There’s a lot of nuance to options investing, so much so that many advisors and investors largely stay away because it’s easy to feel overwhelmed and overwhelmed quite quickly. Derivatives are worth considering though, as they open up all new avenues for expressing opinions and taking positions on how stocks might behave in the future, what markets may or may not do. , or even provide some sort of insurance for the underlying assets.
If a stock is the lever an investor wants to pull, options are a lot like dials and switches that fine-tune the amount of action on that lever, when it’s pulled, or even prevent it from being too actuated by external forces. . They can give someone else the right to pull leverage if they want – for a price, of course – in the form of a covered call or set up stop gaps to prevent the lever is lowered too much in the form of a protective cover.
I wrote an article in May that breaks down covered calls and protection bets in more detail and why advisors might want to use them, which you can find here. Today the topic is all about the money, whether a contract is on the money, in the money or out of the money, and what that means for puts and calls.
Money is not a distant relation of the Loch Ness Monster, though trying to figure it out can sometimes feel like probing those depths that Nessie dwells: Money is how the strike price of an option is linked to the price of the underlying asset. It’s a way to easily know if an option would make money if exercised immediately or not. Selling an option and breaking even is considered to be at the money; everything else beyond that is either in-the-money or out-of-the-money, depending on the type of option and the strategy.
Calls and bets in the money
Options currently “in the money” mean that they can be exercised for profit and are therefore generally more expensive than their “out of the money” counterparts. That doesn’t mean they’re better than out-of-the-money options; which one is best applicable depends entirely on the strategy employed.
Call options grant the contract holder the right to buy a stock at an agreed strike price within the contract window, while a put option grants the holder the right to sell the stock at a price exercise period within the contract window. An in-the-money call means the strike price is lower than the current stock price, while an in-the-money put means the strike price is higher than the current price.
There’s a lot more to math that has to do with intrinsic value, time value, and extrinsic value, but that’s a deep dive for another day.
Out-of-the-money calls and sales
As you might guess, out of the money means the option’s position is the opposite of ITM, which means it’s not currently in a profitable position if it were to be exercised immediately, but it does not mean that an investor is simply throwing money away by investing in an OTM call or sale.
Example of ITM and OTM:
- A call option is purchased with a strike price of $105. It is ITM if the underlying asset has a price above $105 and OTM if the current price is below $105.
- A put option is purchased with a strike price of $100. It is ITM if the underlying asset is below $100 and OTM if the current underlying price is above $100.
Out-of-the-money traders use options for a wide range of reasons and strategies: part of their appeal may be that they are cheaper, which also results in greater volatility than their ITM counterparts, as small price movements can have larger impacts on returns. They can also be a means of hedging or provide a type of insurance for the investment. Purchasing an OTM protection put as a kind of insurance for the underlying asset held during market volatility can protect against large losses at a reduced cost.
A version of this article originally appeared here.
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