Pros and Cons of In- and Out-of-the-Money Options

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When selecting the right option to buy, a trader has several choices to make. One is whether to purchase an in-the-money ( ITM ) or out-of-the-money (OTM) option. While the goal for "vanilla" buyers is to have the option be in the money at expiration, the selected option depends on the amount the trader wants to spend and their risk tolerance, as well as their specific expectations for the underlying stock.

Understanding In the Money vs. Out of the Money

Before delving into the pros and cons of each, let's look at what it means to be in or out of the money. A call is ITM when the underlying stock is trading above the strike price. Conversely it is OTM when the underlying stock is trading below the strike price. Let's say a trader purchases a February 50 call on Stock XYZ. If the underlying shares are trading at $60, that call is ITM. If the stock is trading at $40, that call is OTM.

The same holds true for put options, but in reverse. So, if shares of XYZ are trading at $40, the February 50 put will be ITM. Conversely, a February 30 put would be OTM, if XYZ is trading at $40.

Why Buy ITM Options?

Like all trades, in-the-money options have risks and rewards. These options are generally viewed as the more "conservative" choice, as they have higher deltas -- the measure of how much an options price will change based on the movement of an underlying stock -- meaning there's a better chance for the option to be in-the-money at the time of expiration.

Buying ITM options also lessens the impact of time decay, as they carry both intrinsic and time value. This means that even the if underlying value of a stock remains static through a contract's expiration, the trader can sell to close an ITM option and still collect the remaining intrinsic value, thus avoiding a total loss on the trade.

In-the-money contracts, however, are more expensive to enter than their out-of-the-money counterparts. And while the payoffs on an in-the-money trade can be high, the trader could ultimately suffer a bigger loss if the underlying stock moves the wrong way.

Pros and Cons of OTM Options

While out-of-the-money options are typically viewed as the more "aggressive" of the two, there are potential upsides to purchasing these types of contracts. For one, the cost to buy an OTM option is lower than the cost to buy an ITM option. This is because at the time of the purchase, OTM contracts have no intrinsic value. So, while the potential for a 100% loss is greater, the cost (and risk) to enter the trade is lower.

In the same vein, buying an out-of-the-money contract can give the trader serious leverage if the underlying stock moves in his favor, since the initial cost is relatively low. While all options offer the benefit of leverage, the less money you spend, the more you stand to gain from this feature.

On the other hand, out-of-the-money contracts have lower deltas, so the chances of the trade expiring in the money is slimmer. These contracts are more susceptible to time decay, too. This means that if the underlying stock does not see a dramatic swing in the trader's favor, a 100% loss is likely to occur.

Which Option Should I Buy?

In conclusion, the choice between in-the-money and out-of-the-money options comes down to a matter of preference. Each alternative offers pros and cons, so it's up to you to decide which features are most appealing.

Plus, bear in mind that your choice may change with each trading opportunity. When you're forecasting a quick, drastic rise in the underlying stock, it might make more sense to buy out-of-the-money options. Conversely, if you anticipate a relatively modest rise over a longer time frame, you may prefer to trade in-the-money options.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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