Options Terminology: The Differences Between In, At And Out-Of-The-Money

To put it bluntly, some people are just downright afraid of the options market.

It’s too bad. Most believe the popular misconceptions and myths about options - among them, that they’re too complex, too confusing and too risky - or are just reluctant to the leave the relative comfort zone of stock investing.

It’s also a mistake. Many investors are missing out on some huge gains when all it really takes is a better understanding about the options landscape.

And that’s what I’m here for. Because while options terminology is different, it’s not really that complicated. So let’s run down a few of the basics…

Options Terminology 101

When it comes to option trading, you’ll find that there are two basic varieties - calls and puts.

• Calls: A call option is the right, but not the obligation, to buy a stock at a certain price. This is called the strike price. It’s the right, but not the obligation, because you’re only on the hook for the amount of money that you paid for the option. So right off the bat, you know you can never lose more than what you paid. The extra bonus is that the upside is unlimited. If you want to bet on a higher share price, you buy a call option.
• Puts: A put option works in the opposite way to a call. It’s the right, but not the obligation, to sell a stock at a certain price. So if you’re betting that IBM (IBM) will decline, you’d buy a put option. And again, the strike price that you choose is the level at which you have the right to sell IBM. However, you’re not obligated to do so.

Now let’s break it down a bit more by detailing the kind of options that you can buy and sell…

Three Terms You Need to Know When Trading Options

When we’re talking about options strike prices, there are three distinct terms you need to know, so that trades make sense.

• In-The-Money (ITM): This refers to options whose strike prices are below the current share price if you’re buying calls and above the share price if you’re buying puts.

For example, if IBM is trading at $120, you can buy a call option if you think it’s going higher, or a put option if you think it’s going lower.

If you bought an in-the-money put option, you’d choose a strike price above the current price. So an in-the-money put on IBM would be the $125 strike, giving you the right to sell at that price.

The reason for wanting to buy in-the-money options is simple: you’ll pay less net premium. This simply refers to the amount over and above what we call an option’s intrinsic value. In the examples above, the intrinsic value in each case is $5 ($120 minus $115 for the call, and $125 minus $120 for the put). The net premium would be any amount over the $5 intrinsic value.

• Out-Of-The-Money (OTM): This refers to options whose strike prices are above the current share price if you’re buying calls and below the current share price if you’re buying puts.

For example, if IBM is trading at $120, an out-of-the-money call option would be the $125 strike, while an out-of-the-money put option would be $115. You’d only make this OTM trade, though, if you think IBM is going to go well above or below your strike prices. The premium paid for both of these OTM options would have no intrinsic value at all, just value for time and risk.

• At-The-Money (ATM): This refers to options where the strike price is within a few cents of the current share price. So if IBM is trading at $120, an ATM call and an ATM put would have a strike price of $120.

Again, the amount of money you pay for each option (the premium) wouldn’t have any intrinsic value, but would be purely made up of risk and time premium instead. In addition, an at-the-money option would move dollar-for-dollar with the share price over time, but the premium you paid for time and risk would erode as time passed.

That wraps up this session. And as you can see, options terminology, while different, isn’t all that complex. Essentially, it’s largely based on how time and risk are priced. But the bottom line is that if you’re trading options - the fastest-growing area of investor interest today - you must know the lingo.

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