Recently a member asked me to explain in-the-money (ITM) and out-of-the-money (OTM). I am a bit embarrassed to say that my first thought was how hard is that. Then I remembered that I struggled with it when I was a new member learning about options. There is a great deal to know about options. ITM and OTM are pretty important concepts to know and understand if you want to make money with options. However they are not part of normal conversation so they are just a couple of the many ideas you will need to learn. I have to say it was hard to learn, but it is also very profitable to learn.
I’ve read some definitions of ITM and OTM that just didn’t help me: A call is ITM when the equity price is above the strike. A put is ITM when the equity price is below the strike. Sure I can memorize that but still not understand what it means.
I am hoping this is a little different way to look at it in hopes that it helps those that have struggled with it. ITM and OTM are the same for short options and longs options. An option can only be ITM OR OTM it cannot be both. The strike of the option and the price of the equity determines if the option is ITM or OTM.
Let’s define it from the long side but understand both the long and short side are ITM or OTM.
If an option strike is ITM that option has what I call inherent value. So for a call (the right to buy), the strike is ITM if the call has intrinsic/inherent value. Since a call is a right to buy, it has inherent value if you can use that call (exercise it) to buy the stock for less than the market price. In the case of a put (the right to sell), it has inherent value if you can use that put to sell stock at more than the market price.
Example Long Call: If the SPY is at 180.01 or higher; the 180 strike CALL, the expiration does not matter, has inherent value. You can buy the stock for 180 which is less than you would have to pay for it on the open market, $180.01
Example Long Put: If the SPY is at 179.99 or less; the 180 strike PUT, the expiration does not matter, has inherent value. You can sell the stock for 180 which is more than you could sell it for on the open market, $179.99.
OK just to make sure I ‘ve, er I mean you’ve got it. Let’s look at it from the short side. The short call means I am OBLIGATED to sell the stock for the strike for as long as the option is open in my account. If it is ITM I have to sell the stock for less than I could sell it for on the open market.
Example Short Call: If the SPY is at 180.01 or higher the 180 strike CALL is ITM. The short call has a disadvantage, inherent risk if you will. You have to deliver the stock for 180 when you could sell it on the open market for more.
Example Short Put: If the SPY is at 179.99 or less the 180 strike PUT is ITM. YOU FILL IN THE REST….
So we looked at ITM, if it is not ITM it is OTM or ATM. ATM means there neither an advantage or disadvantage. OTM means there is no inherent value to the long option. Its value is purely extrinsic value.
It all comes down to rights and obligations. Know those rights and obligations, and you can figure out the rest.