinsic value remains. The ITM status remains whether the trader is long or short the option.
Let’s look at a few examples. Let’s say we’re long ABC $40 calls expiring in September. Shares of ABC are trading at $42, so at the time, the option is ITM. This means we are $2.00 ITM and would receive $2.00 should it be expiration day.
Now, just because a stock is ITM, doesn’t mean it’s profitable. If we bought the $40 call for $1.00, then it’s a net gain of $1.00 or a 100% gain. ($42 price – $40 call – $1 debit paid = $1.00). However, if we paid $2.50 for the $40 call, we actually lose $0.50 per share on the trade, even though it is ITM by $2 per share.
The same applies to puts. Let’s say we are long September $35 puts on ABC. On expiration day, ABC closes at $34. It’s ITM by $1.00. Again, depending on what we paid, this may or may not be profitable for us.
What about credit trades? Sticking with the previous example, let’s say we are SHORT the $35 put on ABC. On expiration day, the stock is at $34, meaning it’s still ITM. This is obviously not preferred by the short put seller, given that they want the stock to close above $35. However, it could still be a profitable position if they collected more than a $1 credit in the sale.
This Brings Us to Out-The-Money
An out-the-money (OTM) position refers to an option that has no intrinsic value at the time. However, it may have time value. So sticking with our short $35 put example, an OTM position would have ABC stock trading at $36, for example. The stock price is not trading below the strike price (meaning it has no intrinsic value) and therefore remains out-the-money.
In basic terms, when we are long calls, puts, bull call spreads or bear put spreads, we want the position to trade in-the-money. This does not guarantee profit, but it means there is intrinsic value. When we are short calls, short puts, short call spreads or short put spreads, we want the underlying security to close out-the-money.
Technically speaking, at-the-money (ATM) means — you guessed it — the underlying security is trading right at the option’s strike price. From our short $35 put example, this means ABC would close right at $35 on expiration day. ATM means long holders of the $35 calls and puts both lose money (because neither contract has any intrinsic value). On the flip side, those that are short the $35 calls or puts made 100% of their possible profit. For short sellers, an OTM or ATM close is the best possible outcome. For long call or put holders, it’s the worst outcome.
In most circumstances, a stock either closes ITM or OTM. An ATM close is rare. But ATM often refers to the option-security price dynamic leading up to expiration. For instance, say expiration is a few weeks away. Many consider the closest strike price to the current security price an ATM position. So if shares are trading at $40.25, we can consider the $40 strike price call and $40 put to be ATM. This is despite the $40 call technically being ITM and the $40 put being OTM.
Other Things to Consider
While we generally refer to the “money-ness” of a particular option by its intrinsic value — a $40 call when the stock price is at $42 is “ITM by $2 per share” — doesn’t mean the option price is worth $2.00.
At expiration, yes the $40 call contract is worth $2.00 assuming the underlying security is at $42. However, if it’s two weeks until expiration, the contract might be worth $2.50 — $2.00 in intrinsic value and $0.50 in time value. If it’s a month away, the $40 call contract could be worth $3.00 — $2.00 in intrinsic value, $1.00 in time value.
That time value will decay as expiration approaches, which benefits credit sellers and hurts debit buyers.
We should also note the difference between American style options vs. European style options. Investors can exercise American options at any time leading up to expiration. Most U.S. securities trade American style, (with the exception of a few, like S&P 500 index options or VIX options). For a common stock or ETF though, these options trade in the American style.
Investors cannot exercise European options until expiration. Why does this matter? It won’t likely apply to most traders, however it does impact pricing. For instance, if ABC is at $42, the $40 call option may not trade at $42 necessarily. Assuming there is a bit of time left, it could trade at $41.75 — if the anticipation is that ABC will fall before expiration.
Again, this style won’t affect most traders, but we should be aware of it.
While an option cannot be ITM and OTM at the same time, it can change over time. For instance, a call can start off OTM, but as the stock rallies the option can go to ATM and eventually to ITM. As a stock fluctuates above, below or at a given option price, it changes the Greeks — delta, gamma, etc. — for those options. As a rule of thumb, the deeper ITM an option is, the higher its delta, up to 100. The further OTM it is, the lower its delta, down to zero.