Understanding In the Money and Out of the Money Options

ITM | OTM | ATM

Learn how to use covered calls to reduce the price of buying a call or to hedge for the downside potential of your existing stocks.

Option Basics | Price Action
Understanding How ITM and OTM Strike Points affect Option Price Behavior

Learn how to your choice of strike points will affect the behavior of your options contract

Intro

Option Basics

Understanding Intrinsic and Extrinsic Value of an Option

General

Extrinsic & Intrinsic Value 

  • All option strikes are made up of extrinsic value, intrinsic value, or a mixture of both.  

Extrinsic value is time & volatility value.  

  • This is affected by time until expiration, and implied volatility.  
  • All options have some level of extrinsic value as long as there is time left until the expiration of the option. 

Intrinsic value is real value at expiration 

  • If the strike allows the option owner to buy shares at a discount (calls), or sell shares at a higher price than the market (puts), the option will have intrinsic value and be considered to be in the money.  
  • Calls that are below the stock price have intrinsic value. Puts that are above the stock price have intrinsic value. 

Option Basics

In The Money

Implied volatility is derived using a theoretical pricing model and solving for volatility.

Since volatility is the only component of the pricing model that is estimated (based on historical volatility), it’s possible to calculate the current volatility estimate the options market maker is using.

In The Money 

 

  • In the money options are guaranteed to contain intrinsic value, but they usually have a degree of extrinsic value as well.  
  • For calls, this will be strikes that are below the stock price.  
  • For puts, this will be strikes that are above the stock price.  
  • ITM options that have the lowest extrinsic value can be found extremely deep ITM where the option trades more like long or short stock, or in options that are just about to expire. 

  

As option sellers, this is less than ideal. We want our options to expire OTM and worthless. ITM options will be worth at least their intrinsic value, which means if we want to close the position we may have to buy back our position for a higher price than what we sold it for, which will result in a loss. The opposite is true for someone who bought this option. 

Option Basics

Out of the Money?

 

Out of the Money 

 

  • Out of the money options are made up of purely extrinsic value.  
  • This means at expiration, they have no real worth.  
  • For calls, this will be strikes that are above the stock price.  
  • For puts, this will be strikes that are below the stock price. Why would someone exercise an option to buy shares of stock above the market price? Why would someone exercise an option to sell shares of stock below the market price? They wouldn’t! This is why these options are out of the money and will be worthless at expiration.  

  

As option sellers, this is fantastic. We would have sold an option prior to expiration for a certain value, and it is now expiring worthless. Remember that cash we collected upon trade entry? That can now be considered profit. The opposite is true for someone who bought this option. 

Option Basics

Implied Volatility

 

Why is this important?

Options are insurance contracts, and when the future of an asset becomes more uncertain, there is more demand for insurance on that asset. When applied to stocks, this means that a stock’s options will become more expensive as market participants become more uncertain about that stock’s performance in the future.

When the uncertainty related to a stock increases and the option prices are traded to higher prices, IV will increase. This is sometimes referred to as an “IV expansion.”

On the opposite side of IV expansion is “IV contraction.” This occurs when the fear and uncertainty related to a stock diminishes. As this happens, the stock’s options decrease in price which results in a decrease in IV.

In summary, IV is a standardized way to measure the prices of options from stock to stock without having to analyze the actual prices of the options.

Option Basics

What is Volatility Percentile?

IV Percentile weighs each day equally. In the IV Rank example, that earnings spike to 200% has a much heavier weight than the other days of normal IV, because it single handedly moved the range by 50%.  

  • IV percentile takes all the trading days for the past year, and measures the percentage of days IV was lower than the current level.  
  • This means that even if there was a spike in IV for one day, it wouldn’t change the calculation as drastically. That one data point would then just be excluded from the percentage of days IV was below the current level.  
  • This results in a much smoother calculation, but it is harder to calculate off hand than IV Rank. 

In any case, putting context around IV is important regardless of whether you use IV Rank or IV Percentile.  

 

  • Pick one that you’re comfortable with and sticking with it 

Option Basics

What is Volatility Rank?

  • IV Rank is a measurement from 0 to 100 that analyzes the high IV point & the low IV point over a certain time frame, and weighs current IV levels against those points.  
  • Look at a time frame of one year. 
  • For example, if an underlying had an IV low of 50% and an IV high of 150%, an IV rank of 50 would mean IV was currently at 100%.  
  • If that same underlying had an IV of 50% or lower, it would have an IV Rank of 0. If it had an IV of 150% or higher, it would have an IV Rank of 100.  
  • One of the concerns with IV Rank is that it doesn’t take outlier IV spikes or lulls into account. 
  • If an earnings announcement spikes IV to 200% just for one day, the new measurement for IV Rank would be from 50% to 200% for that same underlying.  
  • IV Percentile looks to smooth out this flaw and provide a more accurate reading.