This post will solely discuss options trading. What is Options Trading? I have discussed this in my previous posts. So this will be a step up of understanding options trading, where I will try to simplify the understanding of the terms used by traders out there. To be honest, I was confused when I came across the OTM and ITM abbreviations in the forums and blogs. To kill this curiosity, and stop making uneducated options bet, I put on my researcher hat and spent hours on google.
First, let’s understand the abbreviation:
ITM = In the Money
OTM = Out of the Money
What factor determines if an option contract is In the Money or Out of the Money?
Strike Price relative to the market value of an underlying stock.
ITM = Strike price has already been surpassed
OTM = Strike price has yet to reach
When evaluating ITM and OTM, a trader needs to understand if they are buying a call or a put option. Example, a stock price of £20;
A call option is purchased when a trader believes the stock price will rise. A call option with Strike Price of $19 will be In the Money because the strike price has already been surpassed. A call option with Strike Price of $22 will then be Out of the Money.
A put option is purchased when a trader believes the stock price will fall. A put option with Strike Price of $22 will be In the Money because the strike price has already been surpassed. A put option with Strike Price of $19 will then be Out of the Money.
To simplify, you have to understand the movement of a call option (price goes up) and a put option (price goes down), and then evaluate the options. The other way to tell is through the options premium.
Which option is more expensive, and why?
ITM = Higher because they have an intrinsic value of the underlying stock
OTM = Lower, as the option premium mainly contains a time value
Which one is more volatile towards the movement of underlying stock?
ITM = Price moves are relatively smaller
OTM = Price moves are relatively higher
Which one should I buy? In the Money or Out of the Money options?
Depending on the situation, but the main attraction of OTM options it that they are cheaper than ITM options. So, if you do not have a lot of capital, and you somehow predict the stocks are going up or down based on your hours of analyzing the chart, OTM options are then more desirable. Since OTM options are lower prices, a small change in their price can translate into substantial percent returns. On the flip side, you can also lose a lot if your bet is working against you.
I tried options trading recently, specifically OTM put option. The option price was 0.42 for the strike price of $5. I sold the contract for 0.66 when the stock was trading at $4.68. With a slight movement in stock price, I gained 0.24 (57%) of the initial investment. I highly suggest considering options trading as part of your trading strategy. The fundamentals of evaluating the underlying stock are still the same; fundamental analysis and technical chart analysis. The difference is, when you trade options, you do not own the stock, but only a contract that gives you the right to exercise at the expiration date.
In conclusion, one option is not better than another. Certain strategies call for ITM options, while others call for OTM options, and sometimes both. It just comes down to what works for you and your best strategy in question. I have to say that I feel more engaged with the charts and market movement in options trading. To a certain extent, I feel like its a newfound passion, and I would like to write more about options trading strategies.
Stay safe, and wash your hands!