Introduction To Options Intrinsic Value

“Ian, I’ve noticed you use the symbols OTM, ATM, and ITM with options trades. Being a beginner options trader, can you educate me on what these mean?”

That was a comment-question I received Monday morning. And because many of you have asked similar questions, we’re more than happy to talk about it today, as part of our ongoing educational series.

We’ve already introduced the basics of options investing, the basics of long-term investing with LEAPS, and even the basics of ETF Options Investing.

Today, we want to dive into some commonly used terminology you may come across, including the usage of “In the Money” or ITM, “Out of the Money” or OTM, and “At the Money” or ATM. We’ll even get into time decay issues and even the “Greeks.”

The Intrinsic Value of Options

Quite often, you’ll hear the above OTM, ITM, and ATM terms when we talk about options investing. These terms refer to the option’s Intrinsic Value.

The strike price of an option, as compared to current underlying stock price, determines the option’s intrinsic value, and therefore determines if the stock is OTM and ITM. If a call option’s strike price is less than the current underlying stock price, the option is in the money.

Intrinsic value represents how much the option is worth if you exercise it right now. You can find intrinsic value by comparing the strike price to the market price of the underlying security. An option with intrinsic value is in-the-money. It’s current price (CP) minus strike price (X).

If the stock’s current price is greater than the option strike price, the remainder is the intrinsic value. In the case of a call, if the price of the underlying stock is above the strike price, the call is in-the-money. If ABC is trading at $40, and you have a $35 call, for example, you have an in the money call.

If a call strike price is higher than the underlying stock price, the call is out of the money because there’s an absence of Intrinsic Value.

Confused? Don’t be.

Here it is broken down further…

Call Options

In the Money describes a strike price that is less than the underlying stock price.

At the Money describes a strike price that is the same as underlying stock price.

Out of the Money describes a strike price that is greater than underlying stock price.

Put Options

In the Money describes a strike price that is greater than the underlying stock price.

At the Money describes a strike price that is the same as the underlying stock price.

Out of the Money describes a strike price that is less than the underlying stock price.

The Greeks and Time Decay

Time decay issues are an important part of options trading, and must be taken into consideration when deciding when and where to exit an options trade. You see, as an option move closer to its expiration date, the chances of you turning a profit decreases.

You wouldn’t want to buy a lot of options on a play with less than 30 days to expiration, unless you had strong confidence that Stock A will definitely be in the money - or you may be one of those people that really likes to gamble.

Time decay is also typically represented by a Greek term known as Theta, or how fast the option will lose value as it approaches expiration.

Theta and other Options Greeks will help you estimate your risk, and allow you to answer specific questions about an option contract’s expected price moves.

Others include:

· Delta, or how will the value of my option change and underlying stock price changes?

· Vega, or what affect will a change in stock volatility have on option value?

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