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Options Terminology: The Differences Between In, At and Out-of-the-Money
by Karim Rahemtulla, Options Expert
Tuesday, November 17, 2009: Issue #1139
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 (NYSE: 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.
Good investing,
Karim Rahemtulla
Editor’s Note: What would you rather do – navigate the options world by yourself, or leave the job to a 20-year market veteran like Karim Rahemtulla, who boasts a highly impressive track record of notching gains from this misunderstood market?
The horror stories you hear about investors losing their shirts in the options market are often because they just don’t understand the basics and get in too deep. But with Karim’s 400 Report service, you’ll get a steady stream of specific options recommendations (what to buy, when to buy, when to sell) that takes the guesswork out and reduces your risk of going it alone. Check it out here.
- The Strangle Options Play: When & How To Use This Trading Strategy
- Deep-in-the-Money Investing: Missed the Market’s Run? Here’s a Second Chance…
- Options Investing: Readers’ Questions Answered
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3 Responses to “Options Terminology: The Differences Between In, At and Out-of-the-Money”
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Karim Rahemtulla is one of the country’s foremost specialists in options trading and Investment Director of Mt. Vernon Research, as well as the founder and editor of Strategic Income, The 400 Report and Investment U. 
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November 17th, 2009 at 8:08 pm
Karim,
First, thank you for explaining , Calls, Puts, etc — even this senior is now starting to understand.
However, is it true that before you start trading in options you have to deposit a specific ammount of cash into your account with a broker?
If so, how much would you recommend?
And second question, I’ll like to ask – Did you ever recommend to buy or sell an option and your recommendation was wrong? God, I hope so, because reading all the literature and testimonials indicate everythibg was a winner, never any losers — I know life is good, but not that good, is it??
Gord from Alpharetta, GA
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Investment U Reply:
November 23rd, 2009 at 10:39 am
Gord,
No problem. I’m glad my explanation stuck for you. As for how much cash you should keep in your options account, that depends on how much you’re comfortable and capable of risking. As a general rule of thumb, you should have at least the amount of money needed to cover a trade in your account before you commit to the trade.
And you’re right to question my track record. Nobody ever gets it 100% of the time, and you should be automatically suspicious of anybody who claims otherwise. My track record over the past several years has remained around 70%, even during the worst of the financial crisis, something I’m very proud about.
Thank you for your comment,
Karim
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November 22nd, 2009 at 11:19 am
on purchasing (or writing) options, do you think it wise to place a stop limit/loss limit order at about 10% below purchase price,or are options better for (position-sizing loss limit plays) than specific stop limits like for stocks? and then replace that with a trailing stop if the position moves in your favor and you can thus then protect your profit? I am a 400 member and appreciate your expertise. My general rule with any investment is: if I can set up a stop loss order around 7-10% below purchase price, it is wise to do just that (unless you want to swing for the fences in a volatile stock).
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