There are many ways call and put options can be utilized; there's a strategy out there for every market view. Today, however, we will be discussing the differences between options that are in the money (ITM), near or at the money (ATM), and out of the money (OOTM), and the pros and cons of each for options buyers.
First off, an option's relation to "the money" depends on three things: whether it's a call or put option; the option's strike price; and the underlying stock's price. For reference, we will take a look at Facebook (FB) stock's November options, with the underlying stock currently trading at around $175.
In-the-money options are the only kind that harbor intrinsic value, which is equal to the difference between the current stock price and the strike price of the call or put option. The rest of an option's price consists of time value.
We can recognize that a call option is ITM when underlying stock is trading above the option's strike price. For example, Facebook's November 150 call is in the money, because FB is trading at $175. The intrinsic value of the call is $25 (stock price minus strike price). Considering the November 50 call is currently asked at $26.25, we can deduce that $1.25 of that (ask price minus intrinsic value) is time value.
When it comes to recognizing if a put option is in the money, the process is similar, exceptthe underlying stock price is below the option's strike price. For instance, FB's November 200 put is ITM because the strike price is above the stock's current price of $175. Facebook stock's November 200 put is 25 points in the money, so its intrinsic value is $25. Considering the put is currently asked at $25.10, the time value of the option is $0.10.
When is a call or put is near or at the money, the underlying stock's price is at or near the option's strike price. Near or at-the-money call and put options typically have no intrinsic value, so their premiums are made up of time value.
For instance, FB's November 175 call is near the money because the strike is around the stock's current market price. The call option was last asked at $5.40. Likewise, FB's November 175 put is near the money for the same reason, and was last asked at $5.10. Considering neither the call nor the put have over a point of intrinsic value (depending on where, specifically, FB stock is trading), buyers of these options are playing a little over $5 for time value -- or, time for the shares to make a move in the wanted direction before options expiration on Friday, Nov. 17.
When a call is out of the money, the underlying stock is trading below the strike price. For instance, FB's November 200 call is OOTM because the strike price is significantly higher than the shares' current price of $175. Because it would require such a big move from Facebook shares to place the call in the money before expiration, the November 200 call is currently asked at just 19 cents.
When a put is out of the money, the underlying stock is trading notably above the put's strike. With FB stock trading at $175, the November 150 put is OOTM by 25 points. As it would require a quick and dirty drop for the put to move into the money before the Nov. 17 expiration date, Facebook's November 150 put is currently asked at just 43 cents.
Not only does the premium you pay for an option determine your breakeven level, but it also represents your maximum risk, should the stock fail to make the desired move. As you can see by the examples above, there are huge price differences in buying ITM, ATM, and OOTM options.
The cost of buying an option that's ITM is higher, because there's already intrinsic value built in. The cost of buying an OOTM option is cheapest, because the underlying stock would need to make a bigger move within the options' lifetime, in order to profit.
Traders purchasing options should pay close attention to time value, as that will determine breakeven on the trade. Specifically, the aforementioned FB November 150 call buyer will profit if the shares top $176.25 -- which is the strike plus the premium paid, or calculated another way, the current stock price plus the option's time value. Meanwhile, the December 150 call will cost even more, resulting in a higher breakeven, as there's another month for FB stock to move.
Option buyers should also note the contract's delta -- a metric measurement on how much the option's price will change for each 1-point move in the underlying stock. For example, a call option with a delta of 0.50, or 50%, indicates the option will gain 50 cents for every one dollar the underlying stock gains.
Speculators looking to hedge a long stock position in the event of a pullback typically buy OOTM put options, as their goal isn't for the put option to move into the money, but for the underlying shares to extend their run higher. Buying OOTM protective puts merely locks in an acceptable exit price in the event of a pullback, and the "insurance policy" doesn't typically cost a lot.
On the other hand, "vanilla" OOTM option buyers who do want the stock to make a big move by expiration should consider equities with elevated Schaeffer's Volatility Scorecard (SVS) readings. A stock with a high SVS is one that has exceeded options traders' volatility expectations in the past year.