Options Trading System

In the money and out of the money options

The premium paid for options could be sum of the intrinsic and time values as well as it could be based on the time value only or intrinsic value only (as a rule at the expiration). For instance if the QQQ stock is traded at $45 then the premium for $44 QQQ call options represent the time value of these options while the premium for $46 QQQ call options is based on the intrinsic and time value.

Options, premium of which made up purely of time value are called "out of the money options". Options, premium of which is based on the intrinsic value or on combination of intrinsic and time value called "in the money options". The table below show in the money and out of the money QQQ options for situation when QQQ stock is traded at $45.10 per share for instance.

Table #1: Example of in and out of the money QQQ options
when QQQ stock is traded at $45.10

From the example above you may see that

• Call options with the strike price above the current market price of the underlying security are in the money options;
• Call options with the strike price below the current market price of the underlying security are out of the money options;
• Put options with the strike price below the current market price of the underlying security are in the money options;
• Put options with the strike price above the current market price of the underlying security are out of the money options;
• At the money options are options with a strike price equal to the market price of the underlying security. traded exactly at the strike price. For instance if QQQ stock is traded exactly at $45 then $45 QQQ calls and puts are at the money options;

Understanding when the options are in or out the money are critical in defining risk and building a options trading strategy. For instance, there is a small chance that you loose everything by buying $40 QQQ call options when the QQQ stock is traded at $45 and only 7 days left until expiration. In order to lose 100% of the invested capital the QQQ stock has to crash below $40 from $45 in 7 days (more then 10% in 7 days). At the same time if you are buying $50 QQQ call options when the QQQ stock is traded at $45 and only 7 days left until expiration there is very high risk that your calls will expire worthless and will lose 100% of invested money (it has to climb up for more than 10% in 7 days).

As you see, depending how far it is until options expiration and on are you options buyer or options seller you may prefer to select either in the money or out of the money options for your trading. At the same time depending on your personal risk tolerance you may select different strikes.