In, At & Out-of-the-Money
Stock Price/Strike Price Relationship
Being an options trader, you need to understand the relationship between the current Stock Price and the Strike Price you choose when buying or selling options. Unfortunately, the options game has it’s own jargon, so you will need to know certain terms to get a grasp of how to effectively navigate the sometimes rocky roads of options trading. When looking at an underlying stock and choosing a Strike Price, we must understand the relationship between the the two. There are 3 terms we must understand when choosing a strategy to use. The 3 terms are: In-the-Money (ITM), At-the-Money (ATM) and Out-of-the-Money (OTM). When explaining these 3 terms I will refer to the graphic below. The graphic is the Option Chain of the company Caterpillar with the ticker symbol CAT. At the time of writing this page the price of CAT was $71.15 per share. This graphic shows 9 Strike Prices (under the word STRIKE) along with the Option Symbol, Bid Price and Ask Price for each Strike Price.
Caterpillar Inc. (CAT)
Current Price $71.15 per Share
STRIKE – If you sell an option for someone to buy your shares of CAT, you pick a price at which you are will to sell your stock. That is the Strike Price. If you buy an option to buy shares of CAT, you pick a price you are willing to pay for the shares of CAT.
OPTION – This is the symbol of the option you pick to buy or sell shares of CAT. It shows the underlying stock which is Caterpillar (CAT). The date is the Expiration Date of your option. The number 69, 69.50, 70, 70.50 etc, is the Strike Price. The “C” means this is a Call Option. If it was a “P” it would mean you were buying or selling a Put Option
Bid – The price you are willing to sell and option for.
Ask – The price you are willing to buy an option for.
In-the-Money
A Call option is said to be In-the-Money if the price of the underlying stock is above the Strike Price of the option. A Put is In-the-Money if the price of the underlying stock is below the Strike Price. Right now let’s look at the Call Option. We will get into Puts in the Put section of the blog. You must read the “Intrinsic Value & Time Value” page along with this page because all In-the-Money options have Intrinsic Value.
In the graphic above, the Strike Prices of 69, 69.50, 70 & 70.50 are all In-the-Money. The stock price of CAT, $71.15 is above all of these Strike Prices. If we wanted to sell the $69 Call, we give someone the right to buy CAT for $69 on or before 12/4/15 (today’s date is 11/27/15) and we would receive a premium of $2.43. If we sold 10 contracts (1000 shares) we would receive $2430 and we would be obligated to deliver 1000 shares of CAT for $69 per share. If you sold this option you are hoping the price of CAT will drop below $69 so you don’t have to deliver the stock and keep your stock and keep the premium of $2430. If the stock drops below $69 the option buyer will not buy your stock for $69 when they can buy it on the open market for a lower price.
At-the-Money
At-the-Money means that the stock price is equal to the Strike Price. This term has both a strict definition and a loose, common usage. Theoretically, a $20 Call is At-the-Money only when the underlying stock is trading exactly at $20. If the stock is not trading exactly at $20, it is either In-the-Money or Out-or-the-Money. In practice, however, the $20 Call is designated as an At-the-Money Call when the stock price is closer to that Strike Price than to another Strike Price. When a stock is trading at $19.65 or $20.25, for example, it is common practice to refer to the $20 Call as the At-the-Money Call. If you look at the Caterpillar chart above, the stock price is at $71.15. In practice the $71 Call is At-the-Money but by definition, for the $71 Call to be At-the-Money CAT would have to be trading exactly at $71. For all intents and purposes, the $71 Call in yellow is At-the-Money.
Out-of-the-Money
A Call is said to be Out-of-the-Money if the price of the underlying stock is below the Strike Price of the option. A Put is Out-of-the-Money if the price of the underlying stock is above the Strike Price. As I said under In-the-Money, we will get into Puts in the Put section of the blog.
In the graphic above, the Strike Prices of 71.50, 72, 72.50 & 73 are all Out-of-the-Money. The stock price of CAT, $71.15 is below all of these Strike Prices. If we wanted to sell the $73 Call, we give someone the right to buy CAT for $73, on or before 12/4/15 and we would receive a premium of $.27. If we sold 10 contracts (1000 shares) we would receive $270 and we would be obligated to deliver 1000 shares of CAT for $72 per share. On the graphic, look at the difference in premium you received for the $69 Call ($2.43) and the $72 Call ($.27). It is very important to understand why such a gap in premiums between In-the-Money Calls and Out-of-the-Money Calls. You must read and understand the page “Intrinsic Value & Time Value.” All In-the-Money Calls have intrinsic value and Out-of-the-Money Calls do not.