In-the-Money or Out: Which Option Should You Buy?

Learn the pros and cons of trading in-the-money options versus out-of-the-money options

Nov 6, 2015 at 11:53 AM
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    Previously in this space, we discussed 3 Tips for Choosing the Right Option. To provide you with even more guidance, let's dive a little deeper into the differences between in-the-money and out-of-the-money options.

    In-the-Money Options

    Generally speaking, in-the-money options are viewed as the more "conservative" choice. These contracts have higher deltas than their out-of-the-money counterparts, which means they have a relatively greater chance of finishing in the money at expiration (and, by extension, in-the-money option holders have a lesser chance of incurring a total loss at expiration).

    Plus, in-the-money options carry intrinsic value in addition to time value. This means your purchased option is somewhat insulated from the effects of time decay, particularly as compared to out-of-the-money options. If you buy an in-the-money option and the stock remains completely flat through expiration, your contract will lose only its time value. At expiration, you can sell to close to capture the remaining intrinsic value, thereby dodging a complete loss on the trade. By contrast, if you'd purchased an out-of-the-money option and the stock refused to budge, your contract would have zero value remaining at expiration.

    The trade-off for these benefits is the higher cost of entry. All other factors being equal, in-the-money options will be more expensive to buy than out-of-the-money options, which means you'll have more capital tied up in the trade. Furthermore, while you may enjoy a relatively lower risk of swallowing a complete loss on the trade, the total amount you
    do risk will be greater than if you had purchased an out-of-the-money option.

    Out-of-the-Money Options

    On the other end of the spectrum, out-of-the-money contracts are considered to be the "aggressive" option for speculators. Since these options carry zero intrinsic value, they're more susceptible to the negative effects of time decay. In other words, unless the underlying stock makes a sufficiently sizable move in the right direction, you could incur a 100% loss at expiration.

    The good news is that your cost of entry is lower on an out-of-the-money option. So, while you risk losing the entire premium paid, at least it's a relatively lesser amount than if you had purchased an in-the-money option. Plus, you'll keep more of your available trading capital free to pursue other opportunities.

    While the reduced cost of entry carries with it the risk of a total loss, it also maximizes the positive effects of leverage. (Leverage refers to the fact that you can collect profits many times greater than your initial investment.) To be clear, all options offer the benefit of leverage -- but the less money you spend to initiate the trade, the more you stand to gain from this feature.

    Ultimately, the choice between in-the-money and out-of-the-money options comes down to a matter of preference. Each alternative offers pros and cons, so it's up to you to decide which features are most appealing.

    Plus, bear in mind that your choice may change with each trading opportunity. When you're forecasting a quick, drastic rise in the underlying stock, it might make more sense to buy out-of-the-money options. Conversely, if you anticipate a relatively modest rise over a longer time frame, you may prefer to trade in-the-money options.

     

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