When a trader decides on a to-buy option there are several choices to make. It is whether to buy ITM [in-the-money] or OTM [out-of-the-money] option. In general, the option buyer aims to choose ITM at expiration. However, the chosen option will depend on the options buyers’ affordability, risk tolerance, and expectations from the underlying asset.
Get familiar with ITM versus OTM
An in-the-money option call is chosen when the underlying asset is trading above strike rate. Alternatively, an out-of-the-money option call is selected when the underlying asset is trading below the strike rate. For example, a trader purchases a 60 call on ABPL shares. If the underlying stock is traded at $70, the call is ITM and if it is at $50, the call is OTM. In the put options, the condition is reversed. If the underlying stock is traded at March $70, the call is OTM and if it is at $50, the call is ITM.
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What is the ITM option?
ITM options are perceived as a conservative choice because they have high chances to stay in-the-money during expiration. ITM options lessen the time decay impact as they carry time and intrinsic value. It means even if the underlying stock value stays static through the expiration of the contract, the trader can sell the ITM option to close the position. The trader gets some of the intrinsic value, thus he does not suffer a total loss.
ITM contracts are expensive than OTM because the payoff is high. However, if the underlying asset price moves against, the trader can suffer a huge loss.
What is the OTM option?
The out-of-the-money option is perceived as an aggressive approach. There are potential perks of buying OTM contracts. The OTM buying cost is lower than the ITM contract because when OTM is purchased it has no intrinsic value. Therefore, the potential to lose 100% is higher than the cost of entering a trade.
Buying OTM options offers the trader, great leverage if the price movement is in the right direction as the initial entrance cost is extremely low. Options trading offer leverage benefits, which means you need to spend less money and earn more.
Alternatively, OTM contracts have low chances of trade expiring in-the-money. OTM options are vulnerable to time decay, which means if the underlying instrument does not swing in the trader’s favor there is a likelihood of 100% loss occurrence.
Which is right – ITM or OTM contracts?
In options trading, the ITM versus OTM involves the position of strike price relative to underlying assets market value called its moneyness. ITM contracts have intrinsic value, so they are highly-priced than OTM options.
OTM options are more preferable as the traders need small capital. Certain strategies need traders to choose ITM contracts, while a few require OTM options, and sometimes they need to choose both. Both have their advantages and disadvantages. The better contract is the one that works best for the chosen trade strategy.
Remember, your choice will change with every trading opportunity. When you assume a drastic and quick rise, it is sensible to buy an OTM contract. If you predict a modest rise across a long timeframe then you can choose the ITM option. So, the choice depends on the existing situation!